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Building a well-diversified investment portfolio from the ground up takes time and effort. But the task has become much easier thanks to the rapidly expanding universe of exchange-traded funds (ETFs).
ETFs are a type of low-cost managed fund that can be bought and sold on the Australian Securities Exchange (ASX) just like shares.
From a standing start in 2001, the number of Australians investing in ETFs rose 22% in the 12 months to October 2018 to a record high of 385,000, according to the Beta Shares/Investment Trends annual Exchange Traded Funds Report.
Some of the most enthusiastic early adopters of the products were SMSF investors. As you can see in the table at the end of this article, SMSF investors mostly use ETFs to gain exposure to global shares or as a passive investment in the broad Australian share market. But as the market expands, other self-directed investors and their financial advisers are catching on.
Even though the number of SMSF investors in ETFs has grown, their percentage of the market has fallen from 51% in 2013 to 31% in 2018. As ETFs go mainstream, the average age of investors has also fallen to 46. Millennials now represent 29% of the market and retirees 18%; five years ago, those percentages were the reverse.
ETFs a beneficiary of the Royal Commission
Financial planners were initially reluctant to recommend ETFs because of their ties to the managed fund industry and the commissions they provided. Now more than half of financial planners recommend ETFs, according to the BetaShares/Investment Trends report, and further 16% plan to do so in the coming year.
This is perhaps not surprising in the wake of the Royal Commission. Advisers are under pressure to provide greater transparency around their fees and shift from a commission-based model to fee-for-service. Advisers have also twigged that ETFs allow them to create low-cost, diversified model portfolios for their clients, something SMSFs and other self-directed investors have already discovered.
According to the March 2019 Class SMSF Benchmark Report, 22% of SMSFs now hold ETFs. International ETFs make up 56% of their top 20 ETF holdings, with Australian shares responsible for most of the remainder. But fixed interest ETFs have also been gaining popularity as a defence against the growing instability in global financial markets.
What investments do they offer?
You can buy ETFs to invest in all the major asset classes – shares, property, cash and fixed interest, local and global – as well as market sectors such as emerging markets, healthcare and technology stocks.
You can also use them to invest in commodities and currency, assets that were previously difficult for individuals to access.
With more than 240 exchange-traded products (mostly ETFs) available on the ASX, where is a new investor to start?
The answer is to know where you are going.
Have a game plan
It is much easier selecting investments if you know what you are aiming for. To use a football analogy, you won’t win the game by kicking the ball around without looking up to check where the goal posts are. The investment game is no different. You need to be clear about your goals and stick to your game plan.
If you are reading this, then it’s a fairly safe bet that one of your goals is a financially secure retirement. To achieve that goal, along with any others you may have such as a holiday or a new car, you will need a diversified portfolio of investments designed to ride out market ups and downs along the way.
To create a portfolio that provides your desired level of capital growth and income when you need it, there are three factors you need to consider:
- Your age and stage of life
- Your investment timeframe
- Your appetite for risk (and aversion to short-term losses).
The answers to these questions will determine the percentage of your portfolio you allocate to higher risk growth assets (shares and property) and lower risk defensive assets (cash and fixed income).
Generally, the younger you are, the more weighting you can give to growth assets in your portfolio because you have time to ride out short-term market fluctuations. While this holds true for retirement savings held in your super fund, you may need to increase your allocation to more conservative cash investments outside super to cover shorter-term goals such as a car or a home deposit.
Investors nearing retirement are generally advised to reduce risk by dialling down their allocation to growth investments. This is to ensure you have access to a steady income stream in retirement without having to sell down investments and crystallise losses during a market downturn. But with today’s retirees facing the prospect of more than 20 years in retirement, some exposure to growth assets is important.
In practice, your personal risk tolerance will determine the most appropriate mix of growth and defensive assets as you move through life.
ETF strategies to build your portfolio
ETFs can be a cost-effective way to build a diversified portfolio from the ground up, or to plug gaps and provide diversification to an existing portfolio.
A core-satellite strategy combines ‘core’ passive investments to gain exposure to a broad market such as Australian or global shares, property and fixed interest with ‘satellite’ investments in market sectors, regions or difficult-to-access asset classes.
Core holdings are designed to be bought and held long term. The aim is to provide returns that track one or more market indexes in one low-cost transaction.
Active fund managers who aim to beat an index have a mixed track record, with many underperforming their benchmark index for lengthy periods. They also charge higher fees than passive index funds due to their high management costs and portfolio turnover. The upshot is that index funds often provide superior performance at a lower cost.
The traditional function of a core portfolio is to gain exposure to a range of asset classes so that poor performance in one asset class won’t have a catastrophic impact on your overall returns. You could construct your core portfolio in one hit with a diversified ETF that invests across the major asset classes. The more common approach is to invest in several ETFs, each with exposure to a single asset class.
Here are examples of the two approaches (for illustrative purposes only, these are not recommendations):
- Vanguard offers pre-mixed diversified ETFs with investments in shares for growth and fixed interest for income. Depending on your risk profile, you can choose between a Conservative, Balanced, Growth of High Growth Diversified Index Fund.
- iShares has core ETFs covering Australian shares, International shares, Australian fixed income, international fixed income and Australian cash. iShares also suggests model portfolios made up of these five core funds with suggested asset allocations for five risk profiles: conservative, moderate, balanced, growth and aggressive. The model portfolio for a balanced profile is made up of the following asset allocations:
- iShares Core Composite Bond ETF 29.5%
- iShares Core S&P/ASX200 ETF 27.5%
- iShares Core MSCI World All Cap ETF 22.5%
- iShares Core Global Corporate Bond (hedged) ETF 10.5%
- iShares Core Cash ETF 10.0%
According to iShares, the aggregative management fee for the portfolio above would be 0.27%, well below the cost of assembling a portfolio of direct investments across these asset classes or by using traditional managed funds. You can read more on the costs of ETFs below.
