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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.