ETFs: Hold the index, cut the risk

Investors who want to diversify concentrated share portfolios can use low-cost exchange-traded funds to hit benchmarks and access the world’s biggest companies.

• Exchange-traded funds cut risk
• Cheap access to vast markets
• Buy to diversity, not for superior performance

Anyone who has invested in direct shares knows the feeling. You read about a company on the cusp of great growth, scramble online to do a cursory check of its track record, look at its share price chart, then place an “at market” order at what will surely be “the bottom”.

Days pass, a small gain is clocked up. More time passes, you’re back to break even. Weeks pass, you’re down. Months pass, you’re way down. A year later, another media story: “Gun stock at 12-month low! Buy!”

But that’s what they said a year ago! Before you lost half your money!

If that sounds familiar, you are not alone. Capital bleeds from the portfolios of well-intentioned amateur investors every minute of the day. Some give up and go to cash. Others never learn, and for them investing in shares becomes a fuzzy excuse for gambling. You win some, you lose some, but those investors can never tell you their performance. They are in the dark, but somehow convinced they know something the rest of the market doesn’t.

Beat the benchmark

Every investor needs a benchmark. Logic says the best benchmark is inflation, because if you don’t beat that then you’re losing money and should stay in the bank. But much of Australians’ wealth is invested in shares in Australian companies. For them, the best benchmark is the S&P/ASX200 index of the biggest 200 companies in the country, worth about 90% of the total listed share market of 2,000-odd companies.

An investor who is running a portfolio of direct Australian shares should aim to beat that benchmark.

If they can’t beat it, they should give up.

Or buy the benchmark?

The alternative is to hold all the stocks in the index, but that would cost a bomb in brokerage costs and be a serious drain on time. Also, it would only be a copy of the index at a point in time. Companies go up and down the top 200 ranking all the time. They have a great business idea and zoom up, slowly lose value and drop off, or shuffle up and down as their share prices oscillate with earnings outlooks and investor sentiment towards them. 

All-in-one

An investor with vast amounts of money and time might want to try to hold every stock on the index and update those holdings daily to always match the benchmark, and some do. These professional investors then package their holdings into units and offer them on the ASX to anyone who wants nothing more than what the benchmark returns and to take aggregate dividends along the way.

The providers of these exchange-traded funds (ETFs) charge a fee, but it’s low: between 0.15% and 0.30% a year. For that, you get 200 or 300 companies in one trade.

 Around the world

Australians love owning Australian companies, but the rest of the world must wonder why. Yes, Australian equities have performed well for decades and pay generous dividends, but the local market is about 2% the size of the global share market. To turn your back on 98% of the listed opportunities doesn’t make sense, unless you believe the next Google or Apple or Unilever will be Australian-made.

That’s hopeful.

The simplicity ETFs offer in holding the Australian index has been translated to offshore markets, however. Of the nearly 120 ETFs available on the ASX, 42 are dedicated to international markets, from funds which offer exposure to the 100 largest companies in the world, to specific indices such as the S&P500 or Nasdaq, to the largest listed Chinese companies, to the fortunes of emerging economies such as India and Brazil.

An investor struggling with a portfolio of local companies can reduce risk by buying up to 2,000 international companies in a few trades, with some of the broader ETFs.

If you believe Australia will grow at a faster rate than most other countries, concentrate on this market. If you think otherwise, ETFs are the cheapest and easiest way to take part.