Cash slashed, Aussie equities up: Why Morningstar updates Model ETF portfolios

Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. Today, with us is Tim Murphy. He is a Director of Manager Research for Asia Pacific. He is here to talk to us today about Morningstar's model ETF portfolios.

Tim, thank you for joining us.

Tim Murphy: Thanks for having me, Emma.

Rapaport: Tim, I think it's worth, just at the beginning, just setting out what Morningstar's Model ETF portfolios are and how you construct them just for people that maybe haven't seen them before.

Murphy: Sure. So, through our ETF models, we are looking to provide a range of portfolios that have diversification across asset classes as well as across issuers. So, providing five different risk profiles depending on your tolerance for risk and the level of return that you are seeking over time from conservative at the low risk end right through to high growth aggressive at the riskier end, putting together a portfolio of all ASX-listed ETFs that you can build a portfolio and gain exposure to in a diversified way.

Rapaport: And how do you choose the sorts of funds that go into the portfolio?

Murphy: Well, there are two things to think about here when thinking about the process. First of all, the asset allocation, of course, is just an important part of the decision. Secondly is then the actual ETF selection to populate each of those asset class exposures. So, our asset allocation team works building some forward-looking forecasts on their capital markets assumptions around future return and risk opportunities for the different asset classes to come out with the appropriate asset class blends. And we're then looking to then populate that with what we think are some of the better ETFs within each asset class, but in particular in the larger equities and fixed interest space blending different styles and approaches of ETFs so that you're not overly exposed to any one particular segment or theme or style or whatever the case may be.

Rapaport: And we are talking today because you've made some changes both to the asset allocation of those portfolios and some of the funds within the portfolio. Can you talk us through what changes you've made and why you've made them?

Murphy: Sure. So, at the first level, there's been a couple of asset allocation changes. So, our asset allocation team has updated its forecasts for each of the asset classes. Probably the most noticeable change is, given the fallen interest rates towards close to zero, clearly the forecast for our cash returns has come right down. So, as a result of that the weightings to cash across all of our portfolios has come down and the fixed interest exposure has therefore risen as a result of that, given they both sit within the sort of broader defensive bucket of each profile. That obviously affects the conservative, moderate and balanced profiles more so than it does the growth or aggressive. And so, within that you've got more money to play with and put to work in the fixed interest, both globally and domestically.

On the equity side, we've got slightly increased forecasts for Australian equities relative to global equities. We've previously had quite a big overweight to global equities, and clearly, that's been the right decision and very strong returns, particularly in U.S. equities in recent years. So, it certainly played out. But we are reducing the magnitude of that somewhat, so reducing international equities slightly and increasing Australian equities are some of the key changes there.

Rapaport: And you've also made some changes to the specific funds; I'm thinking about the fixed interest areas and also in properties. So, could you walk through which funds have changed and why you've selected those funds?

Murphy: Yeah. There's obviously been lots of growth in ETFs in recent years. So, there are more tools for us to play with and consider when thinking about portfolio construction. So, a couple of changes that we did make in this update in the global property sphere – we changed from an unhedged to a currency hedged version of index tracking global property exposures, so out of DJRE into (RENT). That was certainly a key change to make sure we've got that currency exposure hedged that hadn't previously been available to us.

And then, probably most noticeably on the fixed interest side, with the increase in the exposure to fix interest at the same time as we've got record low interest rates, albeit they've certainly started to rise, we've seen bond yields rise in the early part of this year, taking a purely passive approach to that is somewhat problematic. And certainly, we've been exposed to some negative returns there. So, we think blending the passive exposure with some active ETFs that are now available makes some sense. So, we've introduced an active Australian bond ETF in the form of the Legg Mason Western Asset Australian Bond capability, ticker BNDS, blending that with the broader iShares Composite Bond exposure which we've already got there.

Rapaport: When you are adding an active ETF to the portfolio, how do you take into consideration fees? On active ETFs we do see that the fees are typically higher than a passive ETF. Is that something you take into consideration when you are making changes to the portfolio?

Murphy: We absolutely take it into consideration. But ultimately, we are trying to build the best net-of-fee outcomes for these portfolios. So, there is no explicit fee target as such. So, particularly, given where we are in the interest rate cycle and the potential for further interest rate rises, having some active exposure there to help try and manage that rather than just a pure passive exposure, we certainly forecast should be able to add value over and above the additional fee hurdle over time.

Rapaport: I notice that on the emerging markets exposure you've stuck with a passive ETF. There are I can think of at least one active ETF in the emerging market space. Is there a reason you've decided to keep with a passive allocation?

Murphy: Yeah, there's a couple there. I mean, I think we've certainly spent a bit of time thinking about that. I mean, certainly one of the larger growing ones in recent years has just had its portfolio manager walk out the door. So, while we had been thinking about that, that quickly disappeared off the table. So, for the time being, we're certainly comfortable with the passive exposure that we've got there. But as more and more ETFs in that sector become available and as we sort of increase our coverage universe, that's always up for consideration.

Rapaport: One of the big topics at the moment is the rotation from growth to value and somewhat back from value to growth. Is that something you think about in the portfolio? Do you diversify across those different factors? Do you wait more to one or the other at the moment?

Murphy: Yeah, so we should definitely think about that. That's an active part of how we blend the different types of ETFs within both Australian equities and global equities when we are selecting those. So, if you look at the Australian equities, you've got a couple there that's slightly more value leaning meant to offset against one more growthier style of approach within the global space. A couple of them are more – certainly, QUAL and MGOC have historically been more quality with a slight growth tilt. The Magellan one has certainly become a lot more conservative in recent times which has also led it to underperform in recent months. But we are certainly comfortable with that exposure and don't think we were overly exposed to any one particular style or segment of the market.

Rapaport: And just to wrap up, I know that you have chosen not to add any commodities to the portfolios. There is no exposure to gold. There is no exposure to Bitcoin. Although, I guess, there is not a Bitcoin ETF anyway. How do you think about alternatives and commodities when it comes to putting together the portfolio?

Murphy: Yeah, things like commodities are obviously particularly difficult to try and forecast. And we wouldn't pretend like we have any ability to forecast where commodity prices are going. So, they don't tend to be the sorts of things that we use or recommend for clients in our portfolios.

Rapaport: Great. Thank you very much for being with us today.

Murphy: Thanks, Emma.

Documents referenced:

Strategic Asset Allocation Reviewed, Manager Changes to ETF Model Portfolios