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 36

ETFs originated as a tool that simplified investing.

Investor appetite and enthusiasm for the products has resulted in widespread uptake. Whether it’s AI ETFs, vegan ETFs... if you can name it, there’s probably a corresponding fund for it.

I recently had a friend send me a portfolio screenshot to get my thoughts on her ETF holdings. Whilst my rather choice words can’t be repeated on this platform, quite frankly its construction put Shelley’s Frankenstein to shame.

There are over 300 ETFs currently on the ASX. I could probably name about 5% from memory, but I only own around 1% of them. So, for someone like me, looking at that portfolio of 10+ ETFs was Halloween come early – minus the relief you get remembering that none of it is real.

There are varying schools of thought on the benefits of diversification. Some professional investors criticise the term, with a preference for concentrated, high-conviction bets. But we can’t all pick winners. Thus, enter diversification – the process of spreading investments across a variety of assets, sectors, or geographies to reduce exposure to any single risk.

One of the key benefits is risk reduction. But is it possible to over diversity yourself into underperformance? Diversification may be a cornerstone of retail portfolio strategy, but in the case of ETFs, it’s not always the more the merrier.

Founder of Vanguard, John Bogle famously advocated in favour of investors based in the US needing just two funds in their portfolio – a US total stock market and a total US fixed income fund. Whilst Bogle and I don’t share the same enthusiasm for fixed income exposure, I can certainly appreciate the pursuit of championing simplicity in a vast market.

the more the merrier meme

How many ETFs should you have?

Whether in life or investing, we’ve all heard of the phrase “don’t put all your eggs into one basket”. In both contexts, the logic serves as a risk mitigation strategy, rather than a method to derive the maximum returns.

But how far can we take this before it begins to lengthen the proximity to our goals? Enter the term diworsification. The idea that adding too many investments can actually hurt your portfolio. Keep this in mind for later in the article.

I recently read about a panel of experts who suggested a portfolio between 5 to 10 ETFs is an appropriate amount for optimal diversification. But that doesn’t mean you can just pick any 5 or 10. Owning multiple ETFs increases your chances of exposure overlap and might add unintended concentration, rather than value.

Personally, I’d like to think there isn’t a one-size-fits-all answer. Ultimately your choice will be guided by your goals, corresponding investment strategy and capacity to manage your portfolio. But there are benefits to simplicity.

My own portfolio is built around two broad-market ETFs – one for Australian equities and one for international developed market equity exposure. I also have a single direct company holding. I’ll admit I often consider increasing this number to include additional regions or tailored strategies, but for now this setup works for me.

My allocation reflects a long-term horizon through an all-equities strategy. I’ve consciously excluded other classes such as fixed income and alternative assets like private equity, as they don’t align with what I am looking for and add a layer of complexity.

There is also a time consideration involved. Managing a larger portfolio across multiple asset classes and niche exposure takes effort, even if you’re doing it through ETFs. Whilst I am immersed in the financial world all day, it should come as no surprise that there are plenty of other things I wish to fill my time with. Reading a fund’s PDS after 6pm is not one of them.

Fewer fund holdings typically suit those who prefer a hands-off approach or ‘set and forget’ strategy. On the other hand, those on the more enthusiastic side may prefer a larger portfolio that allows for greater diversity and non-core exposure.

But this enthusiasm can sometimes be a detriment to achieving your goals. The point is to find what works for you.

Complexity as the root of investment evil

There is a common misconception that more = better.

The financial industry has long sold the image of delivering superior returns through complex strategies. And this might be the case for a small portion of institutions on a short-term basis. Most fall short. This portrayal of success has worked well and forms part of why we naturally find the sophisticated options more appealing.

Our bias for complexity stems from the assumption that complex structures are inherently superior to simpler ones. Investors often fall into this trap by layering portfolios with additional products, strategies or structures, convinced that it will lead to superior outcomes.

