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Investing basics: How to build a simple, low-cost core portfolio with ETFs – Part 2

Emma Rapaport  |  25 May 2021Text size  Decrease  Increase  |  
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In Part 1 of this series on building core portfolios with ETFs, we looked at the benefits of keeping things simple, defining our financial goals, which in turn helped us define our asset allocation. We also looked at the difference between risk and volatility and why we should separate them when thinking about our own risk tolerance.

In part 2, we'll learn how to populate our portfolios with low-cost, well diversified building blocks, the dos and don't of executing trades, and long-term maintenance to make sure our portfolios adhere to our goals.

As a quick refresher, we're looking at building the “core” element of our portfolio. The core proportion should be invested according to your financial goals. This means defining the balance in your portfolio between risk and return where your assets classes – stocks, bonds, property etc – are weighted according to your objectives. The “satellite” portion of the portfolio is where to express your tactical views on the market.

For simplicity, the next part of this series will examine investments to fill a balanced portfolio that holds 50 per cent of its core in growth assets like stocks and 50 per cent in defensive assets like fixed interest.

Populate your portfolio with low-cost, well diversified building blocks

Growth allocation

We can now turn our attention to identifying the simplest possible building blocks to populate our portfolios. If you're a little fuzzy on ETFs, re-read our previous “back-to-basics” series on ETFs.

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Rapid product growth means global markets have been sliced and diced so finely that the selection process can seem daunting for the do-it-yourself investor. Today, there are over 230 ETFs trading on Australian exchanges. But it doesn't have to be if you know what you're looking for before. We're not looking for anything fancy here: index-tracking, low-cost and broadly diversified equity exposure from a plain-vanilla fund. A fund offering narrow exposure to a particular sector or theme isn't going to do it.

The first step is to define what type of equity exposure you are looking for. The two most common ways to break down the equity universe are by size (large-cap, mid-cap and small-cap) and style (growth to value). From there stocks are often segmented even further by economic status (developed, emerging and frontier), geographic region (Europe, Asia-Pacific, Latin America, etc) or by factor (quality, income, momentum). Index construction rules are also a consideration. Is the fund market-cap weighted or equal-cap weighted?

In our case, we are looking for comprehensive exposure by geography. We don't need to get too granular in our strategic core portfolio by delving into size and style tilts. Such investments or tilts are more appropriate as tactical investments in the satellite portfolio.

For our balanced portfolio, investors can achieve a broadly diversified global portfolio by evenly dividing the equity allocation into two subsets: Australian stocks and global stocks. For example, putting 25 per cent in each of the two equity groups would make up the entire 50 per cent equity allocation in a 50/50 growth-defensive portfolio.

For comprehensive domestic equity exposure investors could look at one of the four major ASX tracking ETFs – Vanguard Australian Shares ETF VAS, BetaShares Australia 200 ETF A200, SPDR S&P/ASX 200 ETF STW and iShares Core S&P/ASX 200 ETF IOZ. These ETFs invest in the 200 – 300 largest Australian listed companies and reach all the way down into the mid-cap territory, covering about 80 per cent of the market. The indexes are market cap weighted meaning weighted according to the total market value of their outstanding shares.

Some things to think about when selecting an ETF include:

  • Look under the hood – what is the ETF investing in?
  • Management fees (built into the ETF)
  • Tracking – or how well it mirrors the index
  • Total fund size
  • Performance
  • Liquidity

Australian Equity ETFs

Source: Morningstar

If you'd like to know more about what VAS holds, we did a deep dive into the fund last year. In short, the ASX 200 is heavily weighted toward large mining companies and financials, which collectively make up around half of all holdings. The index is also top-heavy, with more than a fourth of assets in the top five holdings. Some sectors that are prominent on the global stage are underrepresented in the Australian market.

Next, for the most broadly diversified exposure to developed market global stocks, you can't beat Vanguard MSCI Index International Shares ETF VGS. This fund provides exposure to many of the world’s largest companies listed in major developed countries at a remarkably low cost. With over 1,500 stocks constituting the index, the MSCI World ex Australia is a widely popular barometer for the world developed-markets equities. The index indeed has country concentration risk (the US forms 68 per cent of the index), but a high allocation to the US is a common feature across most global indexes. Helping mitigate this risk is the fact that many of the large US stocks are multinationals (Apple, Microsoft, Amazon, Alphabet, Facebook, and so on), earning a substantial percentage of their total revenue from international markets.

Underrepresented sectors in Australia such as information technology and healthcare are well represented in the MSCI World ex Australia, with over 35 per cent of the index as of 31 October 2020. Other options in this space include the iShares Core MSCI World All Cap ETF IWLD. Hedged versions of both funds are also listed.

Global equity ETFs

Source: Morningstar

What about emerging markets? Adding emerging markets stocks can help diversify your portfolio. But due to their higher volatility, as well as regulatory and geopolitical risks, the most risk-averse investors may choose to confine them to the satellite portion of their portfolio or avoid investing there altogether. In the spirit of keeping it simple and low-cost, Morningstar analysts prefer the Vanguard FTSE Emerging Markets Shares ETF AUD VGE.

