The ETF Blindspot

Executive Summary

Ask most advisers why a client's international allocation runs through a particular ETF, and the honest answer is rarely a good one. The fund was there. It was liquid, low-cost, and next in line, not chosen because anyone tested whether it actually fit the client holding it.

For three kinds of clients, it doesn't fit. US-linked investors holding non-US domiciled funds trigger a punitive tax regime most advisers only discover after the fact. Clients with concentrated equity positions add correlated risk with every ETF purchase, not diversification. And institutions or families operating under exclusion mandates find that a broad-based index either includes what they've excluded, or doesn't exist in the form they need.

The case this paper makes fits in one sentence: for a meaningful share of international equity books, owning the underlying securities directly, not through a pooled ETF, should be the default. However well an ETF is built, it can't get there.

The Problem

Passive fund adoption in European equity markets has moved, in a decade, from a niche allocation to the dominant flow. The market share of passive UCITS funds climbed from 11% in 2014 to 29% by the end of 2024 (EFAMA 2025). European ETF assets alone reached a record $3.11 trillion by October 2025, up 36.7% for the year and the 37th consecutive month of net inflows (ETFGI LLP 2025).

Here is the part that should give an adviser pause: passive adoption isn't simply a response to active managers failing. In 2025, 63% of active international equity funds underperformed their benchmarks, a clear majority, but a meaningfully better showing than the 79% underperformance rate posted by active US large-cap managers over the same period (Ganti et al. 2026). Passive adoption kept climbing regardless, because the decision to hold an ETF is rarely a performance decision at all. It is what happens when no one makes a decision: the product is liquid, transparent, cheap, and one click away. For a generic mandate with no constraints, that is a perfectly reasonable outcome. It is precisely why it has become the industry's reflexive answer rather than one option considered among several.

The trouble is that few sophisticated clients have a generic mandate. Three situations recur constantly across RIA, private bank, and family office books, and in each of them the ETF does not merely underperform; it works against the client who holds it:

• A tax situation that a foreign-domiciled fund wrapper makes worse, not better.
• An existing book concentrated enough that adding an index fund adds correlated risk rather than diversification.
• A mandate (ethical, regulatory, or reputational) that requires excluding or including specific names an index cannot accommodate.

None of these are edge cases. They describe most of the clients on that book. Here is what one of them looks like from the inside.

The Scenario

A US citizen living in Zurich holds an international equity allocation at a Swiss custodian, spread across four non-US domiciled ETFs. On the January statement, it reads as a diversified, sensibly built portfolio. Nothing about it looks like a problem.

It takes a new adviser, running a routine review, to find the first one. Every one of those four funds is very likely a Passive Foreign Investment Company under US tax law. Foreign-domiciled, pooled vehicles meet that test almost by construction, regardless of what they invest in or how well they perform. Nobody chose this outcome; it came bundled with the ticker. And the client has no idea: once someone files this correctly, years of gains get reclassified and hit with retroactive interest, as though the tax had been due all along.

The second problem is sitting one tab over, in the client's employer stock plan, concentrated in a single sector. The four international ETFs, built to replicate a broad global benchmark, quietly add more exposure to that same sector on top of it, not because anyone decided the client needed more of it, but because the index doesn't know what the client already owns, and has no way to ask. And even once the adviser catches it, there's nothing to be done: an ETF can't be told to hold less of one sector for one client.

The third only surfaces in conversation: the family adopted an exclusion around a specific industry some months ago, for reasons of their own. Nobody had flagged that none of the four ETFs can honor it. There is no partial version of a fund holding: either the exclusion applies to the whole position, or it doesn't apply at all.

Three problems, one portfolio, and not one of them visible until somebody went looking on purpose. This is not a hypothetical or a worst case. It is the ordinary condition of a cross-border, concentrated, or mandate-driven equity book, and it maps onto the three failure modes below.

The Framework

Tax, concentration, and mandates. Three structural failure modes, and none of them is something an ETF can resolve, no matter how well it's built.

• Tax situation. Under US tax law, a foreign corporation is a Passive Foreign Investment Company if 75% or more of its income is passive, or 50% or more of its assets produce passive income: a test nearly every foreign-domiciled fund meets by construction (Internal Revenue Service 2025). For a US person, that status means gains are taxed as ordinary income at the highest marginal rate, back-dated with a compounding interest charge, and reported annually on IRS Form 8621 for every holding. A softer election exists, but it depends on the fund publishing data most non-US providers don't produce, so the punitive default is what most holders actually get. The fix is structural: hold the securities directly, and PFIC status disappears, because individual equities aren't PFICs. The market didn't create this liability. The wrapper did.
• Concentration and overlap. Sophisticated clients rarely arrive with a clean, uncorrelated book. Employer stock, a family business, an early investment, or simple home-country bias all create existing concentration before a single new dollar is allocated. An off-the-shelf international ETF has no visibility into any of this. It adds whatever the underlying index holds, regardless of what the client already owns, and can just as easily reinforce a concentration as offset it. A portfolio built security by security, by contrast, can be constructed around existing positions: underweighting or excluding what the client is already exposed to, rather than blindly replicating a benchmark on top of it. An index doesn't know what a client already owns. It only knows what's in the benchmark.
• Mandate and exclusion requirements. Exclusion and screening mandates are no longer a niche concern. A 2025 survey of 420 institutional investors across 29 countries, representing $33.8 trillion in combined assets, found that 85% now integrate sustainability criteria directly into their investment decisions (BNP Paribas Securities Services 2025). Private banks and family offices face a parallel, often more idiosyncratic version of the same requirement: a sector exclusion tied to a family's history, a religious or ethical screen, or a reputational constraint specific to one client. A bespoke exposure can be constructed to any specification, because the securities are selected individually rather than inherited from a third-party benchmark. The exclusion is simply one instruction among the many that define the portfolio. An index is binary, in or out. A mandate rarely is.

