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Mark LaMonica: 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. So, Shani, I think we have a great episode today. That'll be very popular. But I'm trying to remember, what is that social media thing that you used in high school where you rank your friends?

Shani Jayamanne: Bebo.

LaMonica: Bebo.

Jayamanne: Yeah. But you would also kind of do it on Myspace.

LaMonica: Okay. And the concept, as Shani explained it to me, is horrible, by the way. And, you know, they talk about social media causing depression and anxiety in children. And like, this seems to be the number one reason that literally you just sit there and rank your friends. So, if your top friend does something, you can move them down the rankings and everyone can see it.

Jayamanne: Exactly it. It's very public.

LaMonica: Yeah.

Jayamanne: Where are you going with this?

LaMonica: Well, today we're going to talk about ETFs and we'll do a little intro on ETFs.

Jayamanne: Okay.

LaMonica: But we're also talking about the three most popular ETFs in Australia.

Jayamanne: I see a very loose tie-in, but we are, yes.

LaMonica: Okay. Well, let's get into it, Shani. You did not like my introduction, but let's get on with the episode.

Jayamanne: Today we're going to be discussing one of our most popular topics, ETFs.

LaMonica: And there's a reason for this, of course. More investors are gravitating to ETFs. The 2023 ASX investor study showed that the number of Aussie investors using ETFs has risen from 15% to 20% in the space of three years. And it's particularly popular with new investors, probably investors that remember the social media thing that Shani used. And for 14% of investors who got started in the last two years, an ETF was their first investment.

Jayamanne: And ETFs are easy to access. They provide instant diversification and can be used to gain exposure to asset classes that are difficult to access directly.

LaMonica: And much like the person that sat on the top of Shani's list, ETFs are, of course, a popular topic. But we're not just going to be talking about ETFs in general. We are, of course, going to be talking about the most popular ETFs. And we measure that not by what somebody thinks is a good or bad ETF. We measure it by fund flows and how much money is invested in those ETFs in Australia.

Jayamanne: Yes. So these are the ETFs that you are statistically most likely to hold. So we thought it would be good to put together an episode about what our analysts think of them.

LaMonica: All right. So we're going to limit this to the top three. And just because we don't want this to be nine hours long. And it's not surprising, but Shani, why don't you tell us what the most popular ETF in Australia is?

Jayamanne: It's Vanguard Australian Shares ETF with the ticker symbol VAS. It has over $14 billion in funds under management at the end of 2023. So when you're assessing an ETF, one of the first things that you need to look at is the strategy. And for this one, it's a passive ETF that aims to replicate the S&P ASX 300 index. So that's the top 300 stocks by market capitalization in Australia.

LaMonica: And I think this is good news, but our analysts believe that this ETF is a compelling choice for core Australian equity exposure. And it's got Bronze medalist rating. And just as a little bit of a refresher, our ratings are based on expectations for risk adjusted future performance compared to the category benchmark. And basically what this means in English is that it isn't determining how good a fund or ETF is based on if they think it will go up in the future, or if it's gone up in the past. It's based on the expectation that our analysts have for how well it will perform against its actual benchmark.

Jayamanne: And they think that VAS is a diversified index that captures the investment opportunities that well for the Aussie market and that it has a highly competitive fee. It's got a total cost ratio of 0.07% per annum. They also back it because Vanguard is well recognized for its index tracking and trading efficiencies. And that means that they've had a continued vote of confidence in their strategies.

LaMonica: And one of the biggest questions, of course, everyone has to ask themselves is whether they're going to go active or passive. And as we mentioned, this ETF is cheap, which means it sets a significant hurdle for active managers in the same space when looking at a return after fees.

Jayamanne: But our analysts do call out that there are best rated active managers that can add value and cross that hurdle consistently that they see in their coverage. So if you did want to access that, that is through Morningstar Investor.

LaMonica: And one consideration when looking at any market, but particularly when we're looking at the domestic share market in Australia, are of course the unique attributes of our local market. BHP makes up 11% of the index and the top 10 holdings make up 46% of the index as of mid-January. So the Australian market is very narrow, which means that a handful of sectors and industries dominate, including financial services and mining.

Jayamanne: So you're not really getting adequate diversification with this ETF. We've gone through the situation before in our episode on 'How To Build A Portfolio With Three ETFs', but we'll quickly go through what the alternative is to investing in VAS.

