How to build a low-cost, diversified portfolio

By Doug Turek, Eureka

Since the recent launch of exchange-traded bond funds it has become possible to build a properly diversified multi-sector portfolio entirely from exchange-traded funds (ETFs). Given their inbuilt diversification and low cost, this is not an unreasonable way to build a portfolio - although there are some limitations.

In this article I will demonstrate how to build simple and complex portfolios from a palette of 81 funds currently offered by eight suppliers, all available on ASX.

For those not familiar with ETFs, they are simple multi-investor unit-trust funds that track an index or the value of a commodity (the latter is also called an ETC). Exchange traded means you can only buy and sell on the sharemarket. Their low cost derives from their unmanaged style and, for retail investors, efficiencies from being bought on-market rather than directly from a fund manager.

ETFs were launched in 1989 in Canada and the US. More than $1 trillion is now invested globally in them, representing about 10 per cent of investment company funds. Most ETFs are backed solely by physical assets but a few are structured on derivative-based promises, which create concern about their security during times of financial system stress.

After a long incubation, their use is growing rapidly in Australia, with estimates of about $6 billion now invested, capturing about 10 per cent of the local indexed equity market. Although they are similar to listed investment companies (LICs), such as the Australian Foundation Investment Company, ETF holdings are not actively selected or traded, and their unit price is managed to closely reflect the value of the underlying assets.

The ETFs palette

In Australia you can use ETFs to invest in local and international shares, sectors, various commodities and precious metals, currencies and now bonds. The table below shows current Australian ETFs but I expect it to be out of date within a month, given the rapid introduction of funds.

Table of current Australian ETFs as at November 2012

In Australia, the eight suppliers include the big three global providers - BlackRock iShares (locally offering 26 funds), State Street Global Advisors (9) and Vanguard (8) - as well as BetaShares (11), ETF Securities (15), Russell Investments (5), Australian Index Investments (Aii) (6) and Chimaera (1).

ETFs from iShares (I), Vanguard (V), Russell (R), State Street (S), and ETF Securities (ETP) mostly begin with the same letters, while others have tried their hand at making clever acronyms to remember (GOLD, BOND, GOVT, EURO, POUnd, USD). Another supplier could be the Perth Mint's PMGOLD, but as this is only an option to buy gold it is unclear to me whether it is technically an ETF.

While suppliers offer ETFs in similar categories (they share the same row in the table above), not all funds are the same. Many use different index rules about what they include and don't and how much. For instance, each of the four high-dividend Australian share funds (IHD, SYI, VHY and RDV) are based on different indices from the S&P/ASX, MSCI, FTSE and Russell, and as such have different holdings.

You will need to do your own research and/or seek advice to select the one best for you. Look also at the bid/ask spread and assets in each ETF - about one-third of ETFs have less than $5 million invested in them today, and if they don't grow they won't survive.

Simple ETFs portfolio

A very simple multi-manager, multi-sector portfolio could be built, for example, using as little as four ETFs, incorporating:

1. Australian shares - for instance, State Street/SPDR STW, iShares IOZ or Vanguard's VAS, which provide the investment return from owning an index weighting of Australia's largest 200 or 300 companies.
2. US shares - Vanguard VTS, which delivers the returns from owning the largest 3,300 US companies.
3. International ex-US shares - Vanguard VEU, which delivers returns from about 2,300 companies outside the US.
4. Australian bonds - iShares IAF or State Street's BOND, which provide the return from the UBS Composite Bond Index made up of more than 110 representative Australian federal, state and semi-government and corporate bonds (the latter a modest less than 10 per cent).

The above funds' costs range from 0.06 per cent to 0.29 per cent of assets, or about 0.2 per cent depending on your mix of growth and defensive bond investments. Aside from a $150, or 0.1 per cent, one-off discount brokerage cost, your annual costs to invest in more than 5,000 share and bond securities would be about $200 for every $100,000 invested. This low cost and diversification demonstrates the appeal of ETFs.

Interestingly, the cost of this mix is between a half and one-third the cost of Vanguard's unlisted multi-sector index fund range (the amount of saving depends on amount invested). However, in fairness, those portfolios include additional assets and are rebalanced for you.

The reason there is no ex-Australia share fund (a combined US and non-US fund to make this a three, not four, ETF portfolio) is because the Vanguard Australian international share ETFs are investing into large US listed, US-centric ETFs.

iShares provides the broadest selection of international share ETFs, but they too do not offer an ex-Australian international share fund.

