Should you sell an underperforming ETF?

Have you ever bought a flashy new ETF or maybe an alluring thematic with a compelling growth story and eye-catching returns? Intuitively, we know we shouldn’t buy and sell things purely based on expected short-term price movements. But in reality, it’s a trap many beginners and even experienced investors fall into.

The Covid pandemic for example, saw an influx of people pour into the market with additional funds (arguably speculating rather than investing) to realise a quick return. Investors rode waves of immense market momentum with speculative picks paying off – until they didn’t.

Periods of volatility induce our worst behaviour. Our Mind the Gap study found that Covid created an even larger 2% gap in investor returns and fund returns than the usual 1%. I was recently talking to a friend who invested in Cathie Wood’s ARK Innovation ETF ARKK at the height of its hype cycle in 2021. Unfortunately, a few years later Wood now tops the list as one of America’s largest wealth destroyers.

But is that actually a fair assessment? Or are these simply the consequences of buying into a hype cycle and ignoring the fundamentals? ARKK aside, this got me thinking about what to do in a situation when an ETF has severely underperformed your expectations.

A lot of financial content revolves around the purchasing of assets – but when should we sell and how do we do this to achieve the best outcome? A case study of ARK shows the situation that many investors will find themselves in at least occasionally.

What happened to ARKK?

Named the top value-destroying fund family over the last decade, ARK Invest saw the largest aggregate loss of over USD 13 billion. Remarkably, the fund managed to destroy value in a generally favourable market with technology outperformance.

Founded in 2014, ARK Invest is best known for aggressive bets on ‘disruptive innovations’ such as AI, blockchain and robotics. Early bets on Tesla and cryptocurrencies paid off handsomely a few years after inception, posting over 150% return in 2020 and catching the attention of investors. The fund has struggled to retain investor optimism after a sharp and prolonged descent from its peak due to several poorly performing holdings.

Has it actually done poorly?

Interesting, from its inception to June 2025, ARKK has posted a 12.2% annualised return. This may seem reasonable. However, the timing of asset flows mean that the returns for the average investor are much worse. Morningstar portfolio strategist Amy Arnott argues that the real culprit in the case of ARKK, was the flood of assets in 2021, after its best returns had already been realised.

We know that successfully and consistently picking individual stocks can be difficult. This phenomenon is also observed in ETFs – often championed as ‘safe’ investment vehicles. A study by UTS found that ETF portfolios underperformed non-ETF portfolios by 2.3% a year. This was the result of buying at the wrong time, rather than choosing the wrong vehicles. Alternatively, a buy and hold ETF strategy outperformed in the long term.

What we think: Cathie Wood’s high-conviction position sizes have worked exceptionally well on occasion. However, the costs of inevitable stock-picking mistakes have been high. Success requires well-sized positions, rigorous financial analysis, and a strong sell discipline. ARKK has fallen short on these fronts. Wood’s reliance on her instincts to construct the portfolio hasn’t proved effective.

Is your investment really underperforming?

The average ARKK investor has suffered a considerable paper loss due to long term share price depreciation. But underperformance doesn’t always imply you’ve lost money; it can simply mean that the investment hasn’t met expectations.

Investors tend to immediately attribute poor investment performance with their decision making skills, rather than examining overarching factors. To determine whether your investment is underperforming, there are several considerations you can look at:

Valuations: Logically, the higher the valuation at purchase, the lower the expected long term return. In the case of ARKK, my friend (like most covid investors) entered ARKK when the fund was trading 1.6 price/fair value estimate. The ETF currently sits at 1.26 price/fair value implying the weighted underlying holdings are still overvalued.
Benchmark: Underperformance is always relative, whether to your own portfolio, the sector or the entire market. It is important to benchmark your investment against the relevant category or index. ARKK’s NAV return over the trailing 5-year period to June 2025 is a bleak -0.6% meanwhile its relevant index returned 11%.
Time: ETFs experience a slightly different investment cycle than individual stocks. A fund may indicate in their prospectus the investment time horizon required to earn the best potential return. It is important to evaluate where your investment sits within this recommendation. ARKK, like most growth funds, suggests an investment horizon of a full market cycle or 5-7 years.

