ETFs are still are very small component of the Australian market when compared to say the US and U.K. market. I actually like sector ETFs as they help reduce the risk of trying to choose the "one" in a sector I want to be in but, feel I do not have the expertise to choose that single potential winning stock. Combine this with my feeling that this is where significant money is going to flow from the next generation of investors (including the time poor, non interested passive investors and/or the ever growing FIRE proponents) I am happy to ensure I allocate a % of my personal portfolio to specific themes such as cyber security, gaming, asia etc where I feel the growth potential will be significant. 

Thank you for the Post Dustysandwich.

I have often wondered who "rents" stock to Short Sellers.When people buy a prouduct, as in investing with,and  through an entity you should expect they are working for your interest and benifit. If they loan or rent what you have entrusted them with, to another entity for the only purpose of devaluing it, what is going on ? I would not be surprised if there is the biggest Class Action in history, if this ever hits the fan.

1. Security lending programs: did you know that the underlying shares that you own via the ETFs are being lent out to short-sellers. I haven't been able to work out the mechanics and risks fully but on the surface level, this just adds complexity to something that was supposed to be a "simple" product. 

So I'm going to go out on a limb here and start a controversial topic, as I'd really like to get other people's views on my thought process. Apologies in advance this is going to be a long one.

I just want to be clear, I am not saying ETFs are a bad product (I hold 20% of my portfolio in VAE) however I am saying that there are inherent risks, that I believe are being completely ignored or not properly considered. 

First I just want to spell out the benefits of ETFs. 

1. Diversification: You get exposure to a group of equities which ultimately reduces volatility and provides you with average index returns. Some argue for diversification, some argue against it (I am firmly in the "diversification as a protection against ignorance" camp, however for average people or people who are not interested in the market they prefer to be ignorant and get market returns which are great as long as you know that). 
2. Low cost and outperformance against most managed funds: I'm sure you have all seen the research that a lot of managed funds underperform the market hence the preference has been away from managed funds and into ETFs. 
3. Low capital requirement and convenience: It is likely impossible for an individual to hold a position in 100s if not 1000s of companies and balance a fund to match the underlying index on a day-to-day basis. In addition, not sure if many people are familiar with the mechanics of an ETF but the creation and redemption mechanics but that mechanism also saves significant frictional costs such as tax. 
4. Trading flexibility: ETFs essentially trade like a stock so you are able to go in and out of a group of stocks rather than balancing each individual stock within your portfolio.

The biggest gripe I have about ETFs is that there are very clear differences between broad market index ETFs and all other ETFs. More importantly, why I believe all ETFs except broad market index ETFs are counter-productive to long-term passive strategy. 

• Broad market index ETFs does indeed provide you with the true diversity of stocks that people seek, where it covers all sectors however all other ETFs fundamentally preclude the "diversification" benefit as it has been narrowed down to represent a particular group of stocks (including most managed ETFs, sector ETFs etc).
• Excluding broad market index ETFs, by definition sector/other ETFs will outperform the market of a particular time period and also underperform the market for a particular time period. Hence there is no real benefit in holding a sector ETF unless you are looking to "time" the market and pay a higher cost (generally more expensive than broad market index ETFs). This effectively runs counter to what most ETF investors want as a "set and forget" style of investing. 

Here are the other risks of ETFs IMO. 

1. I believe the prevalence of ETFs has made the market as a whole, and individual stocks far more volatile due to the underlying mechanics of how ETFs operate. For example, let's say a widely held stock say BHP for example fell strongly, which means the ETF price is now at a premium (overvalued to Net Asset Value [NAV]) to the market. The creation cycle will kick in and cause the AP (authorised participant) to create more ETF shares and buy the group of shares in the market. All else being equal what this has done is effectively spread the losses from BHP price to other stocks making the underlying BHP shares overvalued and the rest of the market undervalued. This essentially adds to the market volatility even though all else was kept equal in the scenario. Now, in reality, many stocks can make such moves, these moves are then amplified by the number of ETFs they are held in, which creates a compounding volatility effect. Hence you see some crazy moves in share price even though nothing happened in the day for a particular stock. 
2. Stretched PE ratios and price discovery issues. For example, two businesses that have similar earnings and growth profiles however one is included in an ETF and the other is excluded, this will create relative outperformance for the stock listed within the ETF as it will attract a larger proportion of funds. Over the long term and various individual investors and managed funds will take advantage of lower multiples, hence the gap should normalise however this may take an extended period of time which can impact the ability of the company to raise capital. 
3. ETFs themselves are a product and not the underlying security. If you have looked at the flash crash ETFs were disproportionately impacted because when you have trading halts on multiple companies it was impossible to calculate the NAV which crashed ETF prices significantly more than the underlying securities. 
4. Liquidity trap: Similar to above as some ETFs especially the smaller cap etfs, bond etfs, real-estate etfs, or more niche spaces have issues where the underlying security is not liquid means that there is liquidity risk. Hence if the ETF price was to dip below NAV, the AP will have a tough time selling the underlying security to balance the ETF price and the NAV. You often see bond ETFs trade at a discount to NAV because of this reason and in a crash when liquidity dries up you might be caught holding something that falls substantially more than the underlying security. 
5. Security lending programs: did you know that the underlying shares that you own via the ETFs are being lent out to short-sellers. I haven't been able to work out the mechanics and risks fully but on the surface level, this just adds complexity to something that was supposed to be a "simple" product. 
6. Complexity: so an ETF of ETFs such as VGHD - just read all of the risks about and compound them on top of each other. 

In saying all of the benefits for broad market index funds with minimal complexity significantly outweigh the risks (imo). 

Please feel free to tell me that I am completely wrong as I would love to hear your thoughts, however, I believe once something gets way too popular, there are risks that are often overlooked. 

DISC: Hold VAE