3 things to check before adding another ETF
Portfolio overlap, cost and whether the new potential piece moves you closer to your goals.
My colleague Mark recently wrote on whether we have too much choice with ETFs. It can cause a variety of issues for investors – it can be overwhelming, and investors may have to choose between more than one ETF that is fit for purpose.
The large number of ETFs can cause both analysis paralysis and trigger action bias. This refers to the temptation to tinker and trade in an effort to maximise returns. This can cause a portfolio to take on unneeded complexity and be detrimental to investor outcomes.
It can feel productive to add new ETFs to an existing portfolio, but before you click ‘buy’, run three quick checks. Make sure the ETF aligns with your long-term strategy and adds value to your portfolio instead of unnecessary administration and complexity.
1. Portfolio overlap
Are you really getting new exposure, or just doubling up on an existing position? Many investors add ETFs in an attempt to diversify but actually are increasing concentration.
I was a victim to portfolio overlap when I first started investing. I worked at an active Australian equity focused fund manager. I invested across a few managed funds with varying objectives. However, I soon found I had limited visibility across their holdings. Once I gained some experience and explored my managed funds I found that they largely had the same exposure and held the same companies, regions and sectors.
Check the top holdings, sector and region breakdowns of the potential new ETF against your exposure in your current portfolio. You can use tools such as Sharesight for an aggregate overview of your portfolio. Morningstar allows you to see a sector/region/country breakdown through the Portfolio exposure feature. Find the ETF that you’re looking for, and click on the ‘portfolio’ tab.
If overlap is high, understand whether this ETF adds to what you are trying to achieve in your portfolio, or repackages exposure that you already have.
2. Cost
Most investors look at the expense ratio – the top line figure. Unfortunately, it is not the only one. Buy/Sell or Bid/Ask spread will impact your returns, especially for less liquid or smaller ETFs. Holding multiple ETFs that are doing the same thing may seem harmless when looking at a percentage-based fee, but over time, all of the small extra fees across multiple ETFs will make a difference. This is especially true for frequent traders.
These costs are amplified for thematic ETFs. These ETFs often charge higher fees and have less volume compared to broad market indexes. This raises transaction costs and erodes returns over time. Your exposure to a particular theme may be valid and in line with what your portfolio is trying to achieve, but be cognisant of the costs.
3. Align with your strategy and goals
The most common mistake investors make is chasing returns without considering their overall goals and strategy. A thesis may seem compelling but Morningstar research shows stark reasons for caution – thematic funds have tended to lag broad benchmarks.
Investors often hurt returns through poor timing and product churn. Our manager research team reports that many thematic funds underperform their benchmarks and closures have picked up, with closures in some years outnumbering launches.
This is why it’s important to have a written investment strategy that connects your portfolio with what you are trying to achieve. Your strategy is the voice of reason. It will help determine if you are making a decision based on market hype, or if it fulfils a purpose in achieving your financial goals.
To understand what to expect with an ETF and whether it aligns with your investment strategy read the methodology. What is the ETF trying to achieve? Is it similar to the exposure you need to achieve your goals? Put simply, if the ETF doesn’t change your portfolio’s core exposure in a way that maps to your objectives, you’re likely adding a speculative bet.
Speculative bets have higher odds of disappointment. If you are making tactical allocations, ensure that you have sized this in your investment strategy, and stick to these proportions.
A quick note: I’ve mentioned investment strategies multiple times. Don’t have one? Find a step-by-step guide here.
A quick checklist before adding an ETF
- Overlap: Compare the top 10 holdings and sector exposure – will the addition of this ETF materially change portfolio weights, and is it in line with your strategy?
- True cost: Look beyond just the management fee or expense ratio, and look to spreads, liquidity and the likely frequency of trading. Putting funds into 5 ETFs regularly instead of 2 may make a marked different to your outcomes over the long term.
- What are you trying to achieve? Look through the index methodology and see if that meets the criteria you’ve outlined in your investment strategy.
- If it’s a ‘new’ ETF, have a look at our Manager Research team’s guide on how to assess new funds so you’re able to make an informed decision.
Final thoughts
ETFs are powerful when you use them intentionally. The most robust portfolios aren’t the ones with two dozen holdings, they are ones where each holding has a clear purpose, and each allocation ties to your financial goals. This reduces unneeded costs, taxes and poor behaviour that can detract from your returns.
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