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How to buckle up for bull markets with ETFs

Photo of Alan Hull, author By Alan Hull, author

min read

Exchange Traded Funds are also a tool for active investors and traders.

The world’s major sharemarkets are enjoying a bull run and our market is rising along with them. But unlike the US, where the rally is broad based, our market is rising far more sedately.

The following charts of the US S&P 500 and the local S&P/ASX 200 indices demonstrate this difference, with our market rising approximately 20 per cent since early 2016 and the S&P 500 up around 26 per cent.

The other obvious difference in the two markets is their overall volatility. Put in simple terms, our ASX 200 index is bouncing around a lot more.

So, our market has a lower rate of return and greater volatility, and any fund manager will tell you this makes the US a more attractive proposition for investors and traders.

With this obvious choice, we decide to allocate a portion of our total investment capital to the US and contemplate how to go about it. There are several issues to deal with, the first being that the US has two major equity markets, the New York Stock Exchange (NYSE) and NASDAQ.

This means that if we are to create our own portfolio of US stocks we need to master two markets, not just one. We also need access to an international trading platform and be prepared to deal with all the administrative issues of managing offshore investments.

In the case of the US, be warned that the paperwork can be onerous and there are service companies dedicated to helping Australian investors deal with it all.

There is also the complication of currency exchange. If the Australian dollar becomes stronger while you hold investments offshore, this will offset some or possibly all the gains from your investments.

As you can see, there are several hurdles to jump over if you are a DIY investor and want to tap into foreign markets, so you may now understand all the fanfare exchange-traded funds (ETFs) have been getting, because they help leapfrog these issues (note currency risk and US market paperwork may still need to be considered depending on the product).

To access the S&P 500 index directly, you can simply buy an ASX-quoted ETF the same way you would buy shares in Commonwealth Bank or BHP Billiton.

Many ETFs over US sharemarket indices are available but my two preferred options are iShares S&P 500 AUD Hedged ETF - IHVV and Betashares Geared US Equity Fund – Currency Hedged (Hedge Fund) GGUS. Both track the US S&P 500 index, which covers both the NYSE and NASDAQ markets. You don’t need a separate ETF for each market.

(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article.)

You can compare these two ETFs, shown below, to the earlier chart of the S&P 500 to see how well they track the index.

One reason these ETFs closely resemble the S&P 500 index is because both employ currency hedging, alleviating concerns about the direction of the exchange rate between the US and Australia. Although these two charts are very similar in shape, there is one key difference: IHVV rises by the same proportion as the S&P 500 while GGUS rises (and falls) at about twice the rate of the S&P 500.

GGUS is geared slightly more than two to one against the S&P 500, while IHVV has no gearing.

So, to gain access to the US markets in my conservative blue-chip growth portfolio, I prefer to use the more conservative IHVV.

On the other hand, when I am trading and watching the markets daily, I can be more aggressive in my approach and take advantage of GGUS’s gearing.

Within my blue-chip portfolio, I treat the US like a sector and allocate a portion of my total capital accordingly. But the problem I have been experiencing recently is that even though our market is rising, we are seeing a narrow advance. This means very few sectors are outperforming the broad market and only a few key shares are driving these sectors.

Normally if you cannot find enough shares to fill a portfolio, the convention would be to leave the unallocated capital in cash. But this is not going to work too well if the market is trending up over time. Staying in cash would mean falling behind.

One solution would be to overexpose to the few outperforming sectors but this is a breach of sound risk-management principles. Yet here again we can turn to index ETFs for a convenient solution.

Rather than leave any unallocated capital in cash, I can use it to buy the entire market, which is a much better baseline when the broad market is rising. And going back to the earlier chart of the ASX 200 you can clearly see our market is indeed rising over the medium term.

Of course, if you are not entirely confident our market is rising, you can use a mix of both cash and index ETFs, and there is nothing stopping you from adjusting this mix at any time.

The obvious choices here are SPDR’s STW and iShares’ IOZ. Both are ETFs over the ASX 200 index and behave very similarly to each other and the ASX 200 index. They both appear below and you can compare them with the earlier chart of the ASX 200 index.

Here is the simple logic that underpins this tactic: if you own four shares from two sectors that are outperforming the broader market and the rest of your capital is tracking the index, you will outperform the market.

Simply matching the broader market performance over recent months has been challenging as investors have been compromising share selection to own enough shares to make up a whole portfolio. My advice is don’t do it. Sell suspect shares and leave the money in an ETF.

Visit the issuer’s website and read the fact sheets and performance data carefully before buying an ETF. These sites are easy to navigate, even for those not technically minded. These recommendations for certain ETFs are made independently through my personal analysis. I really like index ETFs.

About the author

Alan Hull is one of Australia's leading sharemarket experts. To enroll in one of his free online courses, visit his website.

From ASX

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The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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