Buffett's Words on ETFs Ring True

The words of investment guru Warren Buffett are ringing in the ears of ETF critics, questioning the role of many new exchange-traded fund products. Since Buffett, helmsman of Berkshire Hathaway(BRK.A), suggested that traditional low-cost index mutual funds might be more appropriate for portfolios than ETFs, a host of new exchange-traded products have hit the market with mixed results.

While ETFs have introduced transparency and liquidity to the fund business while adding a wide range of low-cost products, problems have emerged as average investors embrace the funds. Overtrading, illiquidity and inappropriate funds have plagued shareholders, raising Buffett's 2007 concerns once again as investors leave index mutual funds for the open market.

Shortly after Buffett's ETF comments, Elements launched a Buffett-esque ETF that has aptly demonstrated setbacks in the ETF industry. Elements' Morningstar Wide Moat Focus ETN(WMW) lost just 20.31% in 2008 but failed to attract investors to the product.

WMW's three-month average daily trading volume is just 5,500 shares, and the peaks and troughs caused by what little trading the fund has aroused are witness to the illiquidity of this product. A second concern with WMW is its status as an ETN -- a fund comprised of debt, rather than equity -- subject to the credit risk of an issuer in a bad time for credit markets.

Issues such as credit risk and illiquidity would likely be concerns of Buffett, who asserted that index mutual funds are preferable because investors would not be tempted to trade frequently. This constant buying and selling that has turned many regular investors into frustrated traders is particularly dangerous in illiquid funds for which there is little market interest.