Volume IconWhat are exchange traded funds (ETFs)? - Decoded

What are ETFs: Warren Buffett understands stock picking is not everyone's cup of tea. He says most average long-term investors will benefit from low-cost index funds or ETFs. Here's an explainer

ImageSaloni Goel New Delhi

If you are a market investor, it’s unlikely that you wouldn’t have heard of Warren Buffett, the ninth-richest man in the world who has made a fortune by investing in stock markets. And Buffett understands that stock picking is not everyone's cup of tea. In fact, according to him, most average long-term investors would benefit from a much simpler strategy: investing in low-cost index funds or exchange-traded funds (ETFs).

"My regular recommendation has been a low-cost S&P 500 index fund. I just think that the best thing to do is buy 90% in S&P 500 index fund," said Warren Buffett in his 2016 Berkshire Hathaway annual shareholder letter.

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So, let's understand what exactly are ETFs and how you can invest in them.

An ETF is a basket of securities that trades on an exchange just like a stock. So, the price of an ETF fluctuates throughout the trading day as the shares are bought and sold on the market. In terms of ownership style, it runs parallel to a mutual fund, meaning you can own a percentage of a given portfolio put together by a professional manager. ETFs are an appealing option for investors with limited expertise in the stock market.

Based 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 shares of companies and changing the holdings within the fund. Passively managed ETFs perform according to the popular market benchmarks, like the Sensex, Nifty etc. It’s no surprise then that actively managed ETFs will have a higher expense ratio than passively managed ones.

Further, there are equity, gold, debt and currency ETFs based on the type of investments.

There are three parameters that you can look at while investing in ETFs: Expense ratio, Tracking error, and Liquidity.

Expense ratio determines how much of your investment in a fund will be deducted annually as fees. Ideally, investors should go for funds with a low expense ratio.

Tracking error is the divergence between index return and the ETF return. It can impact your returns.

Liquidity is important in ETFs; if an ETF is not very liquid, you may not find buyers when you want to sell them.

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First Published: Oct 04 2021 | 11:24 AM IST

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