Investing in ETFs: advantages, limits and practical choices

The history of ETFs dates back to 1993, with the launch of SPY replicating the S&P 500. Thirty years later, these instruments dominate passive investing with trillions under management. Their success rests on a simple promise: instant diversification at low cost.

But this simplicity hides systematic biases. ETFs massively favour large-cap stocks, display high correlations with one another, and completely ignore the quality and valuation of their components. Between 2000 and 2020, only 22% of S&P 500 stocks outperformed the index itself.

This complete guide reveals how ETFs really work, when they represent the best choice, and in which situations direct stock investing proves superior. With detailed analysis of SPY, VTI, QQQ, VT and their European alternatives.

In this article: ETF advantages and limits • comparative analysis of major indices • correlations and real diversification • micro caps and momentum ETFs • selection criteria • US vs European ETFs

The advantages of ETFs

ETFs allow you to invest easily, quickly, in a diversified manner and at minimal cost. Unlike traditional funds, they trade on stock exchanges in real time, ensuring liquidity and enabling a reliable, continuous investment strategy without sacrificing returns through excessive commissions.

ETFs for beginners with small capital

For a newcomer with limited capital, ETFs allow market entry in a diversified manner with a single purchase and minimal fees. It is even possible, with a single ETF, to build a portfolio spanning multiple asset classes (global equities and bonds). The ETF GAL managed by SPDR (SSGA) is a typical example, mentioned in our previous article.

ETFs for medium-sized portfolios

For intermediate investors with moderate assets, ETFs combine ideally with one another, allowing multiple asset classes — and even sub-classes such as sector or geographic indices — to coexist within a single portfolio. The allocation possibilities are nearly infinite, and we will review several of them in our upcoming articles.

ETFs for experienced investors

For more seasoned investors with larger capital, ETFs are ideal for complementing a direct equity portfolio with minority allocations to other asset classes such as gold, bonds, real estate or even Bitcoin. Leaving minority assets to ETFs allows concentration on equities, saving transaction costs and simplifying portfolio management — particularly for instruments like bonds, real estate and gold that are more complex and time-consuming to access directly.

The limits and flaws of ETFs

ETFs have limitations that derive from the very characteristics that make them attractive. Indices are designed to reflect a portion of the market — and index ETFs faithfully reproduce that image. They therefore constitute an approximate representation of the overall market.

The vast majority of equity ETFs are weighted by market capitalisation. This means that although they include small-cap stocks, their contribution is so small that it has a negligible impact on diversification, performance and overall risk.

For this reason, ETFs have an unfortunate tendency to resemble one another. Their names differ, their reference indices too, but in the end the nuances are subtle unless their asset classes are distinct. It is a bit like walking into a supermarket's dairy aisle: dozens of milk cartons from different brands, formats and packaging — but the content is 99% identical. The choice can therefore be bewildering.

This resemblance means that ETFs within similar asset classes are highly correlated. In most situations, combining them in a portfolio adds nothing in terms of performance or risk management.

Finally, with few exceptions, ETFs pay no attention to the quality or price of their components. More on this important point below.

Comparative analysis: QQQ, SPY, VTI and VT

• QQQ from Invesco replicates the Nasdaq 100, comprising 100 of the largest non-financial domestic and international companies listed on the Nasdaq by market capitalisation. The ten largest positions represent more than half of the index capitalisation.
• SPY from SSGA replicates the S&P 500, comprising the 500 largest US market capitalisations. The index represents 80% of the US market by capitalisation, yet only one in seven American stocks is represented. The ten largest positions account for more than a third of the index capitalisation.
• VTI from Vanguard replicates the CRSP US Total Market index, comprising virtually all tradeable US stocks (just over 3'500 positions), including micro-caps and a large portion of nano-caps (only capitalisations below USD 15 million are excluded). The ten largest positions account for nearly a third of the index capitalisation.
• VT, also from Vanguard, replicates the FTSE Global All Cap Index, covering small, mid and large caps from developed and emerging markets. The index has nearly 10'000 positions and represents nearly three-quarters of global market capitalisation. Yet despite this, only one in five stocks worldwide is represented, and the ten largest positions account for nearly 20% of the index.

These well-known instruments illustrate several key ETF characteristics. They are an approximation of the market — reasonably accurate in terms of capitalisation, but far less so in terms of number of titles. Small companies suffer the most. Capitalisation weighting further accentuates the large-cap bias. The ten largest positions are nearly identical across all these ETFs — and indeed across many others. Even VT, with nearly 10'000 positions, currently has only one non-US stock among its ten largest holdings.