Once you build a core portfolio, there may be times when your strategic asset allocation gets out of whack when particular assets or asset classes over- or underperform. Because ETFs are liquid and easy to trade, they provide a simple way to periodically rebalance your portfolio.
Once you have your long-term core strategy in place, satellite ETFs can be used get exposure to sectors or regions that offer shorter-term opportunities.
For example, you may think the US economy is recovering strongly and make a tactical decision to buy an ETF covering the S&P500 Index which includes the top 500 US listed companies. As you can see in the table below, this is a popular strategy with SMSF investors.
A satellite strategy can also be used to complement or plug gaps in your core holdings. For example, there are few opportunities to invest in global technology stocks in Australia. If you want to get exposure to the world’s leading technology companies but don’t want to pick stocks, you could invest in a global technology ETF or a Nasdaq 100 Index ETF which includes big tech stocks such as Facebook, Apple and Google.
ETFs can also add otherwise difficult-to-access asset classes to your portfolio. Think international shares and bonds but also commodities, gold and currencies.
According to ETF Securities Market Monitor, the top performing ETF in the year to May, based on total return, was EFTS Physical Palladium. Past performance is no indication of future returns, but this is an example of an ETF being used tactically during a period of high performance in the underlying asset.
Because ETFs are liquid and easy to trade, some investors are using them as an alternative to bank deposits to hold their short-term cash. For example, the BetaShares Australian High Interest Cash ETFs which appears in the table below invests in bank deposits and pays regular income but can be sold down if you need access to your capital.
What do they cost?
ETFs are generally regarded as a cost-effective way to build a diversified portfolio or to add to an existing portfolio for three reasons:
- The management fees they charge are generally much lower than the fees for comparable unlisted managed funds.
- Most ETFs are passive index funds, so management costs are low as are portfolio turnover costs because their underlying assets are not actively traded.
- Although you pay brokerage to buy and sell an ETF, they are less costly than buying a large number of shares or listed securities as there are less trading costs.
The table below shows the management fees charged for the 20 most popular ETFs used by SMSFs as at 31 March 2019. The list is provided by SMSF software provider Class, with the latest management fees available from ETF websites.
Management fees range from as low as 0.03% and 0.04% for the popular Vanguard and iShares US shares funds, to 1.35% for Magellan’s Global Equities Fund. Although most ETFs are passive index funds, Magellan’s fund is actively managed and hence more expensive than average.
The fees charged by the funds below are mostly below 0.5%, which is indicative of the broader ETF sector.
Table: Management fees of the top 20 ETFs held by SMSFs
|Rank||Security Code||Name||Management fee % p.a.|
|1||IVV||Ishares S&P500 ETF||0.04|
|2||VAP||Vanguard Australian Property Securities Index ETF||0.23|
|3||IOO||Ishares Global 100 ETF||0.40|
|4||VEU||Vanguard All-World Ex-US Shares Index ETF||0.09|
|5||MGE||Magellan Global Equities Fund||1.35|
|6||VTS||Vanguard US Total market Shares Index ETF||0.03|
|7||STW||SPDR S&P/ASX200 Fund||0.19|
|8||AAA||Betashares Australian High Interest Cash ETF||0.18|
|9||VAS||Vanguard Australian Shares Index ETF||0.14|
|10||SLF||SPDR S&P/ASX200 Listed Property Fund||0.40|
|11||IEU||Ishares Europe ETF||0.60|
|12||VGS||Vanguard International Shares ex-Australia ETF||0.18|
|13||VHY||Vanguard Australian Shares High Yield ETF||0.25|
|14||IEM||Ishares MSCI Emerging Markets ETF||0.69|
|15||VAF||Vanguard Australian Fixed Interest Index ETF||0.20|
|16||DJRE||SPDR Dow Jones Global Real Estate Fund||0.50|
|17||IAA||Ishares Asia 50 ETF||0.50|
|18||IXJ||Ishares Global Healthcare ETF||0.47|
|19||NDQ||Betashares Nasdaq 100 ETF||0.48|
|20||MVW||Vaneck Vectors Australian Equal Weight ETF||0.35|
Source: Class, various
How do I compare ETFs?
If you are considering building a core portfolio with ETFs, or adding ETFs to improve diversification, check out the websites of the major Australian issuers first.
Don’t just look at management fees but compare the underlying investments, index benchmarks and performance of like funds from different issuers. Some, like iShares above, suggest model portfolios using their products but there is nothing stopping you mixing and matching your own core portfolio from different providers.
The main ETF providers operating in Australia (in alphabetical order) are:
- ETF Securities
- iShares (owned by BlackRock Investment Management)
- Market Vectors (Van Eck Australia)
- Russell Investment Management
- SPDR (owned by State Street Global Advisors)
Learn more about SMSF investment in the following SuperGuide articles:
- How to invest in infrastructure through an SMSF
- SMSF guide to hedging
- SMSF investment rules: Collectables and personal use assets
- SMSFs and property: A Super Guide
- The definitive SMSF guide to franked dividends
- What are the SMSF borrowing rules?
- SMSF investment rules: What every trustee should know
- How to create an SMSF investment strategy (including examples)