Young & Invested: Are we too obsessed with ETFs?

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 22

I realise the title of this article may be a little ironic for someone who routinely posts about their enthusiasm for ETFs.

The idea came to me after a social chat with a private wealth adviser from a prominent firm. Imagine trying to rationalise a 2 - 3 ETF portfolio to someone who has spent their entire life building client portfolios through picking individual stocks. Admittedly, this almost had me re-evaluating my investment strategy – for better or worse.

Despite the first ETF being launched on the ASX almost 25 years ago, it has taken a while for momentum to pick up. The last five years have experienced a notable boost to assets under management, leading to consistent record high inflows.

I think it’s safe to say we’re a little obsessed with ETFs. And why not? With instant diversification and relatively low cost management fees, no one can argue they aren’t an attractive product to build wealth. But is there anything we might be missing with this one-track fixation?

Figure 1: Australian ETF yearly market growth.Source: Global X Australian ETF Market Scoop. 2024.

Are they actually safe investments?

ETFs are marketed as a safe, smart and easy.

When we think about the word safe – we assume free from harm. In investing we assume that means you don’t lose your money, or your loses are smaller than other investing approaches.

Do ETFs live up to their marketing? Not entirely. Often championed as one-trade into broad exposure, it’s easy to assume that an ETF can build you a basket of adequately diversified holdings– as it promises. And sure, owning a portion of 300 stocks sounds diversified, but if half the fund’s performance is driven by 10 players, it’s not as diverse as it seems.

Take Vanguard Australian Shares ETF VAS as an example. This fund aims to track the ASX 300 which includes the largest 300 companies in Australia on a market cap weighted basis. From the below figures, it is quite clear that financial services and basic materials (mining), have a substantial influence on performance, at over 50% of the underlying holdings. Further to that, the top ten holdings comprise 46% of overall holdings.

Figure 2: VAS ETF sector exposure. Data as of 31 May 2025.

Figure 3: VAS ETF top ten holdings. Data as of 31 May 2025.

Whilst the ETF is diversified across 300 companies, the top-heavy and sector specific tilt does have implications on performance. It’s important to note that this isn’t just exclusive to VAS. iShares S&P 500 ETF IVV that tracks the S&P 500 is fairly tech heavy with the top ten holdings making up ~30% of the ETF.

This is a classic example of market-cap weighting leading to concentration risk. This isn’t inherently harmful, but it’s important to note that it can lead to a false sense of diversification and underestimation of risk. In the case of VAS, if the financial or mining sector underperforms – either due to regulatory changes, commodity price falls, or an economic downturn – VAS (whilst being ‘broadly diversified’) will likely feel the pain.

We saw this in 2020 when VAS returned just under 2% and underperformed global indices despite a relatively quick market recovery. Performance suffered as banks slashed dividends, faced loan defaults and the mining sector was hit with dwindling demand.

Obviously, there are other ETFs that can negate this issue such as equal weight strategies, but they come bearing their own implications. I think the main point here is we do obsess a little about ETFs because they give us a false sense of ‘easy’ diversification. This is why it’s important to do your research and look past the slick marketing campaigns we are increasingly being exposed to.

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, we believe there are generally established characteristics of successful funds. 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.

The trading trap

Another part of this notion of ‘safety’ is the lack of direct control investors have when determining the underlying holdings and allocations. A common assumption we have when investing in passive vehicles (like 90% of the assets in ETFs), is that the index tracking mechanism saves us from behavioural risk. Overtrading is a common danger when owning individual stocks, but ETF investors certainly aren’t immune.

The reality is, a lot of us make an initial purchase, add a bit more to it, panic and withdraw some when the market falls, or switch to another ETF, then make another purchase after the market recovers. Therefore, our personal return is often lower than the fund’s total return because it assumes an initial lump-sum purchase that’s held indefinitely. Morningstar has been studying this returns gap phenomenon for almost two decades.