Your proportion of these ETFs depends first on your overall growth and defensive bond mix. If you apply a life-stage investment approach to your retirement savings, the amount of assets to hold in defensive bonds could be your "age in bonds" or "your age in bonds less 15 per cent".

Next you need to take a view on your domestic versus international equity bias. If you think the Australian dollar is only temporarily strong and/or the prospect for growth of banks' and miners' profits and price earnings is weak, you might have an equal mix of Australian and non-Australian shares.

However, note that your portfolio income will be lower the more non-franked, lower-yielding international shares you incorporate. Companies listed on the US market, which include many globally operating multinationals, represent about 40 per cent of the world sharemarket. Accordingly, you would mix the US and non-US holdings in a 40:60 proportion, before applying any other tilt.

Complex ETFs portfolio

Although the above portfolio is a neat illustration, I would not invest in it. It is far too simplistic and it is actually not diversified enough in terms of asset types: both shares and cash and bonds. A more complex portfolio can be illustrated to educate about additional tilts to consider improving diversification and potential returns, including:

• Small companies, both local (for instance iShares ISO, State Street's SSO or Vanguard's VSO, which track the Small Ordinaries index) and international (iShares Russell 2000 IRU, which provide returns from 2000 smaller US-companies only). Although these companies may be held in the index, because holdings are market capitalisation-weighted they are not in substantial proportions to provide a necessary effect.
• Value companies (Russell RVL), which long-term studies suggest could also deliver outperformance. This is only possible for the Australian share allocation.
• High-yielding Australian companies (where local investors can choose from iShares IHD, which, incidentally, caps concentration in high-yielding bank shares more so than Vanguard's VHY, State Street's SYI and Russell's RDV variants).
• Emerging markets (for instance iShares IEM), which increases the small allocation already in ex-Australia, ex-US VEU.
• Defensive sectors (like Global Healthcare iShares IXJ, Consumer Staples IXI and Telecommunication IXP) to try to correct for our local market bias to non-defensive resources and banks.
• Listed property (State Street SLF or Vanguard VAP Australian-only real estate trusts) to enhance yield and add inflation protection. As with small companies and emerging markets, there is about a 10 per cent holding already in the broader share index funds but more may be better.
• Inflation-linked bonds (iShares ILB only example) and floating-rate bonds/cash (Australia-only BetaShares AAA) so as to adopt my preferred three-component defensive bond allocation. You could replace the latter with higher-yielding term deposits but there is not yet an ETF for that.
• To further protect your spending power from a falling Australian dollar, the floating-rate cash-like component could be enhanced with cash invested in US$, euros and pounds (BetaShares USD, EURO, POU), although at a yield penalty.
• To potentially enhance the return (and risk) investing in Australian fixed-interest nominal bonds (using iShares IAF or State Street's BOND), the weighting to corporate bonds from the index could be increased (Russell RCB) - noting this mainly increases your exposure to Australian bank bonds and may not be desirably diversified.
• To increase inflation protection, an allocation to gold (priced in US$ BetaShares QAU or in Australian dollars ETF Securities GOLD), other precious metals (ETF Securities ETPIND, ETPCOP, ETPMAG, ETPMPT, ETPMPD, ETPMPM), Chimaera DIGGA, and other "hard" and "soft" commodities (BetaShares QAG, QCB, OOO) could be considered.

This portfolio is shown in "balanced-style" proportions, comparable or benchmarkable to Vanguard's "balanced" multi-sector index portfolio, which has an equal mix of company shares and bonds. I would not compare these with typical Australian employer default super funds, which have less than 25 per cent in defensive bonds - too little for the average age 50-plus investor in my opinion.

The average annual fund fee for this complex ETF portfolio is only slightly higher at 0.27 per cent than the simple portfolio, given the addition of more costly specialist assets. Establishment and periodic rebalancing brokerage will make this uneconomical for a small portfolio of, say, under $250,000.

Admittedly the number of ETFs here is excessive, and small allocations can have a negligible impact (e.g. 2.5 per cent in gold is too little for some and too much for others).

Although this portfolio is more diversified, in my opinion it is still incomplete because of some missing features and some better non-ETF asset choices.

At the risk of mixing metaphors, with the launch of bond ETFs you now have all the food groups from which you can make your own investment pie - with more ingredients on the way. Bon Appetit!

About the author

Doug Turek is Managing Director of Professional Wealth. This article first appeared in Eureka Report, a leading investment publication.

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