This notion has been explored in a paper The Confounding Bias for Investment Complexity (2016) by Jason Hsu and John West. The research shows us that time and again that simple, low-turnover strategies and complex, high-turnover strategies perform similarly on a before-fee basis, resulting in the former having an advantage net-of-fee.

Given financial markets are vast and unpredictable, many investors incorrectly assume that navigating them must demand intricate strategies. The global economy is complex so how can a modest approach hold its own?

The authors explain that it feels counter intuitive to suggest that straightforward strategies typically outperform more elaborate ones, especially to those who’ve spent time immersed in market commentary or academic theory.

Part of the challenge lies in the optics. Complex investment portfolios are often wrapped in layers of jargon, backed by an army of PhDs and their love of differential equations. However, a well-constructed portfolio doesn’t need 15 optimised strategies to be effective.

True, markets aren’t simple, but that doesn’t mean your approach to them can’t be. Amassing a stockpile of different ETFs might just be creating complexity for complexity’s sake, rather than providing a meaningful benefit.

Avoiding portfolio ‘diworsification’

Investing in too many ETFs can certainly be a thing. An investor attempting to hedge against every imaginable risk goes nowhere. And that’s not because they’re overly cautious, but because they’re unfocused.

In trying to cover every base, they end up with a bloated portfolio whilst raising fees and increasing the amount of diligence needed to ensure everything is working correctly. It doesn’t take a genius to realise that this will likely lead to subpar outcomes.

Ironically, although ETFs themselves are diversified products, holding baskets of securities, it’s still possible to be poorly diversified. For example, assume that our investor John, already holds one of the most popular international equity ETFs on the ASX: iShares S&P 500 ETF IVV. This fund offers exposure to 500 of the largest publicly traded companies in the US.

John is growing bored of his vanilla broad market fund and wishes to capture some of the eye-watering returns his friends have recently enjoyed from the AI boom. He searches for a thematic ETF to gain exposure to this niche part of the market and lands on popular pick, Global X FANG+ ETF FANG. This fund seeks to invest in companies at the leading edge of next-generation technology that includes household names and newcomers.

This may appear like a convincing prospect in isolation. But whilst the two index ETFs are from different providers and have different exposure objectives, their underlying composition is highly similar with significant overlap within top holdings. John might believe he is diversified on the surface, but instead he is just paying varying fee levels for comparable exposure.

There is a distinct difference between diversification and indiscriminate accumulation. The key is to understand that the instruments you pick don’t exist in isolation. Each form an important part of your overall portfolio and investment strategy. It is the sum of the parts that matters.

Can you just buy one fund and call it a day?

The answer to this question is a tentative yes. I’ve previously explored the idea of a one ETF portfolio for investors who are either time poor or have little interest in going through the portfolio construction process themselves. All-in-one ETFs such as Vanguard’s Diversified High Growth Index ETF VDHG, are built to provide a singular product that can diversify across multiple asset classes with one trade.

Of course, there are trade-offs with such funds, like the implication of a static asset allocation and higher management fees compared to building your own mix. However, some many find that it’s a fair price to pay for embracing a hands-off approach.

Concluding thoughts

If you’re reading this with 15 ETFs, don’t interpret this as a doomsday scenario requiring you to sell the majority of them. But when your CommSec holdings look like a tapas menu, it might be time for an audit.

Not every new fund deserves a spot in your portfolio. Instead of head hunting for funds that performed best, try asking the below questions to guide your decision making process:

  • What role will this ETF play in my portfolio?
  • Does it add unique exposure or overlap what I already own?
  • Is it aligned with my long-term goals and risk capacity?

The industry will continue to push out new options where there is appetite. However, chasing every product that you perceive as marginally better will work against you. Data shows investors often deploy capital to new ETFs by reallocating them from existing funds. The effect of this adds up over time, introducing unnecessary transaction fees, tax implications and the risk of derailing your investment strategy in hopes of slightly superior returns.

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