
Kris Walesby
ETF Securities
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Kris Walesby
ETF Securities
The exchange-traded funds (ETF) market in Australia is growing quickly. There are now more than 200 ETFs to choose from, with total assets of $56 billion. Over the past three years the amount of money invested in Australian funds has been growing by more than 30 per cent annually.
So, what has been driving the wider adoption of ETFs, particularly by self-managed superannuation fund (SMSF) users?
First, Australians are gradually catching up to other markets in terms of their knowledge of ETFs and the ways they use them in their portfolios. While ETF usage is still relatively small, growth rates are well above those in more mature markets, indicating that Australia is starting to close the gap.
Second, with the proliferation of new products, ETFs are now a viable one-stop-shop for investments and can provide solutions to investors with many different needs and objectives.
Third, in the wake of the findings of the banking Royal Commission and the Productivity Commission, the spotlight has been firmly on fees, adviser commissions, intermediaries and conflicts of interest. The low-cost, high-transparency nature of ETFs has been popular against this backdrop.
With more investors looking to use ETFs to help build retirement portfolios, how should they approach this task? Below we highlight some areas of best practice that can be used when thinking about how best to deploy ETFs in a portfolio.
The process outlined involves the selection of a broad asset allocation, the choice of specific investments and the adoption of procedures for regular review and rebalancing.
Regardless of whether you are a self-directed investor, use some form of advice or are a professional wealth manager, the first step in building a portfolio is laying down its goals and translating these into a high-level asset allocation.
Determine how much to allocate across broad categories of investments, or asset classes, such as stocks, bonds and commodities.
The aim of asset allocation is to arrive at an efficient portfolio that maximises return for a desired level of risk. Risk appetite, or tolerance, will be down to the individual investor, both in terms of their personal preferences and dispositions towards risk and their financial capacity to take on risk. In determining an appropriate level of risk, age and life stage are key factors but other considerations and goals can be equally important.
For professional wealth managers, the asset allocation process will involve setting long-term capital markets expectations and constructing mathematically efficient portfolios.
Self-directed investors will generally be less scientific in their approach, either using model portfolios published by professionals, online tools from firms such as robo advisers or using simple allocation models such as allocating “120 minus your age” to shares and the rest to bonds and cash.
Hypothetical asset allocations might look something like:
Source: ETF Securities
ETFs aid asset allocation by providing simple diversification tools in a transparent and cost-effective manner.
Many of the largest ETFs are designed to passively track entire markets and this means some ETFs fully cover broad asset classes such as domestic and international shares and domestic and international bonds. In the most basic case, an entire broad asset allocation can be implemented with just a handful of funds.
Most investors, however, are more granular with their choice of asset class categories, splitting stocks and bonds into sub-categories along country or regional lines, separating developed and emerging markets or large-cap and small-cap stocks, and including alternative assets such as real estate, infrastructure and commodities. The basic idea remains the same and the ETF industry has grown to accommodate this approach by offering more specialised and tailored funds.
An example of ETF asset selection following on from an asset allocation decision is shown below:
Source: ETF Securities, ASX. MER = management expense ratio
Another common approach to asset selection is to divide a portfolio into “core” and “satellite” components. The core, especially where ETFs are being deployed, should generally be made up of low-cost, broad-based passive funds and represent the bulk of the portfolio.
Satellite positions complement the core and often have a different investment objective to the rest of the portfolio. Here, the asset mix can be tailored to the individual’s personal goals, risk preferences and investment views.
Satellite positions are often deployed to seek outperformance over the broad market, or alpha. Because satellite positions are generally more specialised and tend to be smaller than core holdings, fees, while relevant, are often less of a concern. This is where strategy or smart-beta, sector and thematic ETFs, as well as actively managed funds and single stocks, can be deployed.
Source: ETF Securities.
A word of caution: when mixing combinations of ETFs, active funds and individual securities, investors should be careful how they are affecting their overall asset allocation and exposure to risk factors such as currencies, sectors or individual securities. This should involve a thorough examination of the underlying assets held in each ETF or managed fund to ensure there are no unintended over-weighting to particular areas.
Equally important to setting an asset allocation strategy is deciding how to keep your portfolio aligned with your goals over time. This involves both reviewing your asset allocation periodically and adjusting, or rebalancing your asset selection to ensure they remain aligned.
For many SMSF investors, particularly those with long horizons, asset allocations should be reviewed, but it is unlikely that adjustment will be necessary unless there have been major changes to an individual’s circumstances. For many, a periodic review every three to five years is sufficient. Investors closer to retirement should more actively monitor their allocations.
Portfolio rebalancing is equally important and is something that many self-directed investors neglect. Over time, your portfolio holdings will probably drift away from their target levels. This happens naturally as the value of assets goes up and down relative to each other and as income is distributed.
A prescribed and disciplined approach to rebalancing is the key. Too infrequent rebalancing can result in sub-optimal asset allocations, while too frequent rebalancing can result in unnecessary trading and high transaction costs. This is especially true for investors managing small portfolios.
There are two main ways to approach portfolio rebalancing. The first monitors the allocations on a regular basis and rebalances as soon as they move away from target by a predetermined amount, say, 5 per cent or 10 per cent. The second approach, which involves less oversight, simply rebalances with a predetermined frequency. It is generally recommended to rebalance on at least an annual basis.
ETFs provide SMSF investors with a wide range of portfolio diversification options and the investment choices available will increase over the coming years.
While there are many approaches to building a portfolio of ETFs, investors should always keep three key questions in mind:
About the author
Kris Walesby, ETF Securities
Kris Walesby is chief executive of ETF Securities, a leading ETF issuer.
From ASX
If you have overlooked ETFs because you do not understand them, or because they did not offer you the exposure you were looking for at the time, now might be a good time to review the ASX online course on ETFs.