The core problem with equity ETFs

The biggest flaw in ETFs has been left for last. The vast majority pay no attention whatsoever to the quality or valuation of their components. Highly profitable companies sit alongside chronic loss-makers, and stock performance across the index varies enormously.

An index — and therefore an ETF — is pulled upward by a handful of exceptional performers. According to S&P Dow Jones Indices, only 22% of S&P 500 stocks outperformed the index itself from 2000 to 2020. This explains why the vast majority of investors (between 80% and 97% depending on the source) fail to beat the market. It is not necessarily because investors are poor stock-pickers — it is primarily because the market offers them very little chance. Between 2000 and 2020, while the S&P 500 gained 322%, the median stock rose only 63%. Nearly four in five S&P 500 stocks underperformed the index. Worse: one in four showed an outright negative return.

S&P 500 from 29.12.2000 to 31.12.2020: distribution of gains among its components

So, ETF or no ETF?

ETFs offer undeniable advantages for investors of all experience levels and portfolio sizes. But they also have real limitations: limited diversity within the same asset classes and a clear large-cap bias for equities.

For bonds, precious metals, commodities and real estate, listed ETFs offer compelling advantages in terms of liquidity, simplicity and cost. For investors seeking to diversify into these asset classes, ETFs are a sound choice. For equities, the picture is more nuanced. A small-to-medium-sized portfolio benefits greatly from ETFs for low-cost diversification. Beyond that, the choice depends on personal preference and management skill.

Index investing (via ETFs)

Since the odds of beating the index are very slim, one might conclude that investing solely in equity index funds is optimal. This captures the performance of the large winning companies that pull the index upward, and delivers an average annual return of approximately 10% in dollars on the S&P 500 (7% in real terms). It is a proven, easy-to-adopt approach — far better than leaving money in a bank account. However, as we will see in our upcoming articles, this strategy is not the most advantageous in terms of either profitability or risk management.

Active investing (via direct stocks)

While finding the big winners is difficult, identifying the losers is relatively easier, as the distribution chart above shows. Using Quality, Value and Momentum factors — detailed in my book and in my backtests — it is possible to separate the wheat from the chaff and achieve better results than the market.

Risk and performance

VT

VT was clearly left behind over the 17 years analysed. Despite a very high correlation with SPY, it posted the worst performance of all four ETFs (in USD), with comparatively high volatility and — unsurprisingly — the lowest Sharpe ratio. This may seem counterintuitive given VT's near-10'000 positions spread worldwide.

The explanation lies in its emerging market exposure. As J. Siegel demonstrates in "Stocks for the Long Run", emerging market stocks behave similarly to growth stocks in developed markets: both tend to underperform due to excessive investor expectations. The IWDA ETF (London), covering only developed markets, illustrates this clearly — it significantly outperforms VT, which is dragged down by its emerging market component. Emerging markets have stagnated since 2010, and while current valuations (P/E of 12) suggest a potential catch-up, timing remains uncertain.

It is also worth noting that many developed markets have underperformed. Historically, outside the US, the best-performing stock markets have been Canada, Australia and Switzerland. By sweeping broad, VT picks up a large number of underperforming countries — both emerging and developed. This structural, not merely cyclical, drag is significant. VT adds no value versus SPY in a portfolio, whether in terms of diversification, performance or risk management. In reality, quite the opposite.

VTI and SPY

VTI has a near-perfect correlation with SPY — even higher than VT. Over the analysed period (01.07.2008 – 31.10.2024), it posted marginally lower performance than SPY with slightly higher volatility, resulting in a slightly lower Sharpe ratio. The gap is explained by VTI's exposure to smaller companies. The chart below shows the subtle difference between SPY (blue) and VTI (green), with IWM (Russell 2000, small caps, pink) and IWR (Russell Mid-Cap, orange) — both part of the VTI package — pulling very slightly downward. The effect is minimal because their weight in VTI is modest.

Going back to VTI's launch in 2001 tells a different story. Mid-caps significantly outperformed, and small caps also performed better than the S&P 500 for most of the period. Fama and French have demonstrated that small-cap stocks regularly outperform the market over long horizons.

