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Building a well-diversified investment portfolio from the ground up takes time and effort. But the task is much easier these days 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, there are now 223 ETFs listed on the Australian Securities Exchange (ASX). In March 2021, the total value of ETF assets broke through the $100 billion dollar barrier and continues to rise.
Who’s using ETFs and why
The number of Australians investing in ETFs rose 58% in the 12 months to August 2020 from 420,000 to 720,000, 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 and their numbers continue to grow – up 55% in the year to August 2020 from 135,000 to 210,000. A decade ago, just 30,000 SMSF investors used ETFs.
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 continues to grow strongly, the average age of new adopters is under 40. The report found 65% of new ETF investors were Millenials and Gen Zers, while 23% were female.
The main reasons given for investing in ETFs were:
- Diversification (63%)
- Access to specific overseas markets (42%)
- Avoiding the risks of individual stock exposure (42%)
- Efficiency (39%).
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, 26% of financial advisers see an ETF-dominated portfolio (defined as more than 75% of a portfolio) as appropriate for SMSFs, according to the BetaShares/Investment Trends report.
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.
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 geographic and industry sectors such as emerging markets, healthcare and technology stocks.
As the market develops, thematic ETFs are becoming available covering global companies in emerging sectors such as artificial intelligence (AI), robotics, cybersecurity, gaming, and battery technology and lithium. One of the fastest growing ETF categories is ethical or sustainable investments, especially among younger investors.
You can also use ETFs to invest in infrastructure, commodities and currency, assets that were previously difficult for individuals to access. There is even industry speculation that cryptocurrency ETFs are not far off.
With 223 ETFs across seven asset classes available on the ASX as at June 2021, and more products being listed regularly, 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 safe bet that one of your goals is a financially secure retirement. To achieve that goal, along with medium-term goals such as a home deposit, 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 holiday.
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 in retirement phase 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):
- Alongside its single asset funds, 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 or High Growth Diversified Index Fund.
- iShares has core ETFs covering Australian shares, international shares, Australian fixed income, international fixed income and Australian cash. It also has a core builder tool on its website that allows you to name an investment sum and allocate a percentage to each of the core ETFs. You will be given an aggregate fee for your final portfolio and a breakdown of underlying investments. If you invest through a financial adviser, you may be offered a core portfolio of these ETFs on an investment platform but additional platform and advice costs will apply.
Alternatively, you can select core ETFs from various ETF providers and build your own core 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 that 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 that includes big tech stocks such as Facebook, Apple and Google. These ETFs also feature in the SMSF Top 20 list below.
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 August 2021, based on total return, was BetaShares Geared US Equity Fund (currency hedged) with a total return of 77.7%. Past performance is no indication of future returns, but this is an example of an ETF being used tactically at a time when the US market was recovering strongly and posting record highs. The fund with the largest inflows was Vanguard’s Australian Shares Index ETF, which occupies third spot in the SMSF Top 20 below.
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 diversified portfolio of direct shares or listed securities with separate brokerage fees for each transaction.
The table below shows the management fees charged for the 20 most popular ETFs used by SMSFs as at 30 June 2021. The list is compiled by SMSF software provider BGL, with the latest management fees available from ETF websites. Funds are ranked according to their percentage of the dollar value of all SMSF ETF holdings on the BGL platform. Management fees range from as low as 0.03% and 0.04% for the popular Vanguard and iShares US shares funds, to 0.5% for iShares Asia 50 ETF. Growing competition in the market has put downward pressure on fees; just two years ago the highest fee in the top 20 was 1.35%.
Table: Management fees of the top 20 ETFs held by SMSFs (30 June 2021)
|Rank||Security code||Name||% of total SMSF ETF $value||Management fee % per yr|
|1||IVV||iShares S&P500 ETF||7.00||0.04|
|2||VTS||Vanguard US Total Market Shares Index ETF||6.20||0.03|
|3||VAS||Vanguard Australian Shares Index ETF||5.56||0.10|
|4||VEU||Vanguard All-World Ex-US Shares Index ETF||4.15||0.08|
|5||IOO||iShares Global 100 ETF||4.13||0.40|
|6||VHY||Vanguard Australian Shares High Yield ETF||3.94||0.25|
|7||STW||SPDR S&P/ASX200 Fund||3.06||0.13|
|8||VGS||Vanguard MSCI Index International Shares ETF||2.86||0.18|
|9||VAF||Vanguard Australian Fixed Interest Index ETF||2.74||0.20|
|10||NDQ||BetaShares Nasdaq 100 ETF||2.68||0.48|
|11||MVW||VanEck Australian Equal Weight ETF||2.62||0.35|
|12||VAP||Vanguard Australian Property Securities Index ETF||2.30||0.23|
|13||IXJ||iShares Global Healthcare ETF||2.24||0.46|
|14||VGAD||Vanguard MSCI Index Internátional Shares (Hedged) ETF||2.01||0.21|
|15||IOZ||iShares Core S&P/ASX 200 ETF||1.72||0.09|
|16||QUAL||VanEck MSCI International Quality ETF||1.70||0.40|
|17||MVB||VanEck Australian Banks ETF||1.48||0.28|
|18||MVR||VanEck Australian Resources ETF||1.41||0.35|
|19||IAA||iShares Asia 50 ETF||1.35||0.50|
|20||IAF||iShares Core Composite Bond ETF||1.32||0.15|
Source: BGL, 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.
The main ETF providers operating in Australia (in alphabetical order) are:
- ETF Securities
- iShares (owned by BlackRock Investment Management)
- Russell Investment Management
- SPDR (owned by State Street Global Advisors)
- VanEck Australia