2024 was the first time we compared the returns gaps for open-ended funds and exchange traded funds. We found that these were largely the same (-1% and -1.1%), however index mutual funds had almost no gap (-0.2%). This means that the average dollar invested in an index ETF lagged the buy and hold return of an index mutual fund by around 1%.

The structure of ETFs allows for units to be bought and sold easily. On the other hand, mutual funds are priced and traded only once a day after market close, meaning they are less liquid and therefore discourage the kind of excessive trading that is a common behavioural pitfall and furthermore, a driver of the returns gap.

Now it’s probably a bit too simplistic to conclude that ETFs explicitly encourage excessive trading. This behaviour can occur across all traded assets. But relying on passive ETFs to mitigate the behavioural risk associated with single stocks is an oversimplified assumption.

Better performance elsewhere

When I engage in conversations about ETF-only investing, I am often met with well-meaning criticism from those who have built their wealth through individual shares that have done particularly well. And that’s fair enough. A UTS study found that portfolio performance when investors used ETFs was 2.3% lower than when they didn’t. That is quite a damming inference without the relevant context.

The research actually concluded that the loss was the result of buying ETFs at the wrong time, rather than choosing the wrong ones. ‘Choosing the wrong ones’ – or stock specific risk – is something that is more likely to occur when investing in individual securities. This was demonstrated when evaluating long term returns which determined that ETF portfolios did actually outperform if a buy and hold strategy was executed.

The truth is you can’t expect eyewatering returns through an ETF-exclusive portfolio. Passive ETF investing is by definition, settling for the average – or the market return (in the best case scenario). I think this whole argument about what strategy outperforms is rather contentious. If I could go back in time and put all my cash into Nvidia – I would, but we’ll only ever know that retrospectively. Just because you buy a lottery ticket and make a 200x return, doesn’t mean there’s no point in investing otherwise.

I think the individual shares vs ETFs performance argument is a case of survivorship bias. We rarely hear the losses. Nobody wants to get up on a podium and tell the story of how they lost their entire portfolio on some speculative pick, but they’ll be happy to announce it when the opposite occurs. But that’s not to liken individual share investing to speculation.

Different things also work for different people. ETFs have carved their way into every niche of the market, whether it be obscure thematics, growth or value tilts, fixed interest ETFs – it appears there is truly something for everyone. But is this true? Mark makes a great point in his article that income investors may be disappointed in dividend ETFs.

Costs

I actually think ETF providers do a reasonable job of cost transparency, but it’s often the individual investors who disregard the implications. The emergence of low and no-cost brokerage platforms has led many to believe that ETFs are a cheap option. This may be true in relative terms, but over a longer horizon can significantly erode returns.

For example, if you invest $100k into an ETF that has a 0.1% management fee and the portfolio returns 7% p.a., without fees your portfolio would grow to about $761k after 30 years. Comparatively, when considering the fee, the compounding effect is slightly reduced and your portfolio returns $753k. This difference of $8k is how much you’ve paid in cumulative fees over the years.

Even though 0.1% sounds negligible, your gains are quietly being trimmed through compounding drag. If the fee was double – at 0.2% – this drag would be even more significant. Management fees are ongoing and subject to change; long term investors need to consider how this ultimately effects their returns.

Obviously in comparison, direct shares don’t charge an ownership fee.

Concluding thoughts

This article isn’t some overarching call to sell all your ETFs. I think sometimes it’s important to evaluate why you’re doing something, especially when a lot of other people are doing it too.

As a proponent of an ETF-only portfolio – this may insinuate I’m obsessed with the product. But that’s only because it works for me, and I understand the opportunity cost. I am aware that there will be an endless combination of portfolios that outperform mine. But I have learnt to block out the noise and focus on what strategy will get me to my goals, rather than a pure returns maximisation strategy.

No matter what products are in your portfolio, your behaviour will be the largest driver of the outcome you achieve.

Get Morningstar insights in your inbox