The choice between SPY and VTI is largely a matter of preference. If you want the entire US market in one purchase including small and mid-cap exposure, use VTI. If you want to focus on large caps — particularly if you plan to buy small-cap stocks directly — use SPY (VTI would then be redundant). Buying both is irrational. For those wishing to diversify across two issuers, SPY combined with Vanguard's VOO is more logical than SPY + VTI.

QQQ

QQQ is a special case. Its lower correlation with other ETFs — explained by its relatively small number of positions (100) — and its significantly superior performance make it stand out. Its profitability is more than double that of VT for barely more volatility, and its Sharpe ratio is the best of all four. This lower correlation, niche positioning and excellent Sharpe ratio make QQQ a particularly attractive candidate for portfolio diversification.

Sub-indices and their ETFs

Rather than settling for a global market ETF, one can decompose it into sub-indices. For example, combining US and Swiss equities (SPY + EWL), or decomposing the US market into three sectors: technology, healthcare and consumer staples (QQQ + XLV + VDC). Even though all based on the same asset class (equities), certain sector or geographic ETFs are relatively lowly correlated with SPY and VT (0.8) and even more so with each other (0.6 to 0.7):

It may seem odd to classify QQQ as a sector ETF since it represents a market (Nasdaq). Yet it has a strong technology component and is highly correlated (>0.97) with XLK and VGT (SPDR and Vanguard's technology sector ETFs), with better profitability and a better Sharpe ratio. These four ETFs — QQQ, XLV, VDC and EWL — are strong candidates for building the equity component of a portfolio.

Other asset classes

Gold (GLD) and long-term US Treasury bonds (TLT) are essential portfolio instruments because they display zero or negative correlation with equities, reducing portfolio volatility — particularly useful when markets fall sharply.

• TLT displays the strongest negative correlation with SPY (US equity market). A key diversification asset, particularly when markets fall.
• GLD displays near-zero correlation with equities and low correlation with all other displayed asset classes. Gold follows its own path regardless of what happens elsewhere — no surprise it is considered a safe haven.
• VNQ (US real estate) is quite strongly correlated with US equities — not an ideal diversifier. That said, as we will see in a dedicated article, Swiss real estate ETFs tell a very different story.
• IEF (medium-term US Treasuries) is negatively correlated with SPY but less so than TLT, and strongly correlated with TLT — making it less effective for diversification.
• Corporate bonds, whether investment grade (LQD) or high yield (HYG), are notably correlated with SPY (particularly HYG). They add nothing in terms of diversification, especially given their modest long-term returns.
• DBC (commodities) is fairly strongly correlated with SPY and delivers poor long-term performance. Avoid.
• Other precious metals such as silver (SLV) are more correlated with the market than gold and strongly correlated with gold itself, with inferior returns. Also avoid.

Cryptocurrencies

Cryptocurrencies such as Bitcoin and Ethereum attract growing interest due to their very high return potential. Like gold, they display low correlation with other asset classes, which can offer interesting diversification benefits. However, their extreme volatility is a significant challenge, and their relatively short history limits backtesting — particularly across prolonged bear markets like those of the 2000s. My own tests show that including cryptocurrencies in a portfolio can sometimes improve the Sharpe ratio, but the result varies significantly depending on the existing allocation.

Crypto ETFs were slow to emerge in the US — blocked by the SEC until early 2024 — but supply has since grown considerably. IBIT (iShares), listed on the Nasdaq, offers solid volume at very low management fees. Given the high volatility, variable portfolio effects and limited historical data, I have chosen not to include cryptocurrencies in my base ETF selection for portfolio construction and backtesting.

Micro caps: why to avoid ETFs

The Fama-French Nobel Prize winners demonstrated that small-cap stocks regularly outperform the market. Yet the lower the capitalisation, the fewer ETFs exist: abundant for large caps, reasonable for mid caps, limited for small caps, almost nothing for micro caps and nothing at all for nano caps.

As capitalisation decreases, correlation with the market does too:

And as capitalisation decreases, returns increase:

The conclusions: smaller companies are more profitable but also more volatile. Despite higher volatility, risk-adjusted ratios (Sharpe and Sortino) are very similar to those of larger companies. Value companies outperform growth, particularly at smaller cap sizes. The best results come from small value stocks.