Evaluate the changes

The portfolio construction process involves 1) determining your financial goals, 2) understanding the required rate of returns to reach these, 3) picking the appropriate strategy that allow you to achieve them. Investing requires a disciplined, methodical approach to evaluating whether an asset continues bring you closer to your goals.

It is crucial to understand why you’ve purchased something and whether your decision was fundamentally sound. Core aspects that underpin fund performance is the parent manager, the people making investment decisions and the investment process. If you’ve bought something on a hype cycle, it’s possible that these may have been overlooked in favour of prevailing market narratives.

A change in investment process, or the team managing the money can have a significant impact on whether an ETF is right for you. If this shift conflicts with your investment strategy or no longer aligns you with your goals, there are several actions you can take.

What are your options?

In her article transitioning to a ‘grown up’ portfolio Shani shares the below decision tree for investments that no longer meet your objectives. As Shani mentioned in her article, 75% of the outcomes below result in the sale of the asset.

Source: Transitioning to a ‘grown up’ portfolio. Shani Jayamanne.

A common course of action is to exit the position entirely, especially if conviction is gone and you no longer have faith that performance will improve. This can also occur if the asset doesn’t suit your portfolio anymore or you perceive better opportunities in the market.

On the other hand, if you maintain long term conviction in the investment despite changes to the ETF process and investment team you can double down and increase your exposure. Alternatively, you could maintain current exposure but reduce relative allocation over time. This is common in the circumstance that your risk appetite has changed or you’re transitioning your portfolio.

Naturally, holding that investment comes at the opportunity cost of liquidating and investing elsewhere. This can feel tempting if the investment underperforms for an extended period of time. But beware of recency bias and our tendency to extrapolate short-term performance into the future.

Tax loss harvesting

The end of the financial year is a great time to review your portfolio. Selling an ETF that has underperformed will crystallises losses, incurring a potential tax benefit.

If the allowable capital losses are greater than your capital gain in a given financial year, the loss can be indefinitely carried forward to later years and deducted from future capital gains. Capital losses cannot be deducted from other assessable income such as your employment income.

Beware of wash sales

If you have long term conviction in the fund but perhaps bought at too high a valuation, your only option may be to hold to avoid accidentally partaking in an illegal ‘wash sale’.

A wash sale involves the disposal of poorly performing assets to obtain a tax benefit then repurchasing the same asset in the new financial year. The Australian Tax Office deems this a form of tax avoidance that investors are urged to avoid as they come with compliance action, additional tax, interest and penalties that may apple.

Learn from mistakes

How to predict the performance of an ETF

As an individual investor it can be difficult to predict the performance of an ETF given the nuance required with a large basket of underlying holdings. However, Morningstar believes that there are generally established characteristics within successful funds.

Our Medalist Rating for funds is the summary expression of our forward-looking analysis of investment strategies offered via the specific vehicles e.g. an ETF. We express the rating on a five-tier scale running from Gold, Silver, Bronze, Neutral and Negative.

The three key areas that evidence suggests are essential in predicting the future gross performance of strategies and their vehicles are people, parent and process. Shani provides further insight into how to tell if an ETF will likely underperform.

Don’t buy into the hype cycle

I’m personally not a fan of thematic ETFs for this very reason. I love a compelling story just as much as the next investor. However, I think that is where most thematic ETFs end – as a good story.

Market narratives and crowding often encourages investors to play into the hype cycle, amidst elevated volatility which exacerbates poor investor behaviour. Such is the case of investors who dipped their hands into ARKK at its peak. Despite the fact we’re in a narrative market, the fundamentals are still crucial.