LaMonica: And that's an ETF that actually I hold. And that is going equal-weighted, and that's not an endorsement, of course, of the ETF. I think most people at this point are not doing what I do. But that's an equal weighted ETF, and that just invests proportionately across all the index constituents. So the VanEck Australian Equal Weight ETF with the ticker symbol MVW does this across 80 holdings that represent large and mid-cap shares in Australia. One thing to note is the fee is significantly higher than that Vanguard product VAS, and the fee is 0.35%. And that of course compares to what we said earlier, Vanguard's fee of 0.07%. But our analysts do believe that this higher fee is justified. They award MVW a Silver medalist rating and think it's a great way to get exposure to the Australian market because it's more diversified based on that equal-weight status.

Jayamanne: MVW holds large and mid-cap shares in Australia, and those are the biggest companies and medium-sized companies that are in the ASX 200 and 300. Now, as we said, our analysts really like this ETF and think it is a great way to get exposure to the Australian market because it is more diversified. So why don't we walk through the implications of this equal-weighting?

LaMonica: Okay, so a market cap weighted index like the ASX 200 or 300 allocates more to the biggest companies. That's why we're ending up with 11% in BHP. 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 of that of the market cap weighted product. That gives you more exposure to medium-sized companies, and that diversifies the overall portfolio since so many of the different companies in Australia are banks and miners, and they all happen to be really big.

Jayamanne: That's right, Mark. The exposure to the financial sector drops around 8% from over 29.5% for VAS to 21% in MVW in mid-February 2024. You've got 17% towards basic materials in MVW and 23.15% in VAS. While the allocation to miners is not as different, 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.

LaMonica: We did talk about the fee, but it is still reasonable at 0.35%. Although it's important to note that it is a lot higher, as we said before, than what you'd be paying for the Vanguard product. The other thing to look at is the way that it's rebalanced. Obviously, to keep everything equal weight when those share prices are moving all the time, this does need to be rebalanced. It happens on a quarterly basis, which means that the best-performing shares that make up more of their allocation are sold and the ones that didn't perform as well are bought. This can have tax consequences because, of course, there's likely to be capital gains involved if the market overall is going up, and that is really something to consider for investors.

Jayamanne: But again, overall, we give this ETF a silver rating, which makes it the top-ranked ETF for domestic equities in Australia as it eliminates a lot of that concentration risk inherent in the Aussie market.

LaMonica: All right. We've spent a while and we've only gone through one of three.

Jayamanne: The others are shorter.

LaMonica: Okay. Well, I'm sure everybody is…

Jayamanne: …glad to hear that.

LaMonica: Yeah. Breathing a sigh of relief. The second ETF we're going to talk about is the Dimensional Global Core Equity Trust with the ticker symbol DGCE. It has $6.7 billion at the end of 2023.

Jayamanne: And our analysts believe that Dimensional Global Core Equity Trust is a great pick for investors seeking a diversified global equity portfolio. The fund offers exposure to listed companies across the market cap spectrum from foreign developed markets, but it does exclude emerging markets. And historically, the fund has maintained a pretty significant bias to North America at the expense of Europe and Asia.

LaMonica: And when we look at the strategy, it rests on the research of renowned academics such as Eugene Fama and Kenneth French or Fama and French, as they are always referred to. The strategy tilts towards stocks with lower valuations measured by the price to book ratio, smaller market caps, so smaller companies, and higher profitability using an adjusted measure of operating income. Evidence shows that stocks with these characteristics have tended to outperform over the long term. The fee comes in at 0.36, and it's among the lowest relative to active ETFs.

Jayamanne: Our analysts think that the ETF is a representative and well diversified portfolio, and despite an extended period of around 10 years where value-oriented funds like this one faced headwinds, it only marginally underperformed the average return of the World Large Blend Morningstar category. And the fund held up relatively well in the 2022 calendar year compared to category peers as equity markets around the world slid.

LaMonica: And these are some of the reasons why investors may choose an active strategy over a passive strategy. The first is if an investor has determined that a value tilt is part of their investment strategy. The second is if they want lower volatility but still want global exposure. So they're happy that the fund has no exposure to emerging markets that typically are more volatile. They lower risk further by picking stocks that have lower valuation.

Jayamanne: Overall, with a low expense ratio, the fund has a potential to deliver superior long-term risk adjusted returns relative to their peers.