Yet the available micro-cap ETFs — IWC (iShares) and FDM (First Trust) — have delivered disappointing results, seemingly contradicting Fama-French. The reason is structural to how ETFs function, not to micro caps themselves. The large sums managed by these funds make it difficult to buy and sell micro-cap stocks at fair prices due to illiquidity, significantly increasing transaction costs. To absorb excess cash, these funds dilute into larger companies — IWC contains numerous small and even mid-caps. ETFs are directly responsible for the outperformance of large caps over small caps since the 1990s.

The good news: it is possible to achieve excess returns with micro caps, even since the ETF era — but only through direct stock selection with quality filters:

Asset	CAGR
Quality Micro Caps	13.41%
Quality + Value Micro Caps	16.15%
IWC (Russell Micro)	4.76%
SPY (S&P 500)	8.63%

Backtest 2004-2024, US market. Quality criteria: ROE (TTM) >0, Piotroski score >7, earnings growth (TTM) >0. Value criterion: P/S below industry median.

The conclusion is clear: for micro caps, direct stock investment is necessary. ETFs simply do not work in this segment.

Momentum ETFs: analysis and performance

Momentum ETFs focus not on company characteristics (sector, geography, capitalisation or fundamentals) but on share price momentum — selecting stocks that have performed best over a given period (e.g. 6 or 12 months). Do they work? Not really.

ETF	Index	CAGR	Sharpe Ratio	Correlation with SPY
SPY	S&P 500	8.81%	0.54	1
MTUM	MSCI USA Momentum	8.79%	0.51	0.89
IJR	S&P Small Cap	7.61%	0.40	0.88
XSMO	S&P Small Cap Momentum	7.14%	0.37	0.86
XSVM	S&P Small Cap Value with Momentum	7.19%	0.36	0.83

Backtest 03.03.2005 to 19.11.2024

Large-cap momentum (MTUM) and small-cap momentum (XSMO) fail to beat their respective benchmarks (SPY and IJR). Even adding the value factor (XSVM) does not help. All remain highly correlated with the market.

The conclusion is clear: momentum ETFs are useless in a portfolio. This may seem surprising given the strong academic support for momentum as a return driver. The explanation: momentum works with direct stocks — not ETFs. Applied to Quality + Value Micro Caps, momentum pushes the annualised return from 16.15% to 18.75%, fully consistent with the results in my book. Moreover, all ETFs are inherently momentum-driven: stocks enter indices because their capitalisation (and price) has risen strongly, and exit when they decline. The success of index ETFs is itself the best proof that momentum works. A "momentum ETF" is therefore a pleonasm.

ETF selection criteria

Liquidity first

Unlike stocks — where I sometimes appreciate a degree of illiquidity — for ETFs I prioritise liquidity above all. Volume is the primary criterion. High volume means minimal spread and almost always a very low TER. The most liquid ETFs have spreads so low that market orders can be placed without concern. No limit order needed.

Management fees (TER)

TER matters, but less than most investors think. Today, most ETFs charge less than 0.5% — the difference between them has a marginal impact on results. A lower TER advantage can easily be offset by a wider spread on transactions. The gold ETF comparison below illustrates this perfectly:

• SGLD (London): 0.12%
• IAU (US): 0.25%
• GLD (US): 0.40%
• CSGOLD (Switzerland): 0.19%

Despite different TERs, the four curves are virtually indistinguishable. CSGOLD finishes marginally ahead — but its much wider spread makes it the least attractive despite the lower TER. GLD finishes marginally behind — but compensates with enormous volume and an insignificant spread. Focus on volume and liquidity. TER, at reasonable levels, is secondary.

Where to buy ETFs: US vs Europe

The most liquid ETFs are clearly found in the United States, with negligible fees and an enormous range covering all asset classes and sub-classes.

European regulatory protectionism

The EU has for several years prohibited products from being traded unless the ETF's Key Investor Information Document (KIID) is written in an approved language of the country — a measure ostensibly protecting investors but primarily a protectionist barrier for European ETFs, which struggle to compete with their American counterparts. Switzerland has largely aligned with this directive, though US ETFs remain accessible via Interactive Brokers, Charles Schwab or Saxo Bank.

US tax considerations

The tax risks of US ETFs are often overstated. Double taxation on dividends and potential estate tax (40% on US assets above USD 60'000 at death) are largely mitigated by double taxation treaties — Switzerland's treaty with the US covers both dividends and estates up to approximately USD 10 million. The practical risk of brokers reporting to the IRS is minimal, even at Interactive Brokers. If tax concerns remain a genuine obstacle, European substitute ETFs are a perfectly workable alternative.

