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One of the most popular investment tools could be bad for your health in 2018

It is hard not to fall in love with exchange traded funds (ETFs). But the popularity of these instruments, which provides a painless way to track an index, could cost you big in 2018.

ETFs are probably the cheapest and easiest tool for passive investing for those who are looking for a hands-off approach to generating wealth through capital gain and/or dividends.

The instrument, which is listed on the stock exchange run by ASX Ltd (ASX: ASX), typically reflects the value of an underlying asset such as the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) or gold.

Investors have flocked to ETFs over the past few years because they can buy it as easily as they would any stock and the management fees on ETFs are usually significantly below that of other funds that offer the same exposure.

What better way to gain exposure to Australia’s best known stocks such as Australia’s largest home lender Commonwealth Bank of Australia (ASX: CBA), the world’s biggest miner BHP Billiton Limited (ASX: BHP), iconic biotech CSL Limited (ASX: CSL), supermarket giant Woolworths Group Ltd (ASX: WOW) and the nation’s biggest telco Telstra Corporation Ltd (ASX: TLS), just to name a few.

You would need deep pockets to buy shares in each of Australia’s most profitable companies – or you can buy an ETF that gives you similar exposure but with a far smaller capital outlay.

These are some of the reasons why assets under management in the Australian ETF market have more than tripled over the past four years to hit $25 billion at June of last year, according to a report by the Reserve Bank of Australia (RBA).

However, the ballooning popularity of ETFs have recently drawn warnings from some market experts who believe that the growth of ETFs is distorting the market and creating near perfect conditions for the next market crisis.

If the stock market were to crash, panicked ETF investors would sell these securities into a pretty shallow market (ETF providers typically have to “make the market”) that may not be able to soak up sellers.

As you’d expect, ETF providers are playing down such risks although there is another reason why I think investors should tamper their appetite for index hugging instruments this year.

My caution is premised on expectations that the Big Four banks will struggle over the next 12 months and they make up the majority of the financial sector, which in itself is the biggest sector on the S&P/ASX 200 at around 44%.

This means having a large holding in an Australian stock index-linked ETF could cost you in terms of portfolio performance.

This might be a good year to reduce your exposure to such ETFs and take on a bigger tilt to specific parts of the market that are more likely to be outperforming, such as resources, technology and industrials with large international operations.

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited. The Motley Fool Australia owns shares of and has recommended Telstra Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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