We look at the ETFs that would go into a 3 ETF portfolio, using Morningstar’s Manager Research Medalist ratings.

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Find the transcript for the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: All right, so, Shani, we know that today’s episode will be popular.

Jayamanne: We do, yeah.

LaMonica: Which adds a lot more pressure.

Jayamanne: Yes, we’ve done an episode like this. I mean, I won’t bury it, but we’ve done a 3 ETF portfolio episode before, but we’re going to redo it.

LaMonica: Yes, but because we know it’s going to be popular, there’s a lot of pressure on us, mostly on you, I think.

Jayamanne: Okay.

LaMonica: You wrote an article for this and you got a lot of emails about it.

Jayamanne: I did, yeah.

LaMonica: And a lot of comments.

Jayamanne: Yes, so we’ll see if that continues. Maybe we shouldn’t do this episode.

LaMonica: Well it’s too late now. Will press record. We are committed, Shani. I guess we should explain why we’re redoing it and what people should take out of this because we’re redoing it. Now, we don’t think that investors should just switch in and out of investments every year. That’s the last thing that we ever advise anyone to do on this podcast.

Jayamanne: But as we know, it is really important to be efficient with your investments, but it shouldn’t be to the detriment of your total return outcomes.

LaMonica: Yeah, and the industry is always innovating and there’ll always be new investment products and options for investors to choose from. And choosing a marginally better option each and every time that one appears will be to the detriment of your long-term outcomes. So you’ll incur tax, of course, as we talk about when you sell it, if you’ve made a profit, of course. There’s transaction costs. And hopefully people that listen to this podcast know not to chase returns and principal and switch in and out of products. But this is a case where sometimes you can convince yourself that you should switch into a new product for all sorts of different reasons. But as we’ve said, there should be a logical and sensible reason why you should decide to switch out of an investment product when you have a long-term plan. So you will continue to get all this innovation. There’ll be more investment products out there, more ETFs, and they’re all, of course, competing very hard for your money.

Jayamanne: And as we said, the industry is always continuing to innovate. So with that disclaimer out of the way, let’s get to building a 3 ETF portfolio, which we’ve used to build using Morningstar research and data.

LaMonica: Exactly. And one point we do want to make is that not every investor loves investing and loves, I guess, the art of investing and designing a portfolio. I think some people like that intellectual challenge and trying to put together a portfolio of lots of different holdings. And then others just think that investing is a means to an end. They want a simple portfolio that gets the job done. And that’s sort of the inspiration for today.

Jayamanne: And John Bogle, who founded Vanguard, he had some fans.

LaMonica: Still does, I’d say.

Jayamanne: He does, yeah. They haven’t disappeared. But these fans name themselves Bogleheads. And they followed the advice of their investing mentor. So he advocated for a 3 ETF portfolio that provided exposure to domestic and global shares along with fixed interest. And there has been a surge of new ETFs that cover narrower and narrower parts of the market.

LaMonica: Do you know where Bogleheads came from?

Jayamanne: I do. You’ve told me this before. Parrotheads.

LaMonica: Parrotheads or deadheads. You had never heard of either.

Jayamanne: No.

LaMonica: Do you remember what each one is?

Jayamanne: I mean, if we took a poll, I don’t know who would be on the winning side.

LaMonica: I like how you just assume that everyone, that anything you don’t know, nobody else knows. Do you remember what, what are Parrotheads into?

Jayamanne: It was some guy. I don’t know who he is.

LaMonica: His last name is the same as a very famous investor.

Jayamanne: You’re just going to have to tell me.

LaMonica: Jimmy Buffett.

Jayamanne: Okay.

LaMonica: And how about the deadheads?

Jayamanne: I don’t know.

LaMonica: The Grateful Dead. Like, Parrotheads is harder.

Jayamanne: You can be angry at me after we do this episode. Let’s keep going.

LaMonica: So let’s finish this. So we can’t exactly channel John Bogle, of course, but we can quote John Bogle. So he said, the winning formula for success in investing is owning the entire stock market through an index fund and then doing nothing to stay the course. And I don’t think he’d like any of these niche products, niche ETFs.

Jayamanne: And we strongly believe that a diversified portfolio does not mean an investor needs to own everything. We spoke about this at length in our podcast episode on how many holdings you should have in your portfolio. And it’s going to vary widely on the types of investments, your goal and what you’re trying to achieve. But you don’t need to focus on the industry standards and theory around asset allocation for a portfolio. You don’t need to have 17 different types of asset classes or products in your portfolio. You just need what is going to help you achieve your goals.

