Young & Invested: Why ETFs might be setting you up to fail
Do high market valuations signal it’s time to change strategy?
Mentioned: BetaShares FTSE RAFI Australia 200 ETF (QOZ), Vanguard Australian Shares ETF (VAS), VanEck Australian Equal Wt ETF (MVW)
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 37
If you’ve skimmed the headlines lately, you’ve probably seen the doomsday chatter about share market valuations hovering near all-time highs.
Whilst some of the media coverage borders on sensationalist, traditional indicators do suggest that elevated valuations may be a legitimate and ongoing concern for investors.
As someone who spends a lot of time observing market trends, these warnings have lingered in the back of my mind for months. Their persistence has finally led me to reflect upon my own portfolio and the implications for what lies ahead, especially given my heavy reliance on passive ETFs to drive long-term returns.
Unsurprisingly, the most popular ETFs for Aussie equities track broad indexes weighted by market capitalisation. These funds allocate more to larger companies, meaning the biggest players dominate the index.
Historically, this approach has delivered solid returns. Over the last 45 years, the overall Aussie market has risen by an average of 13% per annum (nominal). Passive investments have proven a way to tap into the rising market.
But conventional wisdom reminds us: the higher the valuation at entry, the lower the expected returns. If the market is already expensive relative to historical norms, it’s reasonable to expect more modest performance going forward.
As someone who favours a hands-off approach that involves dollar-cost-averaging into a handful of broad market ETFs, I can’t pretend this hasn’t concerned me a little. It got me thinking about how we often overlook the implications of ‘passive’ investing – I put that in quotation marks because no investing is ever really passive.
How bad are markets looking?
To avoid derailing this article into a debate over the legitimacy of CAPE and ROE ratios, I’m going to stick to the basics and unpack why many believe the market is currently overvalued.
When looking through a historical lens, both the global and domestic stock markets appear stretched. One of the most common metrics you’ll see floating around refer to the price-to-earnings (PE) ratio. This is a traditional valuation method that compares a company’s share price relative to its earnings. In essence, it reflects how much investors are willing to pay for each dollar of a company’s earnings.
For a simple example: Company A’s stock trades at $10 per share. Recent results show that it earned $1 per share over the past year, giving it a PE ratio of 10. Investors are willing to pay $10 for every $1 of earnings Company A generates.
At a total stock market level, the same principle applies. The PE ratio is used to gauge how ‘expensive’ or ‘cheap’ the overall market is, relative to its earnings. Now if you’re getting into the nitty gritty of valuation methodology, PE is a useful starting point, but not the complete picture.
The ASX 200 currently sits at a trailing price-to-earnings multiple of around 20x, which is well above the long run average of what investors have historically been willing to pay. What makes this interesting is that earnings for the largest 20 companies fell again in fiscal 2025, marking the third consecutive year of outright declines.
Obviously, this is backwards looking, but many investors still rely on it for a relative measure. On a PE basis, the US market (S&P 500) is also trading on a higher-than-usual 30x. However, some say there is reasonable justification for this, given their earnings growth is night and day compared to our market.
The broader issue with absolute statements about valuation is that across a myriad of factors, there is no universal consensus on what qualifies as ‘overvalued’. There are rather compelling arguments in contrary to what I’ve just shared about the Aussie market.
Despite historically stretched valuations, investors and therefore the market continues to push higher. Although it’s not as surprising when we consider many of us retail investors have automated processes in place, whether that be dollar-cost-averaging recurring investments or passive inflows from super contributions. Such processes are sound strategies in most cases as they help temper our behavioural biases. But do the majority understand what we’re betting on? I’m not so sure.
I don’t think retail investors are deliberately ignoring valuations. In fact, I think recent upticks in other niche corners of the market like small caps (typically underrepresented in broader indexes), crypto and gold suggest that investors are increasingly exploring alternatives. Still, it’s way too early to see a notable, consensus pull away from passive flows.
Ultimately, I’m concerned about relative expectations. Buying into an overheated market generally indicates lower future returns. But the goal of this article isn’t to create panic, rather, to present some food for thought.
What are the implications?
Utilising passive investments doesn’t mean we have to be passive thinkers.
It’s important that we’re aware of what we own and how market dynamics can shift the strategies we consider ‘safe’ or ‘diversified’.
Shifting back to valuations, a concerning trend is emerging. Earnings growth amongst the largest players in our market is in a steady decline and will likely continue to do so. Below is our adjusted earnings growth outlook for the ASX 20, where we expect a total earnings growth of just 2% in fiscal 2026 and 2027. When adjusted for inflation, real earnings are likely to go backwards.
