Young & Invested: What I think is wrong with ETFs
Looking back at some of the biggest mistakes I’ve made as an ETF investor.
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 56
I talk a lot about ETFs on here.
I’ve become so evangelical that the reasonable person might assume I’m getting kickbacks of some sort. I’m not, although at this rate, I’m expecting a call from a recruiter about whether I’ve considered a career in sales. The truth is I’m a lazy investor. If there’s a way to avoid monitoring 20 individual stocks and still underperforming the market, I’m taking it (and apparently also writing about it every week).
But I can acknowledge they’re not without faults (often at the hands of their operator). Despite being marketed as a simple, safe way to build wealth, there are certainly ways to mess it up. And in the spirit of public service (and self‑humiliation), I think it’s important to talk about some of the biggest mistakes I made when first building my portfolio.
A losing game
The summer going into 2021 had a distinct cinematic quality to it. Western Australia was basking in the smug serenity of a COVID‑less bubble, I’d just downloaded TikTok for the first time and most importantly, ARKK Innovation ETF was hitting all-time highs almost daily. The thematic ETF caught many eyes after posting over 150% return in 2020 with no signs of stopping. For a lot of investors (myself included) it felt like a once in a generation opportunity to capitalise on the cultural movement to tech.
However, the narrative eventually shifted due to the concentration in unprofitable growth stocks amid rising interest rates. By late 2021, performance had deteriorated with many investors who piled in near the top left with significant losses. This isn’t a sob story about a bad pick going bust. In fact, it represents a broader structural lesson on thematic ETFs that I think is worth passing on.
Thematic funds can be loosely defined as those that focus on long term trends or themes, representing a niche in the market and selecting holdings based on companies likely to benefit from this trend. The pitch is that they’re a way to position a portfolio to outperform traditional indices without the risk of having to pick individual stocks. The problem is that this notion rarely eventuates.
Further to this, a Morningstar study found that in the three-year period ending November 30, 2024, the average dollar invested in thematic funds lost around 7% per year. To put that in perspective, the S&P 500 gained more than 11% per year over that span. Investors also face dismal odds when picking a thematic fund that doesn’t fail over the long term.
The challenge with thematic ETFs is that they tend to attract investors only after the story has already played out. By the time a theme hits the headlines or tops a performance table, most of the gains have been realised. These products are also highly concentrated in narrow, often speculative pockets of the market, which makes them far more volatile than the marketing suggests.
Ultimately, I’ve come to realise there’s a cognitive dissonance involved in thematic investing. Most retail investors are well aware that they can’t consistently beat the market over the long term. But for some reason, the voice in our head convinces us that it’ll be different this time.
I’m not suggesting avoiding thematic investing altogether, although it’s important to recognise how futile these cycles are. Last year it was uranium and precious metals, the year before it was crypto ETFs, and before that it was energy. There’s always a new narrative that feels more compelling than the last. The only thing that remains remarkably consistent is the the data – most thematic funds don’t beat global equities over longer periods.
The cost of sophistication
I first started investing in ETFs around 19. Among many things, the associated fees were something I paid little attention to. On the rare occasion I did spare a glance, I wasn’t sweating over the difference between a fee of 0.5% vs 1%. My logic was along the lines if I’m paying more, I must be getting more. Some kind of upper hand that justified the price tag. And I don’t think I’m alone in this.
The financial industry has long projected the image of delivering superior returns through complex, exclusive strategies, which of course, are associated with higher costs. Outperformance might be the result for a small portion of institutions on a short-term basis. But most can’t do it consistently.
Nevertheless, this portrayal of success has worked incredibly well and forms part of why some investors find the seemingly sophisticated, high-cost options more appealing. You can also argue that we’ve simply been socialised to assume that expensive = better. And which investor doesn’t want these ‘better’ outcomes?