LaMonica: Exactly. And that’s why we’re trying to keep this as simple as possible. So there are some asset classes missing, of course, from a 3 ETF portfolio. Real estate, alternatives are just two examples, but Bogle believed in simplicity. The more straightforward your portfolio, the less time you’ll spend worrying about it. And that means that it’s less likely you would change things around during volatile markets. So investors, as we say often, tinker at their peril.

Jayamanne: So when you’re holding 3 ETFs, it’s important that they’re as broad and representative as possible. One of Bogle’s most famous quotes is, stop trying to find a needle in the haystack and just own the haystack.

LaMonica: Yeah. And we think that, of course, most investors would benefit from following Bogle’s approach. Since trying to beat the market is very, very difficult to do. And we do talk about this research a lot. Morningstar has something called the active passive barometer. It looks at how active managers do against their passive counterparts.

Jayamanne: And the latest edition from 2024 shows that 29% of active managers beat their passive counterparts. Investing is one of those rare pursuits in life, where getting the average return is more than enough to achieve your financial goals.

LaMonica: Yeah. And one last point here, that there is a difference between passive investments and passive investing. So far too many investors take an active approach with passive investments and try and time the market. And that, of course, does not work either. And we have another study. Shani has another study because…

Jayamanne: We love a study.

LaMonica: You love a study.

Jayamanne: It’s the Morningstar’s Mind the Gap study. It explores the difference between the returns that investors get and the returns of the investments that they buy and sell. And there’s a gap, which is the result of investors buying and selling at the wrong time. In the most recent version of the study, it found that investors underperformed their investments by 1.6% per year. And passive investing is really just a set and forget approach.

LaMonica: Exactly. And one of the biggest benefits of passive investing is very low fees. So anytime you’re picking an investment product, consider the value you are getting for the price you are paying. So for passive ETFs, the fee should be minimal, as it of course requires no active stock picking and large investment teams at the ETF provider. So even small differences in fees matter over the long term.

Jayamanne: There’s a very long preamble. But with that in mind…

LaMonica: It was, but a lot of important information around Jimmy Buffett.

Jayamanne: Yes, deadheads.

LaMonica: You’ve heard of the Grateful Dead.

Jayamanne: I’ve heard of them. But let’s get to our picks for the three asset classes that Bogle advocates for in his 3 ETF portfolio.

LaMonica: Okay, we’re going to start with global equity, Shani.

Jayamanne: All right. It’s important to understand what you are investing in, as we always say. When it comes to passive global equity, you’re going to get a large chunk of exposure to the U.S..

LaMonica: Yeah. So the big global equity index is the MSCI World ex-Australia Index. 75% of that index is made up of companies based in the U.S. at the end of 2024. So many Australians and people everywhere have a home bias. So in Australia, that means a large tilt towards Aussie equities in their portfolios. And we will say that while there is a lot of exposure to the U.S., this includes some of the world’s biggest brands and companies, including sectors that are underrepresented in our local market, so technology and healthcare are two of the primary ones.

Jayamanne: And it’s also worth noting that in a globalized world where a company is listed, it doesn’t tell the whole story. Many large U.S. companies are multinational, so that means they’ll sell their products around the world, and that provides a more nuanced exposure than the country that they’re listed or headquartered in.

LaMonica: Okay. So the other option with international equity is to look at tilts, and that could be a sector tilt, a geography tilt, or a size, a size of the company tilt. So for this exercise, we’re just following Bogle’s lead and we’re creating a simplified portfolio where broad exposure is the name of the game.

Jayamanne: Right. And our analysts' preferred choice for core global equity exposure is the Vanguard MSCI International ETF with the ticker symbol VGS. They cite cheap fees, broad diversification, and Vanguard’s track record of being able to match the index returns. VGS bags the gold medalist rating from our analysts.

LaMonica: And when we say low cost, the fee is 0.18%. And because this is a ETF that is traded frequently, there’s a very low or very small buy-sell spread, and it’s an underappreciated part of trading. So that’s another cost that you’re paying. And if you are trading frequently, then of course, you’re going to pay more and more of that buy-sell spread.

William Ton: I’m Will, producer of Investing Compass, and here are this week’s must-reads on Morningstar.com.au. In this week’s Unconventional Wisdom column, Mark runs through what he should do about a position in his portfolio that has grown too large. He’s reluctant to sell it, especially due to the tax consequences, but he’s also aware of the dangers of having a large concentration in one share that violates his investment policy statement. Shani recently wrote an article on why she includes managed funds in a portfolio. She has received many questions about whether this was the right choice. Her Future Focus column this week comes out in defense of her decision and why it’s important that investors consider their own situation when choosing investment products.

