The highest rating that Morningstar Manager Research analysts bestow on ETFs is a Gold Medalist Rating. That means we expect the ETF will outperform other ETFs that invest in similar markets as represented by the Morningstar Category. In non-jargon that means if a passive ETF investing in large-cap US shares receives a gold rating we think it will outperform most other ETFs that invest in US shares.

I’ve summarised our research on 3 Gold Medalist ETFs that invest in different asset classes. For 2 other core asset classes I’ve included Bronze rated ETFs as Gold Medalist ETFs were not available. This allows an investor to build a diversified portfolio of Australian shares, US shares, global shares and Australian and global fixed interest. The allocations to each ETF are based on an investor’s goals and the associated risk capacity which represents the amount of risk required to achieve desired returns.

This article contains a step-by-step process to establish an investment goal and setting an appropriate risk capacity.

All of these ETFs are passive products which track major indexes. Many investors are gravitating towards passive ETFs as they offer a low-cost and tax efficient way to achieve market returns.

US large-cap shares: iShares S&P 500 ETF (ASX: IVV)

iShares Core S&P 500 ETF earns a Gold Medalist rating and offers well-diversified, market-cap-weighted portfolios of 500 of the largest U.S. stocks. The funds accurately represent the large-cap opportunity set while charging rock-bottom fees, a recipe for success over the long run.

The funds track the flagship S&P 500, which selects 500 of the largest U.S. stocks—roughly 80% of the U.S. equity market—and weights them by market cap. An index committee has discretion over selecting companies that meet certain liquidity and profitability standards.

While a committee-based approach may lack clarity, it adds flexibility to reduce unnecessary changes during reconstitution, taming transaction costs compared with more-rigid rules-based indexes.

The end portfolio is well-diversified and accurately resembles the U.S. large-cap opportunity set. This allows the strategy to capitalize on its low fee, ultimately delivering sound long-term performance on both an absolute and risk-adjusted basis.

The bedrock of this strategy is market-cap weighting, which harnesses the market’s collective wisdom of the relative value of each holding with the added benefit of low turnover and associated trading costs. It’s a sensible approach because the market tends to do a good job pricing large-cap stocks. The companies in this portfolio attract liquidity and widespread investor attention, such that prices reflect new information quickly.

However, when few richly valued companies or sectors power most of the market gains, market-cap weighting may expose the strategy to stock- or sector-level concentration risk, as is the case at year-end 2023. As of December 2023, the top 10 holdings made up the largest portion of the index (30%) in several decades, and the 30% allocation to technology stocks was the highest since the dot-com bubble. But this is not a fault in design, the S&P 500 simply reflects the market composition. In the long run, its broad diversification, low turnover, and low fee outweigh these risks.

Global shares: Vanguard MSCI Intl ETF (ASX: VGS)

Vanguard MSCI Index International Shares ETF earns a Gold Medalist rating and provides Australian investors with an affordable and efficient gateway to the global equity markets. This exchange-traded fund and its AUD-hedged version (ASX: VGAD) mirror the MSCI World ex Australia Index (and AUD Hedged version for the hedged class), incorporating net dividends reinvested, setting a challenging benchmark for active fund managers to surpass. With its low expense ratio and Vanguard's expanding scale, the strategy presents a formidable challenge for active managers to beat.

The underlying index has universal appeal for constructing a diversified portfolio that spans 22 developed economies represented by approximately 1,500 holdings. The index is skewed toward the United States (a common feature across most global indexes) but given the majority of its holdings are multinationals earning sizable revenue from international markets, concentration is not a notable risk here.

The strategy will wax and wane with the index and is chained to its notable biases. Of late, it has faced intense competition from skillful active managers who, with their enhanced risk-management skills, can weather the market volatility better to beat the index.

However, in terms of long-term performance, Vanguard edges past most managers in the cohort. The vehicle may receive currency diversification benefits from investing internationally as the currency is not hedged to AUD, but for those who are currency risk-averse, the AUD-hedged version is also available at a modestly higher price.

In summary, Vanguard MSCI Index International Shares ETF stands out as a best choice for Australian investors seeking global market exposure. Its cost efficiency, broad diversification across multiple developed markets, and solid performance record, especially in a competitive landscape with skilled active managers, highlight its appeal.

Australian bonds: iShares Core Composite Bond ETF (ASX: IAF)

The iShares Australian Bond Index strategy earns a Gold Medalist rating and is an excellent product, suitable to be used as the core building block for one’s fixed-income portfolio. The underlying Bloomberg AusBond Composite 0+ Index is a good representation of the overall opportunity set.

The low fee, especially with the recent cut to the exchange-traded share class, combined with iShares’ proven indexing capabilities only increase its attractiveness.
Portfolio manager Craig Vardy and the supporting team have reliably replicated the underlying benchmark characteristics with a narrow tracking error.

Historically, the fund returns have carried higher sensitivity to interest-rate changes owing to the portfolio’s higher duration relative to the average peer. Duration refers to the amount returns will vary based on interest changes. Bonds move inversely to interest rates with rising rates causing prices to fall and vice versa.

The higher duration can be attributed to the substantial allocation to long-term government and semigovernment bonds, which accounted for more than 90% of the total exposure as of 31 May 2023. The remainder of the portfolio mostly consists of corporate bonds and supranational securities. Thus, credit risk has remained fairly modest.

In general, active managers possess the flexibility to adjust to interest-rate changes, whereas passive investments are bound to the benchmark with minimal control over their risk profile. For instance, the period of rising interest rates through 2021 and 2022 was favourable for active managers to showcase their abilities. However, over the long term, few are able to beat the benchmark consistently.

The fund can functionally play the role of a defensive buffer, damping the volatility of equity investments in one's total portfolio. A high-duration portfolio aided the fund over the sustained decline of interest rates over the past decade. Also, high exposure to government securities in lieu of lower credit exposure enabled it to outperform its peers during stressful periods such as the first quarter of 2020.

We have conviction in the fund's ability to outperform and generate alpha over the Morningstar Category average through longer time horizons. This remains a great investment for investors seeking reliable domestic fixed-interest exposure at a low cost.

Australian shares: SPDR S&P/ASX 200 ETF (ASX: STW)

SPDR S&P/ASX 200 ETF earns a Bronze Medalist rating and is a credible low-cost option for investors seeking passive exposure to Australian equities. Our confidence in the exchange-traded fund to serve investors well over the long term remains intact.

The portfolio is well representative of the market-cap ladder of the Australian large-cap blend Morningstar Category, but approximately 84% of its assets are exposed to cyclical and sensitive sectors, implying a high correlation of the strategy's performance to domestic economic activities. STW is concentrated at the top, with almost one third of its assets in the top five holdings. The portfolio is predominantly composed of cyclical sectors; financial services and basic materials account for half of the assets.

STW’s performance over the past decade establishes that the strategy is a significant hurdle for active managers to beat on a net-of-fee basis over the long term. In general, we believe that only the best active managers can beat the broad benchmark over the long term. Even then, the consistency of such outperformance may not always pan out.

Low turnover adds to the vehicle’s tax efficiency and curbs unnecessary transaction costs. State Street’s expertise is clearly visible in the execution here, with narrow bid-ask spreads and a low tracking error. As a passive tracker, the strategy will wax and wane with the underlying index and is chained to its notable biases, but the low fee here more than compensates for that in terms of long-term potential.

In summary, this diversified portfolio represents the collective view of the market quite appropriately, and is offered at a low fee, which makes it a sound choice for investors.

Global fixed interest: Vanguard Global Aggregate Bd Hdg ETF (ASX: VBND)

The global multisector nature of this Bronze Medalist rated ETF can make it work as the central fixed-income element in a portfolio. The strategy tracks an index with returns hedged to multiple currencies. The low ongoing charges levied by all share classes is a strong point in its favor.

The fund offers significantly lower exposure to China than its passive competitors. This is because Vanguard made an active decision to slow down and eventually stop the process of inclusion of Chinese onshore debt approved by Bloomberg back in 2019.

Vanguard argues that there remain issues that prevent access to China and specifically points to the ability to efficiently handle the hedging of CNY exposure. Other passive fund providers do not share this view and report no difficulty in transacting Chinese assets.

This has translated into a significant divergence in China exposure between this fund and competitors tracking the standard Bloomberg Global Aggregate Bond Index. As of this review, the difference stands at around 9% to 1%. This can work for or against this strategy depending on the performance of Chinese bonds.

Irrespective of differences in China exposure, the trade-off of adopting a passive approach to global bond exposure is the lack of flexibility in country, sector, and duration calls relative to active funds, which can substantially alter the portfolio distribution. This can also increase the chances of making mistakes over the long term, particularly in relation to the credit bucket. The steady approach of an index fund may help to iron these out; not least considering the substantial price advantage. But overall, an index-tracking approach to the global aggregate bond market remains something of a blunt investment proposal. It is good enough for earning the index return but leaves room to add value.

Overall, this index strategy has points in its favor, most notably its low fees. Investors seeking a well-managed one-stop-shop fund for broad global bond market exposure and specifically eyeing limited exposure to China should find that this fund fits the bill.

For more on building a portfolio using ETFs see the following:

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