Young & Invested: Are ETF investors missing the bigger picture?

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 33

September marks my one year work anniversary at Morningstar.

Admittedly, when I first stepped this role, I had little idea what I was getting into and where it might lead. A year on, I can confidently say that writing Young & Invested has become one of my favourite parts of the job.

Time has flown and I’ve developed in ways I rarely pause to acknowledge (although the cringe I get from reading some of my early work is a pleasant reminder).

In the spirit of continuous evolution, I’ve found myself questioning everything from my assumptions, my frameworks and especially the way I think about investing within my generation.

This week I’ll be looking at how the ETF industry is evolving and the implications this has for investors.

Reminiscing about the days when Vince McMahon and Donald Trump used to throw down on WrestleMania.

The ETF industrial complex

The ETF market is booming.

Low costs, liquidity and diversification are the key benefits we can attribute to the rapid investor uptake of the product. Given the Australian ETF industry is on the cusp of hitting $300 billion in funds under management, it’s no surprise that a flock of global asset managers are looking to enter our ever-expanding market. There is certainly a compelling business case for it.

Source: Betashares Australian ETF Review. August 2025.

The surge of new products and entrants isn’t just a vote of confidence in our local investment market, but a sign that ETFs have matured into an ecosystem of sorts. One that thrives on the endless expansion of more products, more marketing and ultimately more assets under management.

But will this proliferation have a positive impact on investors? I’m not entirely convinced. A fundie race to the bottom for market share might leave retail investors and their goals as collateral damage.

Not all gloom and doom?

Before I dive into the rationale behind my cynicism, it’s worth acknowledging a potential upside to this shift: lower costs. In recent years, both index-managed funds and ETFs have faced intense fee pressure.

Providers of broad market index funds have been engaged in what has been dubbed a ‘fee war’, which has rewarded investors with cheaper investment products. More recently, other asset managers have followed suit.

Source: Morningstar US Fund Fee study. Data as of Dec 31, 2024.

If you’ve ever taken an economics class, you’d recall that increased entrants typically drive prices down. And for a time, that notion held true. But now we observe that fees aren’t falling as sharply as they once did.

Prominent funds are approaching a floor, with many already charging negligible amounts. As the fee war winds down, the potential for further cost compression (something that was once the primary benefit of new entrants) is diminishing for investors.

The trading trap

I’m a self-described ETF enthusiast. The products form a majority portion of my portfolio and long-term wealth building strategy. I also believe their role in reducing barriers to entry for retail investors has been one of the best recent financial innovations. But accessibility without education and the correct temperament creates a double edged sword.

Let me direct you to an interesting data point – the 2024 ETF Impact Survey by State Street. This found that the top three reasons people held ETFs were the diversification benefits, flexibility in trading and lower costs.

Source: State Street Investment Management. 2024.

Most investors lean on the product as a kind of ‘one trade into diversification’ strategy. The implications of that alone could make up an article in and of itself. But what concerns me more is that almost half the survey respondents stated that they hold ETFs for trading flexibility.

ETFs are a hybrid vehicle. They offer the diversification of traditional managed funds but can also be traded like stocks on an exchange. Thus, they carry added liquidity. Now this isn’t inherently harmful but can lead to worse investor outcomes.

Abusing ETFs by Bhattacharya et al. looked at data from a German brokerage to investigate the impacts of ETFs on portfolio performance. The study found that performance did not improve for investors using ETFs over the observed period. In fact, performance deteriorated due to investors engaging in excessive trading. Poor behaviour is enabled by the very liquidity the products are praised for. Thus, the perceived benefit becomes a detriment.

It’s important to remember that ETFs are simply a tool to access markets. Results are driven by human behaviour. We are driving our outcomes.

Our latest Mind the Gap study revealed that the average investor dollar in US managed funds and ETFs earned 7.0% annually over the decade ending Dec. 31, 2024. On the other hand, the funds themselves delivered an 8.2% aggregate annual return. That 1.2% shortfall wasn’t a fluke. It reflects the cost of investors’ poor decision-making skills.

I frequently reference this study, but what stands out in this context is who didn’t fall into the gap. Investors in allocation funds (diversified, multi-asset portfolios) captured the largest share of their funds’ returns.

If there is one lesson to take away from this, it’s that context is everything. Allocation funds don’t just diversify, they automate rebalancing and are often embedded in defined-contribution retirement plans with rules around withdrawing funds. This fosters a hands-off structure that shields investors from trading such funds like stocks.

It’s no coincidence that investors in narrower, more volatile funds such as sector specific equity funds captured the least of their funds’ returns. These are rarely used in structured contexts and rather, rely on irregular purchases and sales based on a hype cycle.

While flexibility in trading is a well-loved aspect of ETFs, it isn’t the blessing it’s made out to be. The best investment decision isn’t usually the one you make after a 2am doomscroll on r/wallstreetbets.

The marketing play

I came across a great quote the other day from Bloomberg analyst Eric Balchunas who claimed that “95% of media coverage is on ETFs comprising 5% of your portfolio.”

Like life, we generally assume that we have the ability to make rational decisions in our best interests. But we are humans first, and investors second. Our endless pursuit of shiny new things can drive us into the hands of opportunists looking to pad margins.

Competition for Attention in the ETF Space by Ben-David et al. explores the effects of intensifying competition in the specialised ETF space (think thematics – AI, crypto etc). They set out to examine whether such ETFs actually provided value in terms of exposure to successful investment ideas. What they found was damning. In short, their research concluded these ETFs failed to create value for investors and underperformed significantly.

The paper goes further to assert that some ETF issuers exploit investor’s biases and cater to poor behavioural tendencies. The democratisation that ETFs bring about are mixed. On one hand, investors can now access markets at low costs and on the other, the slick marketing strategies used for specialised ETFs attract speculation-prone investors to underperforming investment propositions.

It’s one of my favourite papers because I don’t think we often call out funds for the role their marketing plays in damaging investor outcomes. Nobody needs exposure to every niche area of the market, but when you’re faced with tactical, attention-based strategies from fund providers, it can certainly appear to be a compelling proposal.

However, investing isn’t a blame game. Ultimately, we are the biggest determinant of our outcomes. Having investment goals and a well-defined strategy can negate the marketing noise we’re constantly hit with.

Concluding thoughts

Have you ever walked into an ice cream shop to be greeted by a menu of 26 flavours? Sure, you might indulge in a few exotic samples here and there. But ultimately after dabbling in the new, you realise there’s nothing like ye old faithful (hazelnut, obviously). This happens to me with ETFs too.

Optionality is rarely a bad thing. It is one of the silver linings of capitalism. But investing isn’t about choosing between clothing stores or ice cream flavours – it’s about our ability to build wealth to achieve goals. More choice doesn’t always equate to better outcomes.

Investors are already facing an ever-expanding base of options. The explosion of ETFs on the market creates endless combinations, tailored exposures, and thematic plays. But as the industry consolidates, I can’t help but question whether anything truly new or particularly useful is coming out.

Investing is one of the rare practices in life where mediocracy – or mediocre returns – isn’t something to be ashamed of. Next time you read headlines about some specky new fund launch, it’s worth considering the forces that currently drive the market and whether you’re just adding complexity for complexity’s sake.

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My colleagues Mark LaMonica and Shani Jayamanne have co-authored their own - Invest Your Way, which serves as a guide to successful investing with actionable insights and practical applications.

You can pre-order a copy on Amazon or at Booktopia today.