European and Swiss ETF substitutes

If US ETFs are inaccessible, the best substitutes are Ireland-domiciled iShares from BlackRock — three-quarters of European ETFs are domiciled in Ireland, thanks to special tax treaties with the US. London is by far the best trading venue for these substitutes in terms of volume and spreads.

Asset	US ETF			iShares (European/Swiss substitute)			Vanguard			Invesco
	Ticker	Volume (USD m)	TER	Yahoo Ticker	Volume (USD m)	TER	Yahoo Ticker	Volume (USD m)	TER	Yahoo Ticker	Volume (USD m)	TER
S&P 500	SPY	26'000	0.09%	CSPX.L	75	0.07%	VUSA.L	30	0.07%	SPXS.L	11	0.05%
Nasdaq 100	QQQ	9'000	0.20%	CNDX.L	11	0.33%	no equivalent			EQQU.L	—	0.30%
20+ Year Treasury Bond	TLT	3'000	0.15%	DTLA.L	8	0.07%	no equivalent			no equivalent
Gold	GLD	1'500	0.40%	IGLN.L	11	0.12%	no equivalent			SGLD.L	18	0.12%
US Healthcare	XLV	906	0.09%	IUHC.L	11	0.15%	no equivalent			XLVS.L	2	0.14%
US Total Stock Market	VTI	804	0.03%	no equivalent			no equivalent			no equivalent
Global Stock	VT	144	0.07%	IWDA.L	47	0.20%	VWRL.L	11	0.22%	FWRA.SW	0.2	0.15%
US Consumer Staples	VDC	18	0.10%	IUCS.L	2	0.15%	no equivalent			XLPS.L	0.07	0.14%
MSCI Switzerland	EWL	16	0.10%	CHSPI.SW	6	0.10%	no equivalent			no equivalent

Key findings: US ETF volumes are incomparably higher than European substitutes. London is clearly the best exchange for substitute ETFs. iShares dominates in choice and volume — Vanguard offers little, Invesco even less. If you have the choice, always prefer US ETFs. Otherwise, iShares Ireland-domiciled ETFs on the London Stock Exchange are the right default.

Note on VTI: there is no European equivalent — but given its near-identical correlation with SPY (and therefore CSPX.L), this is no issue at all. For global stock ETFs, IWDA differs slightly from VT in that it covers developed markets only — which, as shown above, is actually an advantage.

Conclusion: the practical ETF shortlist

Among all ETFs reviewed, only a handful are truly relevant for building portfolios:

• US equities — broad market: SPY, VTI or CSPX.L
• US equities — sector approach: XLV (or IUHC.L), VDC (or IUCS.L) and QQQ (or CNDX.L)
• Long-term Treasury bonds: TLT or DTLA.L
• Gold: GLD, IAU or SGLD.L
• Swiss domestic equities: EWL or CHSPI.SW
• Micro caps: no ETF — direct stock selection required

This is our base palette, from which we will compose portfolios and run backtests in the upcoming articles of this series. Not all will be used every time, and additional ETFs may occasionally appear.

Frequently asked questions

What is the difference between SPY and VTI?

SPY replicates the S&P 500 (500 largest US capitalisations), while VTI covers the entire US market with 3'500+ positions including small and mid caps. Their correlation is 0.99, with very similar performance. The practical choice depends on whether you plan to invest in small caps directly (in which case SPY avoids redundancy) or want broad US market exposure in a single instrument (VTI).

Are European ETFs as good as US ETFs?

Ireland-domiciled iShares ETFs replicate the same indices with near-identical performance. The main difference is liquidity: US volumes are vastly superior, meaning tighter spreads and lower effective transaction costs. For European investors unable to access US ETFs, London-listed iShares are the right default.

Why avoid micro-cap ETFs?

Micro-cap ETFs suffer from high transaction costs due to illiquidity, and routinely include small and mid-cap stocks to absorb their large assets under management. As a result, they fail to capture the micro-cap return premium documented by Fama and French. Direct stock selection with quality and value criteria consistently outperforms — delivering more than double the market CAGR in our 2004-2024 backtest.

Is TER the most important ETF selection criterion?

No. Liquidity (trading volume) takes priority over TER. An ETF with a slightly higher TER but minimal spread will be more cost-effective than a low-TER ETF with poor liquidity. At the TER levels common today (below 0.5%), the performance difference between ETFs is marginal. Focus on volume first.