The benefits of portfolio diversification with ETFs
2 | ETF Securities
Investment building blocks for a changing world
In a world where investors are seeking intelligent solutions to protect and grow their wealth through quality, low cost investment options, ETFS Australia provides the building blocks to enable investors to achieve their investment goals.
ETFS Australias range of exchange traded funds (ETFs) are a cost effective, secure and transparent way to access investment opportunities that are normally hard to reach, including local and global equities, commodities and FX investments. ETFs can be used to build a new diversified portfolio, or enhance an existing one, to achieve a range of investment objectives including:
Growth Income Wealth protection
This document explores the benefits of using ETFs within an investment portfolio and explains some common portfolio diversification techniques.
This document is for information only and does not consider your individual needs. You should seek independent advice prior to making any investment.
For more information, contact your financial adviser or visit the ETFS Australia website: www.etfsecurities.com.au
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The benefits of portfolio diversification with ETFs
Diversifying a portfolio means investing in a range of different investments with the aim of reducing the overall risk within the portfolio. By spreading the risk, your investments may be less affected by shorter-term market movements. If one investment loses value, your other investments may help to make up the difference.
The overall approach to portfolio diversification will depend on the investors risk profile and their investment objectives e.g. growth, income and/or wealth protection.
Conservative Preserve existing income, low tolerance for portfolio risk.
Moderately conservative Seek reasonable levels of income stability while retaining the potential for some capital growth.
Balanced Achieve a balance between seeking capital growth and wealth preservation.
Growth Achieve income growth, with income security second to wealth accumulation.
Aggressive growthAchieve higher capital growth than a balanced portfolio, more accepting of higher risk during the holding period.
What is portfolio diversification?
Exchange traded funds (ETFs) can provide investors with access to investment solutions that meet their portfolio diversification objectives, e.g.
Moderate Profile Growth Profile
Australian equitiesGlobal equities Australian property sector Global property sectorAustralian fixed interest Global fixed interestCash
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Investors seeking high growth may invest more in domestic and overseas equity markets while conservative investors may find that maintaining more of their investments in cash and bonds helps them to achieve their income goals. Below are sample allocations based on three risk profiles:
Conservative Profile Moderate Profile Growth
Australian equities 20.86%Global equities 25.06%Australian property sector 0.00% Global property sector 5.73%Australian fixed interest 16.88%Global fixed interest 12.50%Cash 18.97%
Australian equities 33.99%Global equities 36.90% Australian property sector 0.00% Global property sector 5.86% Australian fixed interest 9.22% Global fixed interest 6.73% Cash 7.30%
Australian equities 11.73%Global equities 6.93% Australian property sector 0.00% Global property sector 1.94% Australian fixed interest 24.01% Global fixed interest 16.10% Cash 39.29%
Risk versus return based on investor profile
ConservativeModerately conservativeBalancedGrowthAggressive growth
Source: ANZ Wealth Lifestage Investment Options, March 2015
Source: Stockspot, Online Investment Portfolios, hypothetical example.
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Most Australian investors tend to have a high proportion of their investments in Australian equities.
This approach to investing is acceptable when the Australian market and currency are performing well, but leaves Australian investors portfolios vulnerable to losses should the Australian market or currency suffer a period of poor performance. ETFs can help investors to reduce this risk through investing in other markets, currencies or asset classes.
Australia represents only 2.4% of the global equity market, so it makes sense for investors to expand their horizons beyond the Australian Stock Exchange (ASX). International ETFs allow investors comprehensive exposure to overseas equity markets for a fraction of the cost of going direct or using a managed fund.
Investing in US equities via an ETF enables Australian investors to complement their portfolio with access to over 50% of the international equity market.
Australian investors often hold individual company shares (equities), which can provide excellent returns if those companies are performing strongly. However, holding a small number of individual companies does not allow an investor to spread their risk.
To remove the risk of holding a small number of stocks, an investor may choose to buy a basket of stocks which spreads their risk over many different companies. An ETF allows investors to adopt this strategy, as they hold a large number of equities that can be purchased in a single trade without the expense involved in trading in individual stocks.
If an investor holds five companies and two of those perform poorly, then that could have a big impact on the overall performance of their portfolio.
However, if those two companies were part of a portfolio of 20 or 30 companies, then the impact on the overall portfolio would be reduced. To trade a large number of companies can be expensive, so ETFs can be used to reduce single company risk as an ETF allows an investor to buy a large number of companies in a single trade.
An ETF tracking the S&P/ASX 100, for example, can be bought using normal brokerage accounts by only paying brokerage once, and then an investor has exposure to the 100 largest companies in Australia. If an investor tried to buy the companies individually, then they would need to pay brokerage 100 times.
For a retiree, or an investor seeking income from their investments, receiving income from multiple sources reduces the reliance on a single source to maintain their income levels. ETFs can help investors to reduce this risk by allowing them to invest in other income producing assets or markets.
If the Australian market suffers a downturn, investors who generate most of their income through investing in Australian equities could find their income levels reduced.
By investing in other income producing assets, or in international equities that also produce an attractive level of income, an investor can spread the risk of their income level falling should the Australian stock market experience a downturn.
Why is portfolio diversification beneficial for Australian investors?
6 | ETF Securities
As outlined on the previous page, investors can reduce single stock risk by investing in a diversified portfolio. However investors may still choose to invest in single company stocks as well, as the returns from picking a strong performing company can be great. Combining those companies with a broad diversified basket of investments the single stock risk can still be reduced, this strategy is referred to as Core-Satellite Investing.
The core-satellite approach involves separating portfolios into two distinct segments:
1. Core comprising long-term, strategic investments
2. Satellite comprising shorter-term, tactical investments
This common approach to investment strategy allows investors to construct a diversified portfolio. As ETFs are easy to trade, they can be a more cost effective way for an investor to move in and out of short term investments.
ETFs can be used to trade both strategically (Core) and tactically (Satellite).
Index tracking ETFs, offering a diversified exposure to benchmarks like the S&P/ASX 100, are an efficient way of building Core positions in a portfolio.
Sector, commodity based, currency, regional and other alternative ETFs that offer exposure to Satellite asset classes can then be used to support the Core exposure.
The core-satellite approach also allows investors to combine different approaches to investment management in one portfolio. Investors might choose to blend both active and passive solutions.
Active managers aim to outperform the market using their expertise, picking specific securities that they believe will deliver greater returns. Investors may therefore choose to use active funds or alternative ETFs for their satellite exposure and blend that with a lower cost diversified ETF for their core exposure.
Reducing single stock risk
Broad Based ETFs
Source: ANZ ETFS, hypothetical example.
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8 | ETF Securities
Reducing the risk of over exposure to the Australian stock market
Investment in overseas markets allows investors to gain access to sectors that may be underrepresented in the Australian market for example, Australian equities concentrate heavily on financials and materials, while US equity exposure provides access to IT and utility stocks, as demonstrated in the following chart.