LaMonica: However, there is an alternative if you want a little bit of a broader brush. And that is the Vanguard MSCI International ETF with the ticker symbol VGS. So it's awarded a Gold medalist rating by our analysts for core global equity exposure. You probably guessed by the name of the ETF. It follows the MSCI World ex Australia Index. Our analysts cite how cheap the fees are, the liquidity and ease with which you can move in and out of the ETF, the diversification and the track record that Vanguard has being able to match index strategies.

Jayamanne: And the ETF includes exposure to 22 developed markets and over 1,500 large and mid-cap companies.

LaMonica: And there are a couple other considerations. So it also excludes emerging markets, including countries like China and India. And while it is allocated to 22 countries, over 70% is in the U.S. But ultimately, it wouldn't really matter that much. If this was a representative index that did not exclude emerging markets, China would only make up 3.7% of the index and India would make up 1.8%. So these are very small exposures.

Jayamanne: What does need to be recognized is that when we look at the overall market, it is heavily weighted to the U.S. as U.S. companies make up a huge portion of publicly traded equities. Many of the giant U.S. companies represented in the index are global, selling products around the world. From this perspective, investors are receiving exposure to many more economies than just the U.S. We've spoken about this before in the episode about whether multinationals give you enough international exposure. So give that a listen if you're trying to find the best way to get international exposure in your portfolio.

LaMonica: And one thing to note about countries like China and India, it is important to remember that depending upon the country, the share market can be more or less representative of the overall economy. In the U.S., the share market is highly correlated to the overall economic activity of the country. This isn't the case in China, there are more private companies and more government control. If we look at the U.S. and Chinese share markets, the U.S. is more than four times the size of China's share market. But the economies are a lot closer in size.

Jayamanne: So the fee for VGS is low at 0.18%. And due to liquidity, the buy-sell spread is the lowest out of diversified global equity ETFs in Australia. And we always tell investors to look at fees, but this is often an under-appreciated cost of trading and it'll make a difference if you're frequently making contributions in your portfolio.

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LaMonica: All right, Shani. So that little, I guess that was just, we were just throwing in an extra ETF for free.

Jayamanne: For fun.

LaMonica: Yeah. But now we're on the third one and the last one. And once again, we talked before how we need a drumroll on the show. But the last of the ETFs is of the most popular ETFs is the iShare S&P 500 ETF with the ticker symbol IVV. It has $6.66 billion as of mid-January 2024.

Jayamanne: Many passive Australian investors are anything but, so they deviate from their strategies by making active decisions to be overweight in certain sectors, themes or geographies. It is no secret that Australian investors prefer and are heavily invested in domestic markets.

LaMonica: But we can see is that Australian investors have started to double down on the U.S. as well. And we can't speak for all investors, but we can speculate that this may be due to the U.S. outperforming almost every other market since the GFC. So it's no surprise that this iShares S&P 500 ETF IVV makes the top three.

Jayamanne: And I recently spoke to Danielle Ecuyer to get her perspective on the U.S. market. She is a huge proponent and she actually based her second book around the premise that she sold the Aussie banks and invested in the U.S. markets.

LaMonica: I feel like you need to explain who she is.

Jayamanne: Yeah. So she's currently a host and anchor at Ausbiz, but she's had about three decades of experience in institutional funds management. She focused in emerging markets, but she spent the last couple of decades investing for herself and building a portfolio.

LaMonica: And she lives right next door to Shani. And Shani is like best friends with her. So she would be moving up your little ranking list.

Jayamanne: She would, yeah. Who knows if she's at the top of my Bebo friends.

LaMonica: Oh, all I know is that I'm not on it. But we'll get back to Danielle. So her thesis for increasing her exposure to the U.S. revolves around innovation. So she believes that Australia is, of course, and continues to be the lucky country, blessed with natural resources, a booming housing market, which is thanks to the longstanding immigration policies which underwrite population growth and demand for property. But she thinks there are other things that, of course, can add to the wealth of investors. And that is why she's looking to the U.S.

Jayamanne: And the U.S. is also a world leader in commodities and property. The difference is that for the last 120 years, they've also been huge innovators.

LaMonica: Yeah. And really what she talks about here is what she describes as a starkly different culture around failure and around innovation, which is surprising. I don't still live there since I'm very good at failing, not so good at innovating, but very good at failing.