Buffett explains this phenomenon incredibly well in his 2016 Letter to Shareholders:
“My regular recommendation has been a low-cost S&P 500 index fund… I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager. That professional, however, faces a problem. Can you imagine an investment manager telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these managers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.
The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive. In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” - wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.”
Whilst Buffett pointedly refers to the behaviour of the elites who seek out high-fee products because they feel entitled to something exclusive, the psychology is very much universal. We’re conditioned to believe that expensive things are superior, and the financial industry is very good at reinforcing that belief.
What might feel like a negligible cost difference in the grand scheme of things can add up quickly. For example, if an investor is charged a 0.1% p.a. management fee vs. 1%, the extra 0.90% compounds over time, costing thousands in lost returns. Below is an example of $100k put into two funds, both returning 7% p.a. (before fees) over a 10-year period. The difference results in the more costly fund returning almost $16k less due to erosion from fees.
Before becoming privy to the link between lower ETF fees and better outcomes, I often considered high fees as a signal of higher skill and by extension, higher returns. But it has been well documented that this is certainly not the case over the long term.
Besides the clear difference in success rates, higher fund fees are also a factor in the erosion of returns over time. If we think about it logically, cheaper funds have a better chance of outperforming their more expensive peers due to the lower fee hurdle. I learnt this the hard way after most of the more expensive funds I’d chosen ending up lagging behind the low‑cost, broad funds they were supposed to outperform.
Now when I screen for new ETFs, I tend to instinctively cull those that charge more than 0.5% per year (although I can acknowledge it’s not entirely logical to disqualify investments on an arbitrary percentage alone). I’ve come to realise that lower-fee products stack the probability of reaching my desired outcome in my favour. A lower barrier leaves less room for disappointment, a smaller hurdle for performance and fewer assumptions about manager brilliance that may or may not hold up over time.
High‑fee products can certainly outperform but they demand a level of conviction, scrutiny and ongoing monitoring that most ETF investors aren’t equipped for, nor desire to do. Buffett’s thesis on why select investors are attracted to more expensive products makes an intriguing comment on how the allure goes beyond performance but also reflects a desire to feel like we have the upper hand over others.
Portfolio diworsification
Successful fund providers are great at marketing. As investors we’re constantly bombarded with new products that we simply cannot afford to miss in our portfolio. This was a trap I fell for early in my investing journey.
After almost every asset class fell into turmoil in 2022, the idea of adding additional ETFs to ‘round out’ my portfolio in the name of diversification felt like the most sensible thing to do. What resulted was a needlessly complex stockpile of ETFs that was attempting to hedge against every imaginable risk.
There are varying schools of thought, ranging anywhere from 1 to 10, on how many ETFs it is generally ‘acceptable’ to own. But that doesn’t mean you can just pick any handful. Owning multiple ETFs increases your chances of exposure overlap and might add unintended concentration rather than value.
Many investors make the mistake of layering portfolios with additional products, strategies or structures, convinced that it will lead to superior outcomes. I was one of these. There was one point where I had amassed a portfolio of around 9 funds (which may seem manageable for your average stock picker) which completely defeated the point of using ETFs in the first place.
But of course, this resulted in a bloated, costly portfolio that demanded an increasing administrative burden and ultimately went nowhere. Our bias for complexity stems from the assumption that complex structures are inherently superior to simpler ones.
Although ETFs are diversified products, it’s still possible to be poorly diversified and gain unintended concentration by holding several. Funds can be from different providers, have different exposure objectives and yet their underlying composition can be incredibly similar.
A good example of this was when I previously held both iShares S&P 500 ETF IVV and Global X’s FANG ETF. There’s nothing explicitly wrong with seeking a tactical tilt to tech but it has to be intentional. Investing in both meant that I was paying varying fee levels for comparable exposure in the name of ‘diversification’.
Still, I think there is a distinct difference between diversification and indiscriminate accumulation. The key is to understand that the ETFs you pick don’t exist in isolation, it is the sum of the parts that matters.