But you wouldn’t know it from the strength of the market. Morningstar estimates ASX 20 earnings fell a cumulative 15% in the three years to fiscal 2025 while the index is up 30% over the same period. These stocks now trade at a market cap-weighted premium of about 20% to our fair value estimates, a level we’ve rarely seen in the past decade.
The disconnect highlights how market-cap weighted ETFs can hide underlying weakness in the fundamentals of its largest constituents. When headline performance looks strong, it’s easy to overlook what is actually driving or dragging those returns.
The first half of 2025 saw net flows into Australian ETFs rise by almost 100% (over prior corresponding period) to reach $21 billion. Popular market-cap weighted ETFs like Vanguard Australian Shares VAS continued to dominate, so I’ll use it as an example.
The top 20 companies in VAS currently comprise almost 60% of the fund (per the ASX 300 benchmark). That means nearly two-thirds of your exposure is concentrated in just a handful of names whose earnings (despite share price appreciation) have been shrinking. If these companies fall back to valuation reality in the coming years, your portfolio is likely to reflect a portion of that reversion.
When we pay more for companies that are earning less, we should be wary of inflated expectations which lead to diminishing future returns. This raises the question of whether we keep paying more for less? Given index heavy weights continue to underdeliver while commanding premium valuations, should we consider other strategies?
What are the alternative strategies?
There’s recently there’s been a spectacle surrounding national productivity concerns and it got me thinking about whether we can see this reflected in the composition of our share market. This article on Firstlinks points to our market being dominated by aging incumbents with limited growth and questionable pricing. Many of these have been said to lack innovation and instead survive through conservative management and political protection. Passive products essentially buy into this top-heavy stagnation.
A common alternative approach is an equal-weighted strategy that holds most of the same securities as a broad market fund, however, weights them equally. In essence, you’re underweighting large caps and overweighting smaller players. This negates the concentration risk (sectors, cyclicality etc) that we see in market-cap weighted funds whilst potentially providing exposure to a higher quality of constituents in the case that earnings growth is muted at the top end.
I recently came across a chart that presents a compelling picture for this strategy in the Australian market, at least from a historical standpoint. The figure below looks at the last decade of performance across ASX size segments. We can see from this that mid-caps have consistently delivered stronger earnings growth.
Source: IRESS, Bloomberg, Auscap.
Mark weighs up the arguments for and against using the popular VanEck Australian Equal Weight ETF MVW for Aussie equity exposure. In short, a fund like MVW reduces concentration risk from dominant players, provides more exposure to smaller companies and offers stronger dividend growth. On the other hand, equal weighting requires regularly rebalancing which introduces greater tax implications and also comes at a higher management fee.
I’ve also previously discussed factor-based strategies that target specific drivers of return (value, size, momentum, quality etc), rather than relying solely on broad market exposure. For examples, screening constituents for desirable fundamentals based on the quality factor can prove effective in tempering exposure to value traps. You can read our recent coverage on popular pick Betashares FTSE RAFI Australia 200 QOZ here.
The above options provide an opportunity to stay invested in Aussie equities, without necessarily being trapped in the top-heavy, stagnating index.
Concluding thoughts
All the hoopla surrounding valuations has made me pause for thought. Whilst it hasn’t yet convinced me to shift my strategy, it’s certainly got me thinking. It might be time for us to reset expectations around future returns for Aussie equities. And for some, that may involve a decision to shift strategy.
The reason we invest in stocks is the additional return that we stand to earn, despite the risks they pose. And that doesn’t refer to simple earnings beat or miss. It means the kind of systematic risk that the entire market sells off, dragging your portfolio and goals down with it.
When we’re at inflection points like this, our instincts are to act so we can reassert control in the face of uncertainty. We see that evidenced in the lines outside ABC Bullion, as unnerved investors flock to ‘safe’ assets like gold (at all-time highs!) amidst global uncertainty.
I’ve decided that I’m simply using it as a lesson for now. We’re never fully in control to begin with. All of us are ultimately at the market’s mercy and that’s how we earn a return, not because we’re smarter than someone else, but because of the risk we accept.
I also want to caution against those who claim to know what’s around the corner. Undoubtedly, the industry is full of amazing minds with years of experience at the helm, but the way events pan into investment outcomes is almost impossible to decisively predict.
Modesty isn’t a weakness. Even though things feel increasingly expensive, the most valuable asset might be realistic expectations. Neither pessimism nor blind optimism, just a grounded view of the things we can control.