Defensive allocation

Just like in the stock market, the performance and risk profiles of the different segments of the fixed-income market can vary significantly. Bonds are first categorised by the type of issuer—government, corporate, sovereign, etc—and then by credit quality and maturity. Relative to stocks, the typical individual investor isn't as familiar with how the bond market operates. This is because the bond market is far less transparent. There is (almost) no retail-accessible central exchange where bonds are priced and traded.

That highlights part of the beauty of bond ETFs: they bring transparency and liquidity to the market by bringing bonds on to the exchanges. ETFs also help make bonds more accessible for the masses. There are often high minimum investments and wide spreads associated with buying individual bonds. Along with the costs involved, this pretty much makes achieving adequate diversification unattainable for everyday investors.

However, with just one ETF investors can achieve diversified exposure to the broad Australian bond market, including investment-grade government bonds and corporate bonds across all maturities. Here, investors can look to the oldest and largest broad bond market ETF: iShares Composite Bond IAF which holds a portfolio of around 600 bonds and charges a management fee of 0.15 per cent. For global bonds, take a look at the Vanguard International Fixed Interest Index (Hdg) ETF VIF.

Bond ETFs

Source: Morningstar

A quick aside on active bonds

We've just set out a sample portfolio that consists entirely of index-tracking ETFs. We did this because index-tracking funds are low-cost, transparent, and offer instant diversification. However, Morningstar analysts think now is a pretty decent time to think about using an active-ETF for a component of the fixed income portfolio. This is because active managers can be more opportunistic and defensive.

"At a time of historically low and potentially rising interest rates, we think investors should take a more flexible approach to their bond allocation," says Morningstar director of manager research Tim Murphy.

"We think blending the passive exposure with some active ETFs that are now available makes some sense. This change adds more flexibility to appropriately manage exposure in a potentially rising rate environment."

But remember active managers will be wrong at various points in time. Morningstar analysts have stated a preference for Silver-rated Legg Mason Western Asset Australian Bond BNDS to complement IAF.

Morningstar Premium subscribers can check out our latest Model ETF portfolio strategic asset allocation here.

Execute the trades

If Morningstar senior fund analyst Matthew Wilkinson could say one thing about good trading practices, it would be to check the market depth and spread before trading. This way investors can ensure they can trade the volume they want at the price they want. The depth is a list of all the buy and sell orders in the market.

"Go onto your trading platform, hit refresh, look at market depth, see what happens. Are those inside prices changing, spread widening or contracting?" he says.

"I bet if you did that at different times of the day, morning versus afternoon, you'll see something different."

The idea, he says, is to not cross the spread when its "really wide" and prices spike. The spread is the difference between the ask price and the bid price.

Investors can check the depth and spread via their brokers.

Wilkinson also advises to avoid trading in the first 30 minutes or during market volatility. As the ETFs take a while to "wake up".

"Market makers are setting up their procedures, they're sometimes a bit slow, focusing on different products. They can struggle to get net-asset-value (NAV) accurate and in time.

"Products with offshore assets trading can also sometimes take a little while for market makers to work out price and where the NAV should be."

Wilkinson advises investors to wait about 30 minutes after the opening bell. For similar reasons, he says investors should be on high alert before trading during volatile market conditions altogether, as this is when bid/ask spreads can widen significantly.

Top tips for putting on a trade:

  • Check the market depth and the spread
  • Use limit orders wherever possible
  • Global products are most prone to wide spreads
  • Be most cautious of the mornings and in volatile markets

MORE ON THIS TOPIC: 10 tips for more effective ETF investing

For a practical walk-through of how to execute a trade from broker selection to purchase, see Investing basics: find the best online Australian shares broker (for you) and Investing basics: how to buy an ETF via an online broker.

Schedule regular maintenance

Think of your simple portfolio as a grown child: Just because you don’t have to attend to its basic needs every day, you'll still want to check in periodically to make sure everything’s OK. If you’ve followed the steps above, a thorough quarterly or annual review should be enough to keep things running smoothly.

Over time, the weights of the portfolio will naturally shift based on the performance of the various asset classes. But that doesn't mean you would necessarily have to rebalance the portfolio every year and absorb the associated transaction costs. Morningstar director of personal finance Christine Benz says a good way to control turnover is to establish a rule that you will only rebalance the portfolio when a position has moved 15 per cent away from the target weight. Again, we are just offering an example; you may select whatever threshold is most appropriate for your situation.

To help facilitate the process and, importantly, to ensure that you don’t overdo your check-ups. Benz likes the idea of using an investment policy statement (IPS) that documents the basic outlines of your portfolio (your approach to asset allocation and security selection, for example), as well as how often you’ll check up on your portfolio and how you’ll do it. This article walks you through the process of crafting an IPS and includes a template that you can use.

This series of articles and the steps outlines can feel dense. But I think that's ok. Building a portfolio from scratch involves deep personal reflection, research and hard decisions. But if you take the time now to make the right decisions, you'll thank yourself later. And once you've established yourself, ongoing maintenance is a breeze.

Several Morningstar researchers contributed to this series including director of personal finance Christine Benz and former strategist, passive strategies John-Gabriel.

is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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