Each failure mode has the same shape: the wrapper imposes a rigidity the client's actual situation won't tolerate. The fix, every time, is the same structural move: replacing the pooled fund with a portfolio built directly, security by security.

Implications

The question for any adviser, private bank, or family office was never whether their client book contains one of these three problems. At any scale, the honest answer is almost always yes. The real question is whether anyone has looked. Clients rarely lose trust over underperformance. They lose it when they learn, later, that something was avoidable and no one told them.

None of this requires waiting for a better index to be built. A portfolio assembled security by security can be held directly by the client, screened against whatever a mandate requires, and rebalanced without ever passing through a pooled wrapper, which removes the PFIC exposure and unwinds the concentration risk in the same motion, rather than trading one off against the other. The infrastructure to do this at the scale an advisory practice actually needs did not used to exist. It does now.

What to Look for in a Solution

Once the problem is clear, the temptation is to reach for the nearest fix: a slightly better ETF, a managed account wrapper, a one-off bespoke mandate for the largest clients only. Each of these solves one failure mode and quietly leaves the other two in place. A solution built for this problem, rather than adapted to it, tends to share five characteristics.

• It holds the security, not the wrapper. This is the whole test, and it's simpler than it sounds: if the client's name is on the fund, not the stock, the PFIC exposure survives no matter how the fund is marketed. A "customized ETF" is still an ETF. The fix only exists at the security level, one line down from where most solutions stop.
• It was built for global equity, not retrofitted for it. Ask what the platform was designed to hold on day one. A system built around US-domestic names and later stretched to cover the rest of the world tends to show the seams: thin coverage in smaller markets, clumsy handling of local withholding tax, settlement conventions that assume a US calendar. Look for infrastructure designed from the start around global equity indices and the regulatory and domicile realities that come with them, not a US product wearing an international badge.
• It treats a new exclusion as a data point, not a phone call. Here's a useful test: when the family adds a new exclusion, or a client's employer changes stock plans, does someone have to manually rebuild the portfolio? If the answer is yes, the "customization" is really a one-time favor, and it will not survive the hundredth client, let alone the thousandth. The screening logic needs to live inside the construction process itself.
• It doesn't wait for the right index to be built. Some client needs, a specific exclusion list, an underweight to a concentrated sector, a bespoke regional tilt, simply have no off-the-shelf benchmark. A solution that can only overlay exclusions onto an existing index inherits every one of that index's blind spots. One that builds the exposure security by security never has to ask permission from an index provider first.
• It looks the same at client one and client one thousand. A bespoke solution that works beautifully for the founder's flagship account and collapses under the weight of the fiftieth client isn't infrastructure, it's a favor with a nice pitch deck. The real test of a platform is whether it degrades as the book grows, or whether the process for account one is, mechanically, the same process for account one thousand.

None of this requires a new index provider, a new custodian relationship, or a trade-off between customization and cost. It requires infrastructure built for the problem exactly as it shows up on a cross-border book, not a workaround wearing a solution's clothes.

This paper is the first in a planned series that goes deeper on each of these problems. A companion paper will examine the PFIC issue in detail: the sharpest and most immediate risk for cross-border RIAs and their US-linked clients. Another will address the concentration and mandate problem directly, for private banks and family offices managing complex, idiosyncratic books. Together, they make the practical case for a question every adviser should already be asking their own client book.

About Tessellare

Tessellare is a Swiss-based portfolio technology company, purpose-built for the complexity of international cross-border investing, with tax optimization built into its core. Unlike US-centric direct indexing platforms, Tessellare is designed from the ground up for non-US equity indices and the regulatory and domicile realities of global wealth management.

Sources

• BNP Paribas Securities Services. 2025. "ESG Survey 2025: Institutional Investors Leading the Way." May 20. securities.cib.bnpparibas/esg-survey-2025.
• EFAMA (European Fund and Asset Management Association). 2025. Trends in European Investment Funds: Fact Book 2025. 23rd edition. EFAMA. efama.org/fact-book-2025.
• ETFGI LLP. 2025. "ETFGI Research Reports Europe's ETF Industry Surpassed $3 Trillion Milestone for the First Time at End of September." London, October 10. etfgi.com press release.
• Ganti, Anu R., Davide Di Gioia, Nick Didio, and Liam Flaherty. 2026. SPIVA® U.S. Scorecard: Year-End 2025. S&P Dow Jones Indices LLC. spglobal.com SPIVA scorecard.
• Internal Revenue Service. 2025. Instructions for Form 8621: Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. U.S. Department of the Treasury. irs.gov/pub/irs-pdf/i8621.pdf.