Young & Invested: Two types of ETFs I avoid
Because not every fund deserves a place in your portfolio.
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 73
I spent the past week on what felt like my tenth trip to Bali – a rite of passage for anyone with a West Australian driver’s licence. I’ve come back with the usual souvenirs: a tan (burn), a stomach ache and a brochure for a 25-year leasehold on a villa that doesn’t exist yet. Because if you can’t beat a housing crisis at home, you can just start one overseas.
And now, back in Australia, I opened my inbox to a rather riveting headline along the lines of ‘...new funds flood the ASX...’. A nice reminder that while Bali offers imaginary villas, the ASX continues to offer financial products I’d prefer remained fictional. But that is the free market, always expanding and very occasionally improving. Naturally, it got me thinking about the parts of that expansion I’m not participating in, specifically the types of ETFs I intentionally exclude from my portfolio.
Some context
Firing off a list of funds I do and don’t own is an entirely meaningless exercise without some background. The point of investing isn’t simply to chase an elusive return. We invest to build wealth and achieve financial goals with a strategy that aligns with what we’re trying to achieve.
My high-level investment goal over the past few years has been to build a $100,000 portfolio (excluding super) by the age of 30. As someone who has been in the workforce since I was 15 (and lived at home till 24), this target is within reach. Assuming I stick to regular contributions, this goal currently requires returning an average of ~6% p.a. in real terms.
And despite working in the investments industry, the strategy is to spend very little time tinkering with my portfolio while mindlessly searching for the next big thing.
What I avoid
Inverse ETFs
Inverse ETFs (often referred to as ‘short’ or ‘bear’ funds) are designed to move in the opposite direction of the index or benchmark they track. If the market dips, these products aim to go up. Importantly I should note that these funds won’t deliver a perfectly inverse return of the underlying index over any meaningful period.
Investors don’t get a neat scenario where the ASX 200 falls 5% and the inverse fund rises 5%. Such funds demand precision timing beyond just a general sense that markets might fall ‘soon’. Even if your big-picture call is correct, the path the market takes to get there can completely derail the outcome. Below is a hypothetical example of how an inverse fund may not perform to expectations, despite the underlying index losing value.
Source: Author visualisation. Index vs Inverse ETF performance in hypothetical high volatility scenario.
Inverse funds are often coupled with leveraged ETFs. These are funds that use borrowed money to increase your exposure to the market. They give investors a way to amplify returns without having to use margin loans or derivatives themselves. Adding leverage to an inverse fund aims to deliver a multiple of the inverse return. Fortunately, there are only a handful of such products on the ASX, a far cry from the US market where an entire zoo of these speculative instruments roam freely.
Perhaps my most obvious qualm here is the fact that these are widely regarded as short term investments. Something I have little interest in as a long-term buy and hold investor. Such funds are nothing more than a directional, speculative bet on market movements (which we know are random over the short-term). In many ways, it’s no different to walking into a casino and betting it all on red.
Though I’ll stop being cynical for a moment and admit they aren’t just for the avid gambler. There are a few other reasons why these products hold a certain appeal. During periods of market unease, many investors feel an overwhelming urge to do something to reassert a sense of control over our portfolios and by extension, our financial outcomes.
Instead of simply sitting on our hands (like most of us probably should), an inverse fund can soothe that feeling of vulnerability or the perception of being over-exposed if markets take a turn for the worse. This is a textbook case of loss aversion at work. The discomfort of watching markets fall is often stronger than the satisfaction of watching them rise. Thus, we desperately attempt to protect our remaining capital.
This instinct ties into the idea of hedging, which involves adding negatively correlated assets to reduce overall risk (as defined by volatility). The logic is that if most of your holdings tend to move in the same direction, adding something that moves in opposition should soften a hypothetical blow.
In terms of my own portfolio, I believe the misfit is somewhat obvious. I don’t believe hedging against broad market dips should be a priority for long‑term investors. Equities have risen substantially over extended periods, which makes holding an ETF that is negatively correlated to the market a poor fit for most growth‑oriented portfolios.
Active ETFs
For those unfamiliar with the ongoing active vs passive debate – I must admit, I envy you. Much like the lizard perched in my Bali hotel room, it is one of those things that refuses to die. At a high level, passive ETFs aim to replicate an index, whilst an active ETF is managed by a professional team, seeking to achieve a specific outcome such as outperformance.
In a landscape increasingly dominated by passive strategies, I recognise that excluding active funds from my portfolio isn’t exactly a groundbreaking call. But active managers still have their loyalists, particularly for those who grew up in the era of the ‘star’ fund manager / stockpicker. With around 60% of new ASX ETF launches in the last financial year being active funds, I don’t think they’re disappearing any time soon.
So, why the exclusion? My thesis rests on a few pillars, with Morningstar’s Active/Passive Barometer report being one of them. It is one of many studies that compare the performance of active funds against passive peers across various categories. Active managers have a higher performance hurdle to beat, given they typically charge higher fees for the promise of outperformance. Morningstar data has repeatedly shown that most active funds do not clear this fee hurdle and underperform passive funds in the majority of segments over the long term. Though that is not to say active managers never win.
The categories where active management has historically shown more promise are areas like ASX mid and small caps, global and domestic bonds and global real estate. Most of these are relatively under researched segments of the market where pricing inefficiencies can be better exploited. Nevertheless, these are all things I choose not to invest in. Despite the potential for outperformance, I’ve realised that the pockets where active tends to shine simply don’t overlap with the parts of the market that I’m building my portfolio around.
Another reason I don’t invest in active funds is that I don’t have an edge in picking managers, and quite frankly, don’t want a portfolio that requires me to pretend I do. Manager selection is a difficult exercise for any investor. Past performance is unreliable, skill is difficult to separate from luck, styles go in and out of favour and even the ‘best’ managers can underperform for long stretches. On top of that, managers operate under several constraints such as mandates, risk limits, benchmark pressures and capacity issues, all which can force them to make decisions that run contrary to what one would expect. I consider my investment strategy to be relatively hands off. Because of this, I’m simply not interested in building a portfolio that depends on correctly identifying and continually reassessing who I trust to outperform next.
Ultimately, my decision not to invest in active funds isn’t some grand philosophical stance. The categories where active management has historically added value aren’t the categories I invest in. Additionally, the long‑term data doesn’t give me a compelling reason to take on the extra complexity, cost and uncertainty. This approach is understandably dull to some, but as always, different strokes.
