Young & Invested: The beginner ETF portfolio
Diving into ETFs can often be overwhelming.
Mentioned: iShares S&P 500 ETF (IVV), Vanguard US Total Market Shares ETF (VTS), Vanguard MSCI Intl ETF (VGS), BetaShares Australia 200 ETF (A200), Vanguard Australian Shares ETF (VAS), VanEck Australian Equal Wt ETF (MVW)
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 14
There comes a time in every beginner’s investing journey when you discover the world of Exchange Traded Funds (“ETFs”).
Perhaps it’s after you lost $200 on a crypto token pedalled by your favourite influencer, or $1000 on that small cap miner you swore would rise to 10x in a year – this was certainly the case for me.
After years of investing in poorly performing stocks (mostly inspired by obscure commentators on Reddit), I had enough. My savings were going south, and I concluded investing wasn’t for me. That was until I discovered ETFs.
ETFs or individual stocks?
The short answer to this question is that both stocks and ETFs can hold a place in your portfolio. But admittedly, I far prefer ETFs. Beginner investors have their back against the wall. With over 2000 options on the ASX and the free flow of online financial advice, it can be easy to fall into an infinite rabbit hole.
It’s no surprise that ETFs are popular among beginners and experienced investors – both the time poor or even poorly behaved. The prospect of stock picking may appear enticing to some, but you are at significant risk of a catastrophic loss from a single-stock. ETFs negate this by providing a basket of securities which offers instant diversification. And investors are responding. 2024 experienced the largest 1-year inflows for low-cost ETFs that tracked a broad-based market index.
Most popular ETFs by net flows. Source: Global X Australian ETF Market Scoop. 2024.
In a previous article why I don’t invest in individual stocks anymore, I detail the reasons why I transitioned from picking individual stocks to a purely ETF based portfolio. In short, my choice was due to my past poor behaviour in volatile situations, a lack of investing edge and therefore, an inability to consistently ‘pick a winner’.
Furthermore, Morningstar’s Active Passive Barometer study findings emphasised how even investment professionals struggle to beat the index in the categories I invest in.
The perfect 3 ETF portfolio
ETF portfolios don’t need to be complicated. For instance, one popular suggestion comes from Vanguard founder John Bogle’s who advocated for a 3 ETF portfolio. This simple portfolio provides total market exposure to domestic and global shares as well as fixed interest.
Bogle was a proponent of simplicity – and this appeals to me as well. I don’t want to create and consistently monitor a 10-ETF portfolio, and don’t think this is a constructive exercise for beginners. Bogle championed investing in the entire stock market through an index fund and then doing nothing and staying the course. This is largely the strategy I employ in my own investing - with a grain in salt.
The truth is, there is no one ‘perfect’ ETF portfolio.
The most crucial part of investing is having structure behind your decision making. Not only does this guide your process but can also negate poor behaviour in periods of volatility. The best place to start is defining a goal and creating an investment strategy.
With over 350 ETFs listed on the ASX, jumping in without selection criteria will likely lead you down a rabbit hole of new funds to discover. Defining specific criteria can help you understand your priorities and frame investing from a disciplined approach.
Here’s what my approach would look like for a simple beginner’s portfolio.
4 steps to build an ETF portfolio
Mark’s article 4 steps to build an ETF portfolio raises the below considerations:
- Determine how many ETFs will be in your portfolio
- Research ETFs (active vs passive options)
- Beware of overlap
- Resist the urge to change or add on to your portfolio
Asset allocation decisions
Asset allocation has a larger impact on returns than the securities within a portfolio.
Equities are considered the most growth-centric allocation. Morningstar’s ‘Aggressive’ model portfolio (9+ years minimum investment) has a 90% skew to growth assets like international and domestic equities, as well as property and infrastructure. The remaining 10% lies in fixed interest and cash holdings.
Morningstar ‘Aggressive’ model portfolio allocation.
A fixed interest or property/infrastructure allocation may be too niche for beginners, so for the sake of simplicity I exclude these. Furthermore, beginner investors typically have longer time horizons with a growth focus, so a heavier emphasis on equities is appropriate.
The percentage split between domestic and international equities can be contentious as home bias often influences your choice. Investors generally lean on Australian equities for their income focus and international for growth.
For example, a 50/50 split may seem appropriate, but can be criticised from a ‘maximum diversification’ perspective. Allocating half of your holdings to the domestic economy (which represents around 1% of world GDP) poses some concentration risk. Whilst I don’t encourage making an allocation decision purely based on relative GDP, taking this into consideration helps to reframe home bias.
Despite this, local equities have the benefit of franking credits which add approximately 1.3% to investor returns on average over the last three years.
International equity
Most diversified global indexes have significant exposure to US-domiciled holdings given the large presence of multinationals. The US market has generally enjoyed higher returns than its developed counterparts, however past performance doesn’t dictate future returns.
Popular US-centric funds iShares S&P 500 (ASX: IVV) and Vanguard US Total Market Shares Index (ASX:VTS) present low-cost options with entirely US exposure. I ran a comparison of the two options here.
Alternatively, for those looking at global equity funds with more diverse developed market exposure, Vanguard MSCI Index International Shares (ASX:VGS) is a top option, however, still has a 75% skew to the US.
Domestic equity
The two most popular Aussie equity ETFs are Vanguard’s Australian Shares (ASX: VAS) and BetaShares’s Australia 200 (ASX: A200). The low cost options respectively cover the largest 300 and 200 companies on the ASX on a market cap weighted basis.
Market cap weighted ETFs are often top heavy and can disproportionately skew to certain sectors creating inadequate diversification. Alternatively, there are equal weighted funds on the market such as VanEck Australian Equal Weight (ASX: MVW), that hold 74 ASX securities by equally weighting across companies and thus reducing sector concentration.
It is important to note that MVW, like most equal weight funds, comes at a higher cost and worse tax outcomes to its market cap weighted counterparts, due to higher turnover and transaction costs.
Academic research has shown in the long term that equal-weighted portfolios tend to outperform their mid-cap-weighed peers.
