NOT long ago, a reader of this column emailed me after watching several YouTube videos on exchange-traded funds or ETFs.
He was excited by what he had discovered. ETFs, he said, were low-cost, diversified and easy to buy. Compared with unit trust funds and other investment products, they appeared to be the obvious winner.
He was so convinced that he was prepared to sell all his existing shares and unit trust funds, and move everything into ETFs.
I am glad he paused before doing so.
His question is not unusual. In recent years, ETFs have become increasingly popular among investors who want lower fees, broader diversification and greater control over their portfolios.
The appeal is understandable. In a world where investment costs can quietly erode long-term returns, a low-fee product naturally sounds attractive.
But after more than two decades in holistic financial planning, I have learnt that investors often get into trouble not because a product is bad, but because they use a good product in the wrong way.
ETFs are no exception.
Real advantages
An ETF is essentially a basket of securities that tracks an underlying index. It gives investors diversification like a fund, while allowing them to buy and sell it on the stock exchange like a share.
This makes ETFs flexible, accessible and relatively easy to understand.
The advantages are real. ETFs are generally cheaper than actively managed unit trust funds. A single ETF can give an investor exposure to dozens or even hundreds of companies.
It can provide access to a specific country, region, sector or asset class without the need to select individual securities.
ETFs are also transparent, as investors are usually able to see what the fund holds.
For investors who know what they are doing, ETFs can be a very useful tool.
The problem begins when investors assume that low fees automatically lead to better returns.
This is one of the most common misconceptions I see today. A lower fee is helpful, but it is only one part of the equation.
What matters more is the return generated by the investment before fees, the risk taken to achieve that return, and whether that investment fits the investor’s overall financial plan.
For example, an investment that generates a 10% gross return and charges a 1.5% fee still gives an 8.5% net return.
Another investment may charge only 0.5%, but if it generates only a 2% gross return, the investor receives just a 1.5% net return.
In that situation, the lower-fee investment is clearly not the better investment.
This is why investors should not make decisions based on cost alone. A cheap investment tracking a weak or declining index can still deliver poor returns. A higher-cost investment managed well in the right market may still produce better results after fees.
The more important question is not whether the ETF is cheap. It is whether the ETF is the right tool for the job.
This is especially important because ETFs do not perform equally well in every market.
Mixed effectiveness
In developed markets such as the United States and Europe, ETFs can be highly effective.
These markets are large, liquid and widely researched. Information is quickly reflected in prices, making it difficult for active fund managers to consistently outperform the benchmark after fees.
In these markets, a low-cost ETF can make a lot of sense.
However, developing markets are different. In markets such as Malaysia, China and parts of Asia Pacific, pricing inefficiencies still exist. Companies may be under-researched. Market behaviour may be less predictable.
Strong active fund managers with deep research capability may still be able to identify opportunities that the broader index misses.
In such markets, a well-selected unit trust fund may have a reasonable chance of outperforming the ETF that simply tracks the market.
This is why I do not believe investors should look at the issue as ETFs versus unit trust funds.
That is too simplistic.
A more practical approach is to use the best available tool for each market. In some areas, ETFs may be more efficient. In others, active funds may still add value.
The objective is not to defend one product over another. The objective is to build a portfolio that can achieve the investor’s goals with the right balance of return, risk and resilience.
Another area where investors need to be careful is the belief that one broad-market ETF can solve everything.
Diversification matters
Renowned investor Warren Buffett has often spoken positively about the S&P 500 index.
This has led many investors to conclude that they can simply put all their money into an S&P 500 ETF and wait.
Over the very long term, the US stock market has indeed rewarded patient investors. But this does not mean the journey is always smooth, or that every investor can stay invested through difficult periods.
From 2000 to 2009, the S&P 500 experienced what is often described as a lost decade.
After the dot-com bubble and the global financial crisis, an investor who put money in at the start of 2000 and held faithfully for a full decade would still have ended the period with a negative total return, even after dividends were reinvested.
Ten years is not a short period. For someone approaching retirement, funding a child’s education, facing business difficulties or dealing with unexpected medical expenses, a decade of poor returns can have serious consequences.
This is where many investment theories fail in real life. You do not live in a spreadsheet. You live in the real world, and life gets in the way sometimes.
It is easy to say that one has a long-term investment horizon when markets are rising. It is much harder when markets fall sharply, income is disrupted, business slows down or family obligations suddenly require cash.
Many investors believe they can tolerate volatility until they experience it. During major market declines, some panic and sell.
Others are forced to sell because they do not have sufficient cash reserves. In both situations, the long-term plan breaks down. This is why diversification matters.
Not just diversification within one ETF, but diversification across markets, asset classes and time horizons.
A portfolio concentrated in a single market or index may look efficient on paper, but it can expose the investor to unnecessary risk when life does not go according to plan.
ETFs also carry another behavioural risk that is easy to underestimate: they are designed to be traded.
Because ETFs are bought and sold on the stock exchange throughout the day, investors can act on any impulse the moment markets are open. For a disciplined investor, this flexibility is useful. For many retail investors, it can become a temptation.
Valuable role
The moment you start watching intraday prices and wondering whether to shift between sector ETFs, or chasing whichever theme performed best last month, you have crossed from investor to active trader.
Trading adds costs. It also introduces something more damaging than cost: emotion applied to decisions that should be made without it.
Both work against you, and both quietly eliminate the low-fee advantage that made ETFs appealing in the first place.
Investors should also remember that not all ETFs are low cost or low risk.
Some niche ETFs track narrow sectors or low-volume indices. These may have wider bid-ask spreads and higher costs.
Actively managed ETFs may charge higher fees. Sector ETFs can be volatile. Leveraged ETFs can magnify losses when markets move against the investor.
In other words, an ETF is not automatically safe simply because it is diversified. The risk depends entirely on what the ETF owns.
This brings us back to the reader who wanted to sell everything and move fully into ETFs.
My advice to him was not that ETFs are bad.
They are not. In fact, they can play a valuable role in a well-built portfolio.
But he needed to understand that replacing every investment with ETFs would not automatically make his portfolio better.
Before making such a decision, an investor should first ask a more important set of questions.
What is the purpose of this money? Is it for retirement, education, income, wealth accumulation or legacy planning?
How long can the money truly stay invested? How much volatility can the investor genuinely tolerate?
Is the portfolio globally diversified across solid asset classes? Is there a written financial plan showing whether the investor is on track to meet his life and retirement goals?
These questions may not sound as exciting as discovering a low-fee ETF online. But they are the questions that determine whether an investment strategy can survive real life.
No shortcut
ETFs are useful tools. They can reduce cost, improve diversification and provide efficient market access. Used properly, they can enhance a portfolio.
But they are not a shortcut to financial success.
They are not a substitute for planning. And a low fee is not the same as a good investment outcome.
Investors should not rush into any investment based only on online enthusiasm, product popularity or headline cost.
Before parting with hard-earned money, they owe it to themselves to understand what they are buying, why they are buying it and how it fits into their bigger financial picture.
The question is not whether ETFs are good or bad.
The better question is whether they are being used properly.
That distinction can make all the difference.