Unconventional wisdom: Why this might be the wrong ETF for Aussie equity exposure
Running through the reasons an equal weighted ETF may not be right.
Mentioned: VanEck Australian Equal Wt ETF (MVW), Vanguard Australian Shares ETF (VAS), BetaShares Australia 200 ETF (A200)
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Why this might be the wrong ETF for Aussie equity exposure
“We have no control over outcomes, but we can control the process. Of course, outcomes matter, but by focusing our attention on process, we maximize our chances of good outcomes.”
- Michael Mauboussin
Last week I shared my thesis for why the VanEck Australian Equal Weight ETF (ASX: MVW) is my pick to help me achieve my goals. The caveat in that statement is that I’m talking about my goals. Your goals are different so you might make a different decision. And that is ok.
The point of these two articles is not my conclusion. It is the process of trying to figure out what investments fit a particular set of goals. In this case my goals.
As part of the process of selecting an investment for your portfolio it is worth considering why you may be wrong. Challenging your own thinking can either clarify and strengthen your convictions or poke so many holes in your thesis that you decide not to go ahead with an investment. Either way the outcome is positive.
Here are some reasons I could be wrong.
The cost of an equal weighted ETF
Life is about trade-offs. And there are two costs associated with equal weighted ETFs – higher fees and worse tax outcomes. The positives of an equal weighted ETF need to outweigh these negatives.
Fees
MVW has a total cost ratio of 0.35%. I wouldn’t characterise that as a high fee but it is significantly more than A200 which charges 0.04%. Fees can seem abstract but they add up over time. I have roughly 20 years until retirement. A $50,000 investment in MVW would result in $8,569.78 of fees over those 20 years. This compares to only $1,007.14 in fees for A200.
Tax outcome
One of the advantages of a market capitalisation weighted index is that there is no rebalancing needed. Vanguard founder John Bogle lauded this feature of passive investing because it improved tax outcomes. Rebalancing generates capital gains if the shares sold have appreciated in value. Those capital gains are passed on to ETF investors through distributions.
An equal weighted ETF must rebalance frequently to remain equal weighted. In the case of MVW that rebalancing occurs quarterly. In 2024, 7.17% of the distribution was made up of capital gains. Holders of MVW owe taxes on those capital gains. These are taxes that wouldn’t have to be paid if an investor owned a market capitalisation ETF like A200 which generates very little in capital gains.
How much taxes matter is based on your personal circumstances. If you are investing in a pension account in super you likely don’t care at all. If you are investing outside of super in the highest marginal tax bracket you probably care a lot.
My take
Fees and taxes matter. And clearly MVW falls short here. To justify buying MVW as an income investor I need to think that I am going to get more income over the life of my investment than I would buying A200. The additional income also needs to make up for the higher fees and taxes.
I think I will make enough additional income to justify the investment. In the first part of this article I showed how MVW has grown distributions much faster than the market capitilsation weighted index. I think this will continue.
The current yield on MVW is also higher. MVW yields 4.11% and A200 comes in at 3.21%. Part of the MVW distribution is made up of capital gains. But even if I lower the distribution by the portion attributed to capital gains MVW still has a higher yield at 3.77%.
Do I really avoid the industries that I want to avoid?
One of the reasons I’m drawn to an equal weighted ETF is because I don’t like the business models of miners and banks. I went through my rationale in the first article.
Am I avoiding those two sectors? Partially. This is still Australia and it is hard to get away from miners and banks. Below is the sector weightings of MVW and A200.
You can see the exposure is lower for MVW in the basic materials sector which includes miners and financial services which includes banks. It is still high. This argument for MVW is only partially true.
Valuation
Valuation is a critical component of investing. I took the fair values of the Morningstar Equity Analysts on the individual holdings of MVW and A200 and aggregated them into a price to fair value for each ETF. At the end of May MVW came in at 1.20 and A200 at 1.23.
That means the holdings in MVW are trading 20% above our fair value and A200 at 23% above our fair value. That is high. But since they are similar they don’t tip the scales in any direction.
From a relative valuation perspective the two ETFs are similar as well. MVW is currently trading at a price to earning ratio of 18.33 with A200 coming in at 18.55. Again not much of a difference or reason to pick one ETF over another.
Is my thesis on the largest ASX companies wrong?
Simplistically, the difference in future performance between MVW and A200 will come down to how things go for the largest companies in Australia. That will influence their share price and dividend growth.
Over the last year CBA has been the catalyst for the ASX 200. The shares are up over 40% and CBA is now the most expensive bank in the world. According to MST Marquee strategist Hasan Tevfik the ASX 200 would fall 5% if CBA traded at the historic average valuation for the bank.
My thesis is the prospects for the miners and banks isn’t great as I outlined in part one of this article. To be transparent I thought this before CBA’s run as I’ve been buying MVW for more than the last year.
I’m not going to go through the case of why I’m wrong on individual large companies in the ASX 200. I’m not sure this is needed as I think the most likely reason I’m wrong is the impact of super.
The largest super funds are doing everything possible to find places to invest the flood of money they are taking in. They’ve been putting it into global investments and private markets. But they still need to buy Australian shares.
Any passive super inflows will disproportionately go to the largest companies. Active managers can pick where they invest but in the case of giant super funds there are limitations related to scale. That makes it more likely that they will gravitate to the largest companies.
The shear scale of super money could overwhelm all my arguments about China demand slowing, valuation levels and the lack of growth opportunities for the big 4 banks. Academic arguments about investing aside the driver of share prices are simply supply and demand.
My decision
One of the reasons investing is so personal is because each investment plays a role in a portfolio.
And in this case my other Australian holdings inform my view of MVW. I hold another Australian ETF in my portfolio which is the Vanguard Australian Shares High Yield ETF (ASX: VHY).
VHY is a dividend ETF but many of the top 10 holdings mirror the ASX 200. It is also highly concentrated. Owning VHY and A200 would involve a good deal of overlap and would double down on some of the largest companies in Australia which I’m looking to avoid.
MVW and VHY also play different roles in my portfolio. I’ve written previously about how dividend ETFs like VHY deliver high yields but often fail to generate dividend growth.
As an income investor yield is important to me. But growth matters too because the purpose of generating passive income is to pay for things. As you’ve probably noticed ‘things’ keep getting more expensive.
VHY plays the role of a higher yielding ETF and MVW and some of my individual share holdings to contribute dividend growth.
Final thoughts
This was a worthwhile exercise for me as I’m still comfortable with MVW playing a role in my portfolio. That doesn’t mean MVW is right for you.
If I wasn’t an income investor I would likely come to a different conclusion. Think about your own goals and how that impacts the criteria you use to select an investment. And always stay humble and consider all the reasons you may be wrong.
A favour
Shani and I wrote a book. And we got somebody to publish it. All of that was challenging but now comes the really hard part - trying to get people to buy it.
Our book Investing Your Way will be released by Wiley on October 6th in Australia.
Investing Your Way is a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.
The book is currently in presale which is an important time to build momentum. If anyone would like to support this project you can buy the book now. Thanks in advance!
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What i’ve been eating
Conquering and ruling Gaul was no picnic for the Romans. The Gauls were fierce warriors. But ruling the territory did have some fringe benefits. In addition to fighting, the Gauls were also good at making charcuterie. The Romans developed a taste for it and exported Gallic cured meats to the rest of the empire. Part of the Gauls’ legacy is Saucisson Sec which is a dried pork sausage. Below is the version from Hubert in Sydney. The restaurant and jazz venue is located in a basement far below Bligh Street.
