ETFs or direct holdings?

Peter Lynch, the legendary money manager, has called excessive diversification as "diworsification". By this he meant that you should not be afraid of putting a lot of eggs into a single basket. However, unless you happen to devote most of your working time to screen potential investments and looking deep into company files, you are probably not going to have enough confidence to do so. And even if you would, you are probably better off if you diversify (distribute your money over lots of quality companies) anyway. Most money managers don't actually beat their benchmark index.

After reading "Random Walk Down Wall Street" I become believer of investing into index funds. However, after trying it out for a couple of years I noticed some drawbacks in passive-index ETF (exchange traded fund) investing:

• Some ETFs do not replicate index by directly owning the stocks. They do this by swap-contracts. So you have got some level of counter-party risk (in case the other bank defaults and can't make good on the contract).
• Most ETFs are expensive (net fees and costs 0,5%-1% per year or more)
• Most ETFs have very big spreads (difference of buy/sell bid)
• This is typically tied to size of fund and daily volume of it.
• You have to trust the company running the fund
• Even if they claim that the assets are separate, I don't trust any banker 100%.
• Taxation of dividends
• Atleast in Finland, there is a difference in directly holding stocks and holding an ETF
• I get a 30% tax break on dividends from Finland and all countries with whom we have a tax contract. Essentially this means paying capital tax on 70% of received dividends.

Therefore, I mostly invest directly into stocks. Typically I pick big corporations that would anyway be well presented in any passive index. I also diversify over several companies in the same business. Lately, I have noticed that there are several big ETFs (>billion dollars of capital) with very low fees (as in 0,1% or less) and low spreads. Those remove some of my concerns.

Generally I think passive-index unleveraged ETFs are good if you can't diversify otherwise. Also, when investing outside your county and developed markets, it is probably a good idea to use ETFs. However, even with ETFs you need to think about diversification (across multiple funds and money management companies). Don't trust any one money management company too much!