The key to low-cost diversification

3 min read  
Date: 17 January 2017

In an increasingly volatile investment environment, it is more important than ever to ensure all your eggs are not sitting in the one basket. 

Diversification ensures you are not tied to the fluctuations in any one asset class, region or sector, and goes some way to mitigating losses in one area affecting the outcome of the entire portfolio. The problem is, it is not always easy to capture those opportunities domestically and internationally, and this is why exchange-traded funds (ETFs), have become so popular. 

The ETF market is expected to reach US$7 trillion by 2021, and there is a very good reason why: ETFs provide investors cheap, easy and highly liquid access to assets that can otherwise be very difficult to access. In a recent Netwealth webinar, Tracey McNaughton, Head of Investment Strategy for Australia and New Zealand at UBS outlined how they use ETFs to provide cost and tax efficient solutions to investors. 

Essentially, an ETF is a managed fund that is traded on a securities exchange like the Australian Stock Exchange (ASX). Investors purchase units of the fund in the same way they would buy and sell a listed company share, for example Commonwealth Bank of Australia (CBA). 

The vast majority of ETFs track indices like the S&P/ASX 200 or the S&P/ASX Small Ordinaries Index, which provides transparency regarding the underlying assets held in the ETF.  This is an advantage over many traditional managed funds. 

As McNaughton explained, there are now roughly 4,400 ETFs available to investors. These products run the investment gamut from large cap domestic and international equities to bonds, commodities, currency, lithium mining and indices that track socially responsible companies. Because 'units' in ETFs can be purchased in a single trade on an exchange, you can rapidly build out a balanced and diversified portfolio at a very low cost. ETFs are also extremely tax efficient as typically the underlying turnover of securities that make up the ETF is low, consequently there are little or no taxable distributions - as with 'active' managed funds.

To explain this approach, McNaughton illustrated how UBS manages the ETFs in the Netwealth Index Opportunity Fund. She said the first step was to ensure UBS was not buying "any old ETF". The ETFs used in the fund need to map the fund's investment strategy, track specific indices UBS is looking for exposure to and have sufficient volume to ensure low trading costs. The fund is then regularly weighted to reflect the balance UBS is trying to strike with the fund - for example, given UBS' "cautious investment views" at the moment, allocation to international bonds was recently reduced to accommodate a 15% allocation to cash.

At the time of the webinar, the Index Opportunity Fund comprised 15.3% cash, 19.9% Australian shares (via the UBS IQ MSCI Australia ETF), 12.1% in global fixed income (via the SSgA Global Fixed Income Index Trust), 11.4% in Australian sovereign bonds (via the UBS IQ Australia Government Bond Index Fund), 9.9% in the S&P 500 (via the iShares S&P 500 Core ETF) and 8.9% large, mid and small-cap companies in Europe, Australia, Asia and the Far East. The remainder was distributed across international corporate bonds and other, smaller allocations.

McNaughton noted the importance of being "active" in one's ETF allocations, even if the instruments themselves are passive. After all, opportunities to capture growth and minimise risk change over time. However, since the average investor may not have the time to regularly reallocate to different ETFs as 'as regularly as a professional fund manager', it reinforces her point that “you have to win by not losing”. If you lose 10% of your investment portfolio, you need an 11% return to get back to your original position the return gap is exponential, which emphasises why it is crucial to keep investments diversified as much as possible. Consequently, UBS maintain a well diversified portfolio across the funds it manages in the Netwealth Opportunities range which minimises draw-downs and smooths returns across the investment cycle. 

Ultimately, ETFs allow investors to build a diversified portfolio of their own - which if done correctly, can be low cost, tax efficient and have low volatility. However, it is important remember that even a portfolio of ETFs carries investment risk and will still require regular monitoring to keep it in check. If an investor is interested in harnessing the benefits of ETFs but does not have the capacity to watch over their portfolio full time, then it may be worth considering outsourcing their investment management to a fund manager. 

Any questions?

Speak to your financial adviser to find out more about ETFs and whether they are appropriate for your portfolio, or if you have any questions for the team at Netwealth, email or call us on 1800 888 223.