Should You Invest in ETFs?

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An Exchange Traded Fund (ETF) is a marketable security that tracks an index, commodity, bonds, or a basket of assets like an index fund. However, unlike index funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual funds, making them an attractive alternative for individual investors. Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated once at the end of every day like a mutual fund does.

By owning an ETF, investors get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. There are no minimum deposit requirements too. Another advantage is that the expense ratio for most ETFs is lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order. Does this mean you should increase your exposure towards ETF?

If Mr. Buffett is to be believed than the answer to the same is in affirmative. Recently, Buffett wrote about index funds in his annual letter to Berkshire shareholders which stunned the investment community. Here's the quote, from page 20 of his most recent annual letter to Berkshire shareholders. After all of his Berkshire shares are distributed to charity, Buffett says, take the cash, and just buy index funds:

"My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors - whether pension funds, institutions or individuals - who employ high-fee managers."

However, going by historical returns the performances of majority of ETFs have not been impressive. Reportedly, MSCI India which is a popular ETF has underperformed BSE100 as well as the Nifty over the past five years.

Further, decision to include a stock in the index fund also depends on its Foreign Inclusion Factor (FIF). To put it simply, if the stock has almost exhausted its foreign investment limit then the same won't make it to the ETF. Hence, fundamentally strong stocks such as HDFC Bank won't make it to the ETF portfolio. This acts as a big drawback.

Further, ETF usually advertises the amount and date on which it is going to buy a stock. Supposedly, ETF decides to include Maruti Suzuki in its portfolio, the fund will give an intimation of the amount and the acquisition date on which it will purchase the shares. This usually drives the stock prices northwards as a well-known ETF is buying the stock. By the acquisition date the stock has already surged upwards and ultimately the fund has to buy the stock at expensive levels. It appears that there are many drawbacks in investing in the exchange traded funds.

Investing in any quality stock is ultimately a matter of price and earnings. If earnings growth is healthy and the price the stock is reasonable in relation to earnings, only then does it make sense to invest in the stock. Otherwise, it's best to stay away, however good the company may be. This basic fact is missed out by the ETFs, which in turn is the prime reason for their underperformance.

Whereas, we at Equitymaster believe in the bottom-up approach in investing. This approach focuses more on stock specific fundamentals and valuations. Hence, makes the portfolio returns immune from economic and market cycles in the long term.

For information on how to pick stocks that have the potential to deliver big returns, download our special report now!

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