I recently wrote an article on my investment strategy. As an investment specialist, I have institutional grade investment research and data at my fingertips. It is often assumed that I have a portfolio full of exciting stocks with huge potential. As I explained in my strategy, it is like a plain white piece of bread. Boring. Consistent. Simple.

Many Australians are realising that the traditional Aussie investment in property is not feasible, or are looking to diversify their wealth outside a single asset class. Some Australians like the process of choosing investments. Researching stocks, understanding the companies, even building the models. Others just want to get the job done with as little fuss as possible.

If you wanted to really simplify it, you could build a diversified portfolio with three ETFs with a set and forget approach. For those that are looking to build a core/satellite approach, this could be used for the core. Core and Satellite refers to a portfolio designed to minimise taxes and fees by investing in index funds in a core portion of your portfolio. It then allows you the opportunity to attempt to outperform the market by using a small portion of your portfolio to pick specific investments – that is the satellite.

Why three?

For this exercise, three ETFs have been chosen because it is what is advocated by Bogleheads. Bogleheads are followers of Vanguard’s famous founder John Bogle and his investment philosophy.

Each of the ETFs chosen represents a different exposure desired in our portfolio. The first is domestic shares, the second is international shares and the third is fixed interest.

There are some asset classes missing from this mix, such as real estate or alternatives. Bogle really believed in simplicity. He believed that the more straight forward your portfolio the less time you would spend worrying about it. That means it is less likely you would change things around when the market is down or up significantly.

When you’re holding three ETFs, it is important that they are as broad and representative as possible. One of Bogle’s most famous quotes is ‘stop trying to find a needle in a haystack and own the haystack.’ Owning the entire universe of shares means that you are taking part in the growth of the economy as represented by publicly traded businesses.

Holding these broad, representative investments comes some pros and cons. The first has been mentioned – you are less likely to change your portfolio when markets are down or up significantly. This reduces behavioural risks. Having a simplistic approach also means that it is easier to reduce transaction costs.

There are many studies that show the benefits of having exposure to a variety of asset classes, but none of these benefits hold up compared to the negative impact of selling at the bottom or going all in at the top. If you’re prone to making these mistakes and just want a simplistic portfolio, three ETFs could work for you.

With that in mind, Morningstar’s Manager Research and analysis has been used to pick 3 ETFs that are available in Australia, representing global shares, domestic shares and fixed interest.

Global exposure

Our pick for global exposure is the Vanguard MSCI International ETF VGS.

This is our analysts’ preferred choice for core global equity exposure. They cite how cheap the fees are, the liquidity or the ease with which you can move into and out of the ETF, the diversification and the track record that Vanguard has of being able to match the index returns. That is what earned it a Gold rating from our analysts.

It’s important when you invest that you understand what you are investing in. The ETF includes 22 developed market countries and approximately 1,500 large and mid cap companies. Large cap refers to the biggest companies in these 22 developed markets and mid-cap refers to medium sized companies.

VGS Exposure

Notably, the ETF excludes emerging market countries like China or India. While it is allocated to 22 countries, over 70 percent is allocated to the US. When we look at the overall market, US companies make up a significant portion of publicly traded equities. We get exposure to that by taking a passive strategy. In this case, it is accepting that it is a simplistic strategy and you are getting an investment representative of the market.

It is worth saying that many of the US companies in this index are global. They sell their products around the world, giving you a more nuanced exposure than just to the US economy. For more involved investors that are considering multinationals as a replacement for international equity exposure, I’ve written a detailed article here.

In terms of exposure to countries like China and India, it is important to remember that the share market can be more or less representative of the overall economy. The US is very representative of the overall economic activity of the country. In China, there are more private companies and more government control – it isn’t as representative. When we look at the US and Chinese share markets, the US is more than four times the size of China even though the economies are closer in size.

Once again, there are many arguments to be made to have emerging markets exposure. There are also cases to be made to tilt your portfolio away from the US given the run that the market has been on. However, when putting together a simple portfolio, the thesis is that the benefits of simplicity will outweigh the benefits of diversifying more widely.

The simplicity of this ETF is backed up with low costs. The fee is 0.18%. Due to it being frequently traded, the buy/sell spread is the lowest among diversified equity ETFs in Australia. This is an underappreciated cost of trading and will make a difference if you are frequently buying this ETF as you make more contributions into your portfolio.

Domestic exposure

The Vanguard MSCI International ETF VGS global exposure pick removes Australian exposure. Regardless, Australia would make such a small portion of the investment that you would want to bolster it with another ETF.

Morningstar does an Active Passive Barometer report that looks at which asset classes investors will find more success with active or passive management. For Australian large-cap exposure, the report reveals that it is difficult for active managers to outperform the index. For this reason, we focus on passive exposure to the Australian equity market.

There are two primary passive market cap weighted ETFs. There is Vanguard Australian Shares VAS and SPDR S&P/ASX 200 ETF STW. These two ETFs are slightly different. STW tracks the ASX 200 which is the 200 largest companies by market capitalisation in Australia. VAS tracks the ASX 300 which is the 300 largest companies.

On the surface, 100 holdings seems like it will make a significant difference. However, as it is allocated by market capitalisation, the 100 smallest companies in the ASX 300 have a 2.7% overall index allocation. Realistically this will not make a large difference in returns. None of those 100 companies have more than 0.5% of the overall index allocated to them.

In saying that, the index is top heavy. 48% of assets are held in the top 10 assets in the ASX 200. Commonwealth Bank CBA makes up 9.16% (at July 18, 2024). Overall, the exposure between the two assets is similar.

For passive ETFs, a large consideration is cost. VAS costs 0.07% and STW costs 0.05% (both at 22 July 2024). This is not a large difference. Our analysts’ assessment awards both ETFs a Bronze medalist rating.

With that in mind, the choice for Australian equity exposure has a third contender, and our choice for Australian equity exposure. VanEck Australian Equal Wt ETF MVW.

The reason for selecting this ETF is based on the unique attributed of the Australian market. The exposure, as mentioned, is extremely concentrated. This only tells one part of the story. The Australian market is really narrow, which means that a handful of sectors and industries dominate, including financial services and mining.

In this situation, you aren’t getting adequate diversification. An equal weighted ETF allocates an equal amount to each company. In the case of MVW, there are 74 holdings representing large and mid-cap Aussie shares (at 19 July 2024).

Morningstar analysts believe it is a great way to get exposure to the Australian market because it is more diversified.

This includes the size of the companies that you get exposure to. A market cap weighted index like the ASX 200 or 300 allocates more to the biggest companies. In a market like Australia that is top heavy that means that a disproportionate amount goes to them. The average market cap of the equal weighted ETF portfolio is less than half that of the market cap weighted products. That gives you more exposure to medium sized companies and that diversifies the overall portfolio since so many of the biggest companies in Australia are banks and miners.

The exposure to the financials sector drops around 9% from over 31% for VAS to 22% in MVW (at 19 July 2024). While the allocation to miners is around the same (17% vs 20%), you are getting more exposure to some smaller miners rather than just the biggest ones in the industry where half your basic materials allocation is to BHP Group Ltd BHP.

The fee is still reasonable at .35%, although much higher than VAS and STW.

It is important to mention a feature of the ETF. To keep it equal-weighted, it needs to be rebalanced. On a quarterly basis, the best performing shares that make up more than their allotment in the portfolio are sold, and those that didn’t perform as well are bought. This can have tax consequences are there are likely going to be capital gains involved. This is important to consider.

Our analysts give the ETF a Silver Medalist rating, making it their top ranked ETF for broad domestic equity exposure, eliminating a lot of concentration risk inherent in the Australian market.

AU ETFs exposure

Fixed Income

This ETF is used to lower the volatility in the portfolio. For fixed income exposure, the preferred choice is iShares Core Composite Bond ETF IAF.

It’s cheap, at 0.15% and has low tracking error which means that you are getting the index return. In this case, the index is the Bloomberg AusBond Composite index. This index is mostly government bonds, but also has exposure to corporate bonds.

There are a few main considerations with fixed income ETFs. The first is the running yield. This is the annual coupon payment of the bonds in the portfolio, divided by their current price. This will change over time, but will give you a snapshot of the interest payments you will receive. It is currently 3.09% (at 18 July 2024).

The other consideration is the duration. The duration is 4.95 (at 18 July 2024). This indicates that if interest rates rise by 1%, the price will fall by 4.95%.

Morningstar analysts award IAF a Gold Medalist rating and considers it excellent low-cost access to Australian fixed income.

Asset allocation

Depending on your risk capacity, your allocation to each of these assets will change. If you require less volatility in your portfolio, you will have a higher allocation to fixed income.

This portfolio is simple, and a way to get started for investors. There are missing exposures to asset classes and larger exposures to countries such as the US, but it is a simple way to get started for investors.

Some investors could simplify this even further. If they have a very long time horizon, it could be restricted to global and domestic exposure, with cash. As you approach your financial goal and want to remove volatility from your portfolio, you may choose to include an allocation to IAF. Conversely, if you have a short time horizon, the majority of your portfolio may be in cash or IAF.

For allocation between global and domestic equities, most Australians are likely overly exposed to Australian equities. The Australian market is very cyclical and concentrated in certain industries. An equal-weighted ETF helps, but the exposure to industries such as technology are still low.

Overall, weigh up a larger allocation to global shares than you may originally consider.

Final thoughts

Investing isn’t a sport to be enjoyed. It is a means to an end. If a simplified portfolio is more palatable for you and allows you to get to your financial goal, it has served its purpose. Getting invested in the market, understanding what you’re invested in and being consistent with your approach will pay dividends (literally).

Get Morningstar insights into your inbox.

Articles mentioned: