How to thrive in the booming world of investment ETFs
Sometimes the most important revolutions are the silent ones that don’t attract the column inches.
Just as profound demographic changes are almost certain to have profound macroeconomic implications, I’d maintain that the rise of ETFs (exchange-traded funds) and passive funds has profoundly changed your investment world, mainly for the good – though with some important caveats.
The year 2025 was, you may be surprised to learn, truly crucial for the slow-burning ETF revolution. Net inflows to ETFs reached an all-time high in 2025 of $372bn (£275bn) globally, according to Fidelity – up 32pc from 2024’s record-setting year.
Today, more than $3.2tn is invested in ETFs. The USA led the way but Europe is catching up fast. According to ETFBook.com, the European market recorded $24bn in inflows in November alone.
This collection of numbers may sound remote but it has real-world implications.
Massive, relentless passive fund flows, mainly into ETFs, are helping push US equity valuations ever higher.
Each dip in US equities seems to bring out more buy-the-dip investors who use ETFs to buy US equities because it’s such a liquid, efficient market where active fund managers struggle to add value and ETFs now dominate.
Those stretched valuations help power more artificiail intelligence (AI) innovation, fuel an IPO boom, make the wealthiest 10pc of US consumers who invest heavily in equities ever richer and underwrite their massive consumer spending surge of the last few years.
That, in turn, helps keep much of the rest of the world in business, exporting to the US.
Many Wall Street types hate ETFs, accusing them in slightly hyperbolic language of being a Marxist innovation.
They are not. Moreover, the leviathans of ETF land – such as BlackRock (which owns iShares), State Street and Vanguard – are paragons of capitalist virtue.
They’ve also helped investors globally cut costs, with estimates suggesting that ETFs have saved tens of billions of dollars in fees and tax costs per annum.
A few years ago, for instance, Bank of America estimated that US investors alone had saved about $250bn since 1993 by choosing ETFs over traditional mutual funds.
That low fee revolution is now sweeping across Europe and the UK.
ETFs and passive funds have also helped steer investors away from many poorly performing actively managed funds, with study after study – most notably reports by the S&P Dow Jones Indicies (SPIVA) – showing that the great majority of actively managed funds underperform their index benchmarks most, though not all, of the time.
What’s not to like? I’ve long championed ETFs and even set up the biggest ETF events and news service in Europe called ETF Stream – but even I find myself pondering some of the challenges.
Like every revolution, enthusiasts can overreach and the chart below from a technical website called Topdown Charts does put the fear of God in me.
It shows the net change in the number of US ETF-listed funds, with a hyperbolic increase in the last 18 months.
This suggests to me that there may be too many new ETFs being issued, swamping the market. Have we reached peak ETF?
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I think these funds are a force for good and intensely democratising but you need to tread carefully.
The first thing to watch out for is understanding which underlying assets an ETF invests in. I’d politely suggest that anything that is difficult to sell in a panic is problematic.
In that category, I’d highlight everything from small-cap equities, many if not all private assets and even – slightly controversially – much of the UK equity market.
I’m a big fan of UK equities but as our market has shrunk liquidity has become more challenging.
I’m now a big believer that if you want to invest in UK equities, you need an active fund manager who can avoid the value traps and cyclically-inclined resource leviathans.
Assuming you get past that challenge, the next step is to understand the index or benchmark you want to track. Let’s take the supremely popular example of investing in global equities.
MSCI, alongside FTSE, dominates the big equity benchmarks and many investors reflexively default to the MSCI World index.
I think they could be making a mistake and would politely suggest an alternative index: the MSCI ACWI, which includes developed markets as well as key emerging markets.
Beyond this choice of index, there’s also the issue of whether you want to blindly buy all the major stocks in an asset class, or screen out some stocks that might be too expensive or only include those with a generous dividend.
My point here is to understand the index you track and do your research. It’s the index, not the ETF wrapper, that really counts – and not all indices are created equally.
Next up, there’s the issue of cost. Plenty of investors shortcut everything by just choosing the cheapest ETF. That can be a great idea – but not always.
Cheapest doesn’t always mean best. You also need to look at the bid-ask spread and the average daily trading volume in the ETF over the last few months.
Also, check out the tracking error, which is the difference between the fund’s returns and the index’s returns.
Usually, larger funds – as measured by their assets under management – tend to be a tad more expensive but they often offer favourable trading liquidity on a day-to-day basis.
Also, there’s been a trend to rubbish what are called synthetic ETFs, which don’t actually buy all the assets in a well-known index but instead use swaps or IOUs to pay out the index return the ETF is tracking.
By contrast, a traditional ETF physically buys all the stocks in an index. With a synthetic ETF, you’re exposed to counterparty risk because those IOUs might end up worthless.
But in many markets, like emerging markets, a swap might give you a better return and lower tracking error than a traditional structure – mainly because there are lots of trading costs in the physical, underlying securities.
I’ll finish with two final caveats. The first is to diversify your fund providers.
BlackRock’s iShares business is the gorilla of the ETF industry and it’s easy to end up with a portfolio jam-packed full of their ETFs.
They are frequently big, cheap and easy to trade. I use iShares ETFs all the time, but I try to ensure I have a diverse set of ETF providers just in case. You don’t want to rely too heavily on a single provider.
I’d also keep a cagey eye on popular trend-driven, thematic ETFs. These might be everything from AI-focused stocks to junior market gold mining stocks, both of which have done well over the last few years.
These ETFs force you to become tactical and active, as you are not building broad market exposure – but instead focusing on what can sometimes be a handful of stocks based on a market hunch.
There’s absolutely nothing wrong with that approach but be aware that in our momentum-driven, liquidity-driven world, you can end up with unwanted, unloved funds that are then wound down. Trends can reverse incredibly quickly and fall out of fashion.
Keeping on top of the ebbs and flows of our ETF-dominated world requires you to be pretty active and the weight of academic evidence suggests that if you take too many speculative positions, too often, you’ll probably fail most of the time.
Keep it simple, diversified, cheaper, liquid and minimise that tracking error.