For instant diversification, just add ETPs

Photo of Robin Bowerman By Robin Bowerman

min read

Good friends and family are a source of support and influence that is hard to overstate. They are also a primary source, for better or worse, of financial advice.

If you are looking to take your first tentative steps into the sharemarket, it is a reasonable bet that friends and family will be happy to share their successes and tales of woe. There will be a spectrum of views, from those who question the sanity of anyone not leveraging everything into residential property to the latest hot stock tip for a new listing.

To “stick with what you know” is a common phenomenon among investors and that’s understandable. The thought of diversifying further afield, into non-traditional sectors and asset classes as well as overseas investments, requires a level of research and time spent managing a disparate portfolio that many investors might find daunting.

For the first-time investor, this can be overwhelming to the point where it is easier to do nothing. Where do you start in selecting a stock to buy out of the 2000-plus on ASX?

That’s where exchange-traded funds (ETFs) can play a role. Rather than ponder what to buy in the market, why not buy the whole market?

(Editor's note: Learn about the features, benefits and risk of ETFs with the free ASX online course, Exchange-Traded Funds and Exchange-Traded Products.)

For an investor looking to diversify and tailor their portfolio’s exposure to various markets, sectors and asset classes, ETFs offer a simple and cost-effective way to leverage investment dollars further afield – and someone else does the hard yards in managing a wide array of investments for you.

So if ETFs are on your list of investment resolutions for 2016, here’s what you need to know.

Setting expectations for the year ahead
First, it’s worth considering the likely market outlook for the coming year, it is useful for setting realistic expectations.

According to the 2016 Vanguard Economic and Investment Outlook, the year looks to be one of muted but steady growth, with lower returns than in previous years for developed markets, including Australia, Europe and the US. There is also an expectation that the high-growth phase of emerging markets has ended, with growth in China continuing to slow.

This outlook indicates that investing broadly in equities across major markets could see consistent returns, if not scaling the heights seen in the years since the GFC as markets have normalised.

Rising rates in the US could have a short-term effect on fixed-income securities, particularly government bonds. Although prices for bonds with some way to go until maturity will drop, as rising rates mean newly issued bonds will fetch higher prices. It is important to remember that holding a bond fund for the long-term will see investors benefit from progressively higher returns over time.

ETFs can help you position your portfolio for growth across different markets and asset classes this year.

Buy the market, spread your risk
A simple way to describe an ETF is a managed fund that can be bought and sold on ASX. When you invest in an ETF, you are buying a collection of either company shares or fixed-income securities.

ETFs are typically index funds: they aim to track the overall performance of a market benchmark by buying securities according to their proportionate share of the index (i.e. their market capitalisation weighting).

Let’s look at how an investor tied up in Australian banks, miners and direct property might benefit from ETF diversification. They could buy into an ETF that follows a broad selection of the major ASX-listed companies. Vanguard’s broadest Australian ETF covers the 300 largest ASX-listed companies, while other ETF issuers such as iShares and SPDR also offer products with diverse exposure to the Australian market.

The investor will have exposure to the big banks and miners because of their high market cap weighting within the ASX sharemarket, but they will also gain exposure to myriad other companies. This spreads the risk at a specific security level and gives greater protection from downturns in individual sectors.

Diverse assets and asset classes
As well as shares, ETFs provide an avenue to easily diversify into other asset classes.

For example, if the investor already owns an investment property or feels the residential market is overvalued, they might consider an ETF that follows an Australian listed property index, which will give exposure to more industrial and commercial real estate ventures, as well as some residential.

The difference here is that, like individual shares, the ETF is a much more liquid investment than a bricks and mortar property and does not carry a hefty price tag to enter the market.

An ETF comprising fixed-income securities, such as Australian-issued bonds, gives investors the option to build a defensive element into their portfolio.

Bonds provide diversification benefits to riskier asset classes such as equities. Although they can experience periods of volatility, this generally pales in comparison to volatility in equities. High-quality bonds tend to provide considerable downside protection during equity market corrections and bear markets.

Although access to international bond markets has been limited for Australian investors, Vanguard recently added two global fixed-income ETFs to its product suite.

Australian-listed ETFs provide access to overseas markets, either tracking “all-world” indices or specific regions such as the US, Europe or Asia. Data and analysis from various industry data providers covering both retail and institutional offerings show that Australians allocate a large proportion of their equity exposure – usually at least 50 per cent and in some cases substantially more – to Australian equities.

This represents a significant overweighting to Australia compared to a weighting in global markets of closer to 3 per cent. One or two trades on ASX can work to address this bias.

Lower costs mean greater returns
Wide diversification is arguably the major benefit of ETFs but there are other factors investors should be aware of.

First, all the time and expertise a fund manager employs to run a broadly diversified ETF does incur costs for investors. Each ETF will have a management expense ratio (MER), which is subtracted from the fund’s total returns to cover expenses.

For example, the Vanguard US Total Market Shares Index ETF has an MER of 0.05 per cent, meaning that for every $1000 invested the underlying management fee is $5 plus brokerage charges.
Investors must keep in mind that the lower an ETF’s MER, the more of the returns they will receive. With index-based ETFs, investors should make sure a product they are considering does closely track its market performance benchmark.

ETF investors are also often subject to buy/sell spreads. These are typically small expenses, a few percentage points, that the investor incurs when buying or selling units of an ETF. But they are variable based on market conditions, so investors need to be aware of them when placing buy or sell orders.

Know the product, know its risks
Finally, investors should be clear on what kind of ETF they are investing in. Most in Australia are based on mainstream, third-party developed indices that track broad market benchmarks across a diverse range of securities.

The success and growth of ETF assets in 2015 naturally encourages innovation and competition, and more ETF providers in Australia are offering more specialised sector or rules-based investment approaches that come with quite different risk profiles that investors need to understand.

These more specialised ETFs have risk profiles more akin to active management than traditional market cap weighted index ETFs.

Both can play a role in a portfolio but it is important for investors to understand the risk profile. A sensible strategy can be to consider traditional market cap weighted ETFs as the core of your portfolio, with direct shares and active or specialist funds providing higher-risk – and hopefully higher-return – satellites.

About the author

@RobinBowerman is Vanguard’s Head of Market Strategy and Communications.

From ASX

If you have ignored ETFs because you do not understand them, or because they did not offer the exposure you were looking for at the time, now might be a good time to review our online course on ETFs. The course is free and no registration is required. The material is divided into topics so you can skip those you are not interested in and focus on those you are. There are lots of graphics and activities to help you reinforce what you have learned.

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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