Benjamin Graham is widely revered as the dean of value investing and a master of flipping stocks that have traded below their asset value. Despite this, Graham’s best ever investment actually stemmed from a very different approach. This week’s edition of Bookworm, Joseph finds buy and hold inspiration from this most unlikely of sources. In Sims day to day, she often gets asked for investment advice when she least expects it. Whether it’s about shares at the dinner table or Bitcoin at a doctor’s appointment. Recently, this turned into a request from her younger sister to invest her savings in the market as she sees fit. In Sims' latest column, she discusses how she’s constructed her sister’s portfolio, admits the added pressure of giving financial advice to family. These articles and more are now available in the episode notes.

Now it’s back to Mark and Shani.

LaMonica: Now we need to keep on trucking Shani.

Jayamanne: I feel like you’re trying to make a reference to me. Let’s move on to.

LaMonica: It was a Grateful Dead reference, Shani.

Jayamanne: Let’s move on to Aussie equity and this is obviously a crowd favorite. Many of us have concentrated exposure to the asset class in our portfolios and there are a few ways to approach domestic equities. First, you need to get familiar with the market to make an informed decision.

LaMonica: So we’ll look at the S&P ASX 200 index. So that is the 200 largest companies that trade on the ASX. The Australian market as I think we’ve alluded to in multiple podcasts, highly concentrated in two industries, mining and financial services. So it’s important to note that these companies are cyclical. Means that 85% of the market of this index is allocated to companies that have a high correlation with economic conditions. So basically that means if the economy is doing well, generally these companies do pretty well. If it’s not, they don’t. The second is that the index is very top heavy. So the big hitters take up a large part of the overall index with the top 10 companies out of that 200 company index. Making up 48% of it. And 20% is in just two companies, CBA and BHP.

Jayamanne: And there are ways to minimize the risk that this concentration brings. Investors could opt for an equal weighted ETF that invests equally across all constituents. They could also look at tilts for their portfolios if they’re looking to achieve particular goals like income.

LaMonica: And income is a goal for many investors and generally the Australian market. Although less so recently, does deliver income and the yield is higher and it’s still higher than most other global markets. And of course, as an added bonus, you get franking credit, Shani. And that adds 1.34% to investor returns if we look at the average over the last three years. And that’s of course hard to ignore.

Jayamanne: For passive Aussie equity exposure, that’s market cap weighted. We look to the SPDR S&P/ASX 200 ETF with the ticker symbol STW. Our analysts believe that it is a credible low-cost option for investors seeking passive exposure to Australian equities. It was awarded a bronze medalist rating from our analysts.

LaMonica: Okay, I’m going to go off script a little bit, Shani.

Jayamanne: Love it.

LaMonica: So personally, and we should be clear, this is just me. And I do own this in my portfolio. I go for the equal weighted ETF. So Van Eck has one with the ticker symbol MVW. And basically all of the things, the reason I do this was all of the things that we described in there that I see as problems with the Aussie market. And it is important, obviously, that all the investments in your portfolio are based on your goals and align with your goals. And my goal in investing is income and getting income growth. And basically, I don’t like the dividend prospects from the banks. They are not growing earnings or hasn’t been any income growth. I have very little interest in investing in a miner. They are just really, really cyclical, as we said. And I want steady growing income. And that’s hard with cyclical companies or basically just doesn’t happen with cyclical companies. So I also want to say that I do own more than three ETFs and I own individual shares. So this is only a portion of my portfolio. But I did just want to put that out there that I think we look at the overall Aussie market. I’m much more interested in those mid cap companies and the large cap companies. And of course, an equal weighted ETF will be spread out amongst all the companies so you get much more mid cap exposure. All right. So that was me going off the reservation, Shani.

Jayamanne: Well, why don’t we move on to fixed income? Do you want to share your picks for fixed income too?

LaMonica: Well, I’ve been clear my pick is nothing. I don’t own fixed interest.

Jayamanne: Cash.

LaMonica: Yes. I like cash.

Jayamanne: All right. So let’s move on to fixed income.

LaMonica: Okay. So there are a couple of different considerations when you’re picking a fixed income ETF. And the first is something called the running yield. And that is the annual coupon payment of the bonds in the portfolio divided by their current price. So this will change over time, but it’ll give you a snapshot of the interest payments you’ll receive. That is, of course, one component of the returns of fixed interest.

Jayamanne: The other is changes in prices. Bond prices are impacted by interest rates. The level of impact is measured by a metric called duration. If, for example, an ETF has a duration of five, that indicates that if interest rates rise by 1%, the price will fall by 5%.

LaMonica: Yeah. And it’s been, if anyone’s noticed, if you actually followed the fixed interest market, it’s been a crazy couple of years basically coming out of COVID. And in this environment, active bond managers have done very well. And so on average over this relatively short period, they have beaten their passive rivals. But that’s basically because they have the flexibility to adjust to expected interest rate changes. But passive investments can’t do that. They’re bound to a benchmark. You obviously have no control over everything. You’re just following that benchmark. So between 2021 and 2022, that was when interest rates were going up quickly and pretty far. It was just a really favorable, and a lot of that was predicted, just a really favorable environment for active managers. But over the long term, we want to emphasize this again, that Shani said earlier about active managers in general. Over the long term, very few fixed interest managers have been able -- active managers have been able to beat that benchmark.

Jayamanne: So for fixed income exposure, analysts preferred choice is iShares Core Composite Bond ETF, IAF. Our analysts believe it is a high quality and low cost way to access the Australian fixed income market.

LaMonica: Yeah. And if it’s not clear through my little preamble there, that is a passive ETF. So I guess we should make that clear. So it is cheap. Once again, 0.10%. It is low tracking error, which means that you’re going to get that index return. In this case, the index is the Bloomberg AusBond Composite Index. So it’s mostly government bonds, but there is some exposure to corporate bonds. The running yield, as we talked about earlier, is 3.21%. And the duration, and these are all figures at the end of January, the duration is 4.86.

Jayamanne: And Morningstar analysts award IAF a gold medalist rating and considers its excellent low cost access to Australian fixed income.

LaMonica: All right. So we’ve got one more disclaimer, not like the official disclaimer. There is something that’s more important than the ETF you choose, Shani. And what is that?

Jayamanne: What’s more important than the ETFs that you choose is your asset allocation and how you allocate funds between different asset classes. This is true if your portfolio has three ETFs in it, or if it has 50 holdings. And asset allocation has a far bigger impact on returns than the individual securities that are selected.

LaMonica: Yes. So the higher the return you need to achieve your goals and figure that out, because it’s very helpful, the more you should allocate to growth assets. So those are those two equity picks, those two equity ETF picks. So in Morningstar’s aggressive portfolio, so this is the most aggressive portfolio with long time frame. So once again, you do want long time frames. So this is over nine years, 90% allocated to growth assets.

Jayamanne: And we’ve spoken about this multiple times and across many episodes, but asset allocation is, in our opinion, at the most important decision that an investor can make outside of deciding to invest in the first place. And in many studies, it has been shown that asset allocation is a largest determinant of your results.

LaMonica: Yeah. And we will say, I think we’ve mentioned this fact as well, because maybe I’m shocked about different things and other people. But I think it’s kind of shocking that Australia Super, the largest super fund in Australia, 90% of their members are in the balanced option. So that has 24% in defensive assets.

Jayamanne: And we can’t speak for any single individual, but we can definitively say that more than 3 million people in that option, a good deal of them should probably not be in that balanced option, because that’s not going to get them to their retirement goal. A good deal of them would also have more than nine years left until retirement, which is a minimum time frame for Morningstar’s most aggressive portfolio with 90% growth assets.

LaMonica: Yeah. And so obviously, the caveat is future returns may not resemble what they were in the past. But if we go back 10 years, we’re looking at Aussie Super again, the high growth option deliver an annualized return of 9.04%. The balanced option, 8.07%. So if we extrapolate that, for some people, that may not sound like a lot. But if we extrapolate that out, so use those returns and investors contributing $10,000 a year into super for 35 years, the investor in the balanced option have $1.75 million. In the high growth option, the investor would have $2.17 million. So that’s 25% more in retirement savings, which is a lot.

Jayamanne: It is a lot. So how much you allocate between the three ETFs you choose is likely going to have a larger impact on your investment portfolio than the actual ETFs that you do choose. But in saying that, it is incredibly important to be smart about what you’re allocating to and ensure that they align with the goals that you’re trying to achieve, their low cost, and you understand the underlying objectives and investments contained within the ETF.

LaMonica: Okay. Thank you very much for listening. We made it through all three ETFs.

Jayamanne: Yes.

LaMonica: Shani and I are going to share.

Jayamanne: Argue.

LaMonica: I was going to say share a pint of Cherry Garcia. Okay. Ben and Jerry’s.

Jayamanne: I know Ben and Jerry’s.

LaMonica: Named after Jerry Garcia. All right. Ben and Jerry, we’re both big fans of the dead. It’s like talking to a wall here. Anyway, thank you guys very much for listening. If you have any questions, email me at [email protected] and let me know about Shani’s music taste.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)