News & Commentary

ETFs at the core of your portfolio 30 Jul 10

As growth in the ETF market in Australia continues to gather pace, many advisers are seeking practical applications for these funds to use with their own clients.

Indexing in any form (be it managed funds or ETFs) carries with it the benefit of being a diversification tool for advisers, and diversification that comes at a much lower cost than an actively managed style. Indexing is also a tax efficient approach due to a lower turnover of underlying securities.

In determining a client’s suitability for ETFs, a good first step is to determine whether or not your client is a regular investor – for example, if they want to regularly add to their investment or if they tend to invest lump sums irregularly.

Regular investors into any type of listed fund or security will incur a brokerage cost each time they transact - ETFs are no different. While brokerage fees can be minimal, this approach could prove costly over time if dollar cost averaging, in comparison to an equivalent index managed fund. Conversely, an investor who invests lump sums or makes a once only investment into an ETF can do so for as little as $30 brokerage.

Investors who have their entire portfolio of shares online with the ASX may also favour the fact that ETFs are quoted on the exchange unlike traditional managed index funds.

Once you know that your client is suited to ETFs – you can to take advantage of the benefits of indexing by using ETFs effectively to construct their portfolio.

What are the benefits of ETFs? Lower costs, diversification, tax efficiency, liquidity and transparency coupled with the trading flexibility which comes with being quoted on the ASX.

To trade an ETF you simply place an order through an administration platform and the trade will settle like any other trade and, as such, they can be easy incorporated into your suite of products.

The rest of this article explores how to construct an international ETF core satellite portfolio which is an effective way to blend ETFs to achieve broad diversification.

International Shares ETF Core-Satellite strategy

This strategy involves combining exchange traded funds with other actively managed funds, LICs or directly held funds in order to create a balance of core and satellite international equity investments.

This approach can provide your clients with an opportunity to seek alpha or additional performance over the benchmark in their actively held satellites while lowering the overall cost of the portfolio with a core of index Exchange Traded Funds.

It would suit an investor who has a moderate appetite for risk to the benchmark while also seeking the comfort of knowing that they have a very well diversified core portfolio of index funds.

By way of example, the portfolio invests in a combination of the Vanguard® All World ex-US Shares Index ETF (which seeks to track the returns of the FTSE All World ex-US Index) and the Vanguard® US Total Market Shares Index ETF (which seeks to track the returns of the MSCI US Broad Market Index).

The blend of these two ETFs enables the core portfolio to be broadly exposed to 93 per cent of the world’s sharemarkets. The combined cost of blending these ETFs (ex brokerage and bid/ask spreads, based on a 50:50 split) is 0.16 per cent per annum for a portfolio of about 5579 securities. To achieve this level of diversification by purchasing individual securities at such a low cost would be almost impossible.

With the core portfolio set up, you can then carefully select satellite investments which have a low correlation to the core, in order to tilt a portfolio towards a particular market or sector with the objective of achieving outperformance.

What are the benefits of this strategy?

This approach allows you to lower your client’s investment costs while also streamlining your operational process as investing in ETFs is simple and can be done any time throughout the ASX trading day – settling just like any listed share.

The approach also provides you and your client piece of mind that their core holding is investing in 93 per cent of the worlds sharemarkets at a low cost.

At the heart of the core satellite strategy is asset allocation and why a client value proposition should centre on the asset allocation strategy and execution rather than on the promise of investment returns. It is a controllable and sustainable approach from an adviser point of view and ultimately can help create trusted, values-based relationships with your clients.