What Warren Buffett Thinks About ETFs

Exchange-traded funds have exploded in popularity in recent years, ushering in exponential growth in assets, and adding hundreds of new ETFs to the market. ETFs were touted for their multiple advantages over traditional index mutual funds, including the flexibility to trade throughout the day, the ability to sell short and buy on margin, and the allure of greater tax efficiencies and generally lower fees. Thus, the debate began over whether ETFs might supplant traditional index mutual funds.

Opinions have come from both sides -- but one voice often carries extra weight. After all, he's probably the most famous investor in the world.

Buffett weighs in
In 2007, Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) chairman Warren Buffett suggested that traditional index mutual funds were more appropriate for most investors, in part because they present less pressure to engage in frequent trading. Buffett feels that with ETFs, investors may face pressure from their brokers, who stand to make money from any trading activity.

Anytime an investment guru makes a pronouncement, I always hesitate a bit. I think the worst thing you can do in life, and in investing, is to assume that the superstars always get it right. Just because he's Warren Buffett doesn't mean everyone should blindly nod and agree with him. Fools always need to put their own critical-thinking hats on before coming to their own conclusions.

However, I think in this case, Buffett is absolutely right.

The pitfalls of ETFs
I have no inherent problem with ETFs -- they were no doubt created in response to an unfulfilled market demand. On their own merits, I think they're terrific investments that can provide investors with access to segments of the market that are essential to success. For instance, a broad-based ETF like Vanguard Total Stock Market ETF doesn't just give you exposure to big-cap stalwarts such as General Electric (NYSE: GE  ) , ExxonMobil (NYSE: XOM  ) , and AT&T (NYSE: T  ) . It also owns smaller companies like priceline.com (Nasdaq: PCLN  ) and Pride International (NYSE: PDE  ) that add diversification and can improve returns. That strategy makes sense for many investors.

However, the problem arises with how investors actually use some ETFs. Just because these funds can be traded at every minute of the trading day doesn't mean you should actually do so. If buying an ETF leads you to try to time the market, you're fighting a losing battle, my friend. It's been proved many times that individual investors are poor market timers, with a far greater likelihood of making wrong calls than right ones.

Theory vs. real life
But what about those other purported advantages of ETFs: tax efficiency and lower fees? Shouldn't those translate into a slight performance advantage over traditional index funds? Some 2007 research from Morningstar and The Wall Street Journal showed that when it came to real-life returns, ETFs actually performed worse than index mutual funds.

Morningstar looked at several of the biggest and most popular index funds and ETFs in several different categories. Almost across the board, the biggest, lowest-cost index funds, such as those offered by Fidelity and Vanguard, outperformed the corresponding ETFs. In fact, the index funds outperformed in 34 of the 40 time periods studied, including all of the one-year, three-year, and 10-year after-tax categories. And this study didn't even take into consideration the commissions ETF investors incurred each time they traded their shares. Frequent traders may very likely be digging themselves into an even deeper hole, compared with holders of traditional index funds.

The bottom line
Does this mean that ETFs are not all they're cracked up to be? Well, yes and no. Exchange-traded funds can absolutely serve a purpose in the portfolios of many investors. And given their low costs, they can outperform many traditional actively managed mutual funds.

But in comparison with index mutual funds, ETFs don't have any real cost advantage. Even though some ETFs have narrowed the performance gap since the 2007 study discussed above, they still force investors to incur additional trading costs, which can add up over time.

If there is a strategic reason for you to own an ETF, by all means do so. But don't assume that just because ETFs are all the rage right now, you're missing out by not owning any. After all, if Warren Buffett thinks that most investors would be better served by sticking to low-fee index mutual funds, maybe we should listen.

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This article, written by Amanda Kish, was originally published on May 18, 2007. It has been updated by Dan Caplinger, who owns shares of Berkshire Hathaway and General Electric. Berkshire Hathaway and Priceline.com are Motley Fool Stock Advisor selections. The Fool owns shares of Berkshire Hathaway, which is also a Motley Fool Inside Value selection. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (17)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 04, 2009, at 8:13 PM, rufianno wrote:

    WARREN BUFFET does not know what he is talking about.WHEN HE WRITES A BOOK HIMSELF I WILL LISTEN.

  • Report this Comment On December 04, 2009, at 8:16 PM, rufianno wrote:

    Warren buffet does not know what he is talking about.he has not write a book himself.then i will listen to him

  • Report this Comment On December 05, 2009, at 3:45 AM, ldanby1952 wrote:

    Are you kidding???

  • Report this Comment On December 07, 2009, at 7:50 AM, kstoltz wrote:

    There are two classes of investors in Buffett's view: Those willing to do the work to buy individual stocks, and those who need to find the simplest investment possible and get the heck out of the way. It's not that ETFs are poor vehicles for investing...they're not.

  • Report this Comment On December 08, 2009, at 10:27 PM, vens wrote:

    Seems hard to believe that ETFs with a lower expense ratio could do worse than corrsponding mutual funds!

    Motley Fool has posted no link to this alleged "study" so it may be a mistake or other fictious finding.

    Anyhow, why 2007? What about a comparison in 2009?

    Some incredulity from yours truly.

  • Report this Comment On December 08, 2009, at 10:43 PM, AlexOppenheim wrote:

    First of all, you are overextending what Warren Buffett said to fit your opinion. Warren has ALSO admitted that he has done many "quick sells" in his early career, AND that these were not a bad thing, but a different "preference" towards investing. Of course, Warren as well as any other investor would agree that it is better long term to invest in index mutual funds and individual stocks, but you are comparing apples and oranges. Furthermore your are grossly underestimating the advantages. They are not require to invest cash, hold reserves, have lower ERs and maintenance costs/fees. Contrary to what the article claims, over the long term, their fractional costs do aggregate and multiply downward in resulting savings compared with mutuals. Your "problem with ETFs" is not a problem with ETFs at all. Your problem is that ETFs are not idiot proof enough. The loss from trading reflects uninformed and inexperienced investors dabbling in complex active trading and their losses earned rightfully from their stupidity. It is possible to invest long term in ETFs and it is also possible to trade for profit. Risk results from stupidity. But there are a plethora of stock and mutual fascists (flamboyant and moneyed brokers and fund managers) who would greatly benefit by your immediate divestment from any investment that does not pay them them the commission or dividends they are looking for. However if you have a JOB like most people and don't have the time or knowledge required to study individual and industry metrics, you will certainly do better in a long term held index ETF than you would do with randomly picking stocks, or worse; letting a stock broker "play" with your money. He or she has a security license to kill.

  • Report this Comment On December 08, 2009, at 10:44 PM, AlexOppenheim wrote:

    First of all, you are overextending what Warren Buffett said to fit your opinion. Warren has ALSO admitted that he has done many "quick sells" in his early career, AND that these were not a bad thing, but a different "preference" towards investing. Of course, Warren as well as any other investor would agree that it is better long term to invest in index mutual funds and individual stocks, but you are comparing apples and oranges. Furthermore your are grossly underestimating the advantages. They are not require to invest cash, hold reserves, have lower ERs and maintenance costs/fees. Contrary to what the article claims, over the long term, their fractional costs do aggregate and multiply downward in resulting savings compared with mutuals. Your "problem with ETFs" is not a problem with ETFs at all. Your problem is that ETFs are not idiot proof enough. The loss from trading reflects uninformed and inexperienced investors dabbling in complex active trading and their losses earned rightfully from their stupidity. It is possible to invest long term in ETFs and it is also possible to trade for profit. Risk results from stupidity. But there are a plethora of stock and mutual fascists (flamboyant and moneyed brokers and fund managers) who would greatly benefit by your immediate divestment from any investment that does not pay them them the commission or dividends they are looking for. However if you have a JOB like most people and don't have the time or knowledge required to study individual and industry metrics, you will certainly do better in a long term held index ETF than you would do with randomly picking stocks, or worse; letting a stock broker "play" with your money. He or she has a security license to kill.

  • Report this Comment On December 11, 2009, at 2:21 PM, AA501 wrote:

    Does the article compare INDEXED mutual funds with INDEXED EFTs?

    Or, are you comparing apples with oranges?

    I don't see how an indexed mutual fund could possibly outperform an indexed EFT, IF both are indexed to the same market.

    By definition, two indexes should track almost exactly the same, minus expenses.

    Since an indexed mutual fund has higher expenses than an indexed EFT, it will by definition perform below the equivalent ETF.

    These articles do a great injustice to people who are trying to learn, as they confuse people and make investing more difficult than it needs to be.

    FACT CHECK:

    1. An ETF will outperform a Mutual Fund if both are indexed to the same market using the same indexing method

    2. Most investors don't have the discipline to hold an EFT for the same duration as a Mutual Fund

    3. Thus, most investors would be better served by the Mutual Fund

    The facts are that most investors are speculators. This is because most people are smart, but have jobs that consume most of their day. Thus, they don't waste their time reading financial reports that are most BS (sorry, but can you seriously believe the crap that comes out in an annual report!). Thus, they take educated guesses on what stocks may go up in the future.

    So, it is reasonable to say that an intelligent person who knows him/herself will choose between an indexed EFT or inded mutual fund based on their ability to hold steady during stormy waters.

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