This article is a contributed piece to Morningstar from ETF provider VanEck Australia. The views and opinions expressed in this article are those of VanEck Australia and may not reflect the views of Morningstar.

The accessibility, transparency, liquidity and low costs of index-tracking exchange traded funds (ETFs) have made them a valuable tool for investors to achieve their investment goals. There are several different ways investors can use ETF’s to build portfolios to create wealth.

The range of ETFs has exploded in recent years resulting in over 215 different ETFs available on the ASX as at 28 February 2021. Australian investors can now get diversified exposure to a huge range of domestic or international asset classes via a single trade on the ASX. The proliferation of ETF offerings has led to the emergence of entire portfolios built exclusively with ETFs.

This has been enabled by the increasing sophistication of the ETF industry, particularly the growth of smart beta ETFs on ASX, enabling investors to achieve thematic investing and targeted investment outcomes. We discuss below some different strategies investors can use to build portfolios.

Core and satellite

As the name suggests, this involves building a portfolio by investing in a fund that comprises a core strategy and adding individual positions or satellites around that core. For an Australian equity-focused portfolio, a core strategy would be achieved by investing in a broad based Australian equity ETF. 

For satellites you could take positions in sector specific funds and/or individual stocks that reflect your current views on markets. For example, if you think that the resources sector is going to outperform you could put a percentage of the portfolio allocated to satellites into a resources sector ETF, of which there are several listed on the ASX. Satellite exposures can easily be adjusted by buying and selling ETFs exposed to different sectors.

MORE ON THIS TOPIC: Investing basics: how to build a core and satellite fund portfolio 

Strategic Asset Allocation (SAA)

Asset allocation is a critical element of any investment strategy. It underpins portfolio performance and drives the bulk of an investor’s risk and return outcome. SAA is generally a long term portfolio strategy that involves setting target allocations for various asset classes for the long term and rebalancing the portfolio back to the target allocations periodically when the allocations change due to market movements.

Investors can adopt SAA strategy across a number of asset classes to achieve diversification. You can achieve the recommended exposure to each asset class via investing in different ETFs, which provide investors with a simple and cost effective way to obtain diversified exposure to a specific asset class via a single trade on ASX. The example below highlights this.

Strategic asset allocation

Investors can also use model ETF portfolios, which offer a diversified approach to portfolio construction, taking the hard work out of asset allocation decision-making. Some research houses have put together model portfolios. Each model portfolio is split between growth and defensive assets across a range of ETFs that provide an appropriate exposure to the relevant asset class. ETF model portfolios can be used by investors to effectively implement SAA tailored to different risk/return profiles such as balanced, growth and high growth.

Tactical Asset Allocation (TAA)

TAA is an active portfolio strategy that takes advantage of short term opportunities in the market with a view to actively generate trading profits. TAA may be implemented at the portfolio level or could be used within the asset allocation of a SAA strategy.

For example, consider a SAA that allocates 70 per cent to growth assets comprising Australian equities. If you think that banks are undervalued today, you may decide to tactically allocate some of that 70 per cent to banks. You can use ETFs to do this type of trading. In this example you could buy an ETF focused on bank shares for the additional exposure to banks. If you later decide that banks are overvalued and think property is undervalued, you could switch your TAA from banks to property by selling out of the bank ETF and buying an ETF focused on listed property, of which there are several to choose from on the ASX.

MORE ON THIS TOPIC: Why we can’t resist tactical asset allocation (Firstlinks)

ETFs can also help mitigate concentration risks for an investor, who may only hold one or two stocks within a particular sector without the benefit of a more diversified ETF which can help to reduce risk.

As we move forward, portfolios constructed entirely from ETFs will become more common. Investors are increasingly demanding that investment portfolios provide better diversification at lower cost; index-tracking ETFs offer this while delivering transparency, liquidity and simplicity. ETFs too are democratising investing so that all types of Australian investors can buy into asset classes previously only available to institutional investors.

Investors too are demanding better outcomes given the underperformance of most active managers. That underperformance is backed by research from S&P Dow Jones Indices. Research from S&P Dow Jones Indices, the SPIVA Australia Scorecard has found that during the first half of 2020, the majority of actively managed funds in all categories (apart from Australian real estate investment trusts, or A-REITs) suffered worse drawdowns versus their respective benchmark indices. This is a trend evident over the longer term too, so ETF use is likely to become more common in constructing portfolios to complement or replace actively managed funds.Â