Gavin Shepherd assesses a range of strategies designed to deliver a high probability of meeting an investor’s risk and return objectives after fees.
There has been substantial growth in domestic exchange traded funds (ETFs) and exchange traded commodities (ETCs) over the past few years. Currently, there are 41 domestic and internationally-based ETFs and six ETCs listed on the Australian Securities Exchange, offering exposure to the major domestic and global indices. It is expected many more issuers will enter the market over the next 12 months, resulting in new products being offered.
It could be argued that the primary drivers of this growth in ETFs are clients looking for a low-cost investment that is simple, transparent and flexible, while the interest from financial planners has been sparked by the introduction of fee for service and the banning of commissions.
When constructing a portfolio for a client, the adviser’s aim is to build an investment portfolio that has a high probability of achieving their client’s overall return and risk objectives after fees. While ETFs are a cost-effective investment vehicle for accessing the various markets, total returns (that is, returns after fees) of the portfolio may suffer if the portfolio is constructed inefficiently. In other words, the decision to use ETFs is only half of the story. The other is how to blend ETFs with other investment structures and products so as to design the most efficient portfolio for the client. The steps discussed below provide a framework in which an efficient portfolio can be built for clients.
Portfolio design process
When building a portfolio with ETFs, the following portfolio design process may be followed:
Step 1: Determine the risk and return objectives of the client’s Australian equities portfolio
The first part of the process is to determine the client’s return and risk objectives from Australian equities.
A client’s return and risk objectives can generally be broken down into four investment strategies. These may include: index return, index plus active return, absolute return and specific investment strategy, such as achieving tax-effective income.
In the first scenario, the client can achieve index returns by using a variety of investment structures such as ETFs and/or index funds. In the other scenarios, the client can achieve the required outcome through the use of investment structures such as ETFs, actively managed funds or direct equities, or a combination.
Step 2: Determine the type of investment products that will be used within each investment strategy and structure
Once the client has determined which investment strategy and structure best matches their total return and risk objectives then the client will need to consider the type of investment product(s) that will be included in their portfolio. If the client invests in ETFs, then they must choose which type(s) of ETFs they will use in their portfolio. These may include broad based ETFs, market cap ETFs, sector specific ETFs or investment strategy based ETFs. The diagram on the next page shows