Jayamanne: Have you felt a difference here, Mark, that your failure was more accepted in the U.S. and not so much here?

LaMonica: No, I don't think it's been accepted in either place.

Jayamanne: Okay.

LaMonica: Anyway, she just talks about, and I think we've heard this a lot, right? We've heard this innovation culture in the U.S. And part of that, of course, is getting over that hurdle of fear of failure when you're going out and starting your own business. So she thinks that sort of the combination of this culture and also the fact that the U.S. sees itself as a little bit of a pushback against more of the sort of worker union-oriented European economies and the establishments there. And there are a lot of critics, of course, of this, but she believes that even though this sort of unfettered capitalism, as we said, could have some issues, she believes that this actually leads to a lot more innovation and that's reflected in the share market.

Jayamanne: And you don't need to look any further than the journeys of the latest round of billionaires. So there's Elon Musk, Jeff Bezos, and Bill Gates. And the road to success has come with near-catastrophic failures for all of them. And it's in the same spirit that investors are more than happy to back startups.

LaMonica: And I think here, since I moved here, I guess there obviously is a lot of sort of government push for more innovation, but I just don't know how successful it's been. And I think that that would be Danielle's point as well, that it hasn't been as successful in Australia. And, Shani, you wrote an article on this.

Jayamanne: I did. It hasn't been released yet, but by the time this podcast comes out, you'll be able to read it on Morningstar.com.au.

LaMonica: Well, that is good. Okay, let's get back to the ETF. So that's Danielle's case, who can be found having coffee with Shani.

Jayamanne: And my dog.

LaMonica: And your dog pretty much on a daily basis. But that's her case for the U.S. And one great way to get exposure is, of course, the S &P 500 and this ETF IVV that tracks it. So, given the breadth of coverage and the cost efficiency, the iShares S&P 500 ETF is a good choice for investors that want that U.S.-specific equity exposure. So the strategy is expected to outperform its peers, namely the active funds by our managers over the long term. And they think it remains a clear choice for investors that want access to the U.S. And of course, you can create a balanced portfolio using this ETF and then non-U.S. products to get that diversification that you're looking for.

Jayamanne: So a little bit about the underlying benchmark.

LaMonica: It really needs no introduction, though.

Jayamanne: The S&P 500 is a market cap weighted index of the largest 500 companies in the U.S. And it offers giant to mid-cap exposure, covering about 80% of the free-float adjusted market cap of the U.S. equity market.

LaMonica: And so you get this well-diversified index at both a stock level and also at a sector level. And we've done a few episodes on active versus passive. But this is a textbook example, the type of market segment where active managers have generally struggled to outperform. It's highly liquid stocks. Material stock-specific valuation information is quickly incorporated into those prices because there are so many investors, so many professional and individual investors that follow and track this index.

Jayamanne: And from an Aussie perspective, IVV gives exposure to a broad portfolio of some of the world's most noteworthy companies, including sectors that are underrepresented in Australia such as tech and healthcare. S&P 500's correlation to Aussie equities has also come down in recent years. And this does effectively add to diversification for Aussie equities exposure. And it earns a silver medalist rating from our analysts.

LaMonica: And it also has lowest fee of anything we've talked about today, so 0.04%, which is very good. So it's certainly priced attractively, I think, against all ETFs, but also compared to the active and passive peers with exposure to the U.S. And if we take a quick look at the index, 51% of the index is in the top 10 holdings. And over 7% is in the largest holding, which is now Microsoft, used to be Apple, Apple's number two at 6.75%. But the index is highly concentrated in tech. But as Shani said, that could be something a lot of Australian investors want, because you don't have that exposure locally. So 30% of the index is in tech as of mid-January. We've done it.

Jayamanne: We've done it. The three most popular ETFs in Australia.

LaMonica: The three most popular ETFs.

Jayamanne: In everyone's Bebo top three.

LaMonica: Yes, and we learned one person in yours. And so maybe on future episodes, we can find out who are your top three people or who are the other two top three besides Danielle.

Jayamanne: We can explore that. If you would like to, Mark, if you like your feelings hurt, we can do it.

LaMonica: My feelings are hurt every day, but thank you guys very much for listening. We appreciate it. And of course, any comments or questions or requests to be in Shani's top three, please send them to my email address, which is in the show notes.

(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.)

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