If you’re a stock investor, it’s unlikely you’ve never heard of Warren Buffett, the ninth richest man in the world who made his fortune investing in the stock markets. And Buffett understands that stock picking isn’t everyone’s cup of tea. In fact, he says, most average long-term investors would benefit from a much simpler strategy: investing in low-cost index funds or exchange-traded funds (ETFs).
“My usual recommendation has been a low cost S&P 500 index fund. I just think the best thing to do is buy 90% of the S&P 500 index fund,” Warren Buffett said in his annual letter to Berkshire Hathaway shareholders. 2016.
So, let’s understand what exactly ETFs are and how you can invest in them.
An ETF is a basket of securities that trade on a stock exchange like a stock. Thus, the price of an ETF fluctuates throughout the trading day as stocks are bought and sold in the market. In terms of ownership style, it works alongside a mutual fund, meaning you can own a percentage of a given portfolio that is put together by a professional manager. ETFs are an attractive option for investors with limited expertise in the stock market.
Depending on their management styles, ETFs can be actively or passively managed. Actively managed ETFs are operated by a portfolio manager who is more involved in buying and selling company stocks and changing holdings within the fund. Passively managed ETFs operate according to popular market benchmarks like Sensex, Nifty, etc. It is therefore not surprising that actively managed ETFs have a higher expense ratio than passively managed ETFs.
In addition, there are ETFs on stocks, gold, debt and currencies depending on the type of investment.
There are three parameters you can look at when investing in ETFs: expense ratio, tracking error, and liquidity.
The expense ratio determines how much of your investment in a fund will be deducted annually as an expense. Ideally, investors should opt for funds with a low expense ratio.
The tracking error is the discrepancy between the return of the index and the return of the ETF. This may impact your returns.
Liquidity is important in ETFs; if an ETF is not very liquid, you may not be able to find buyers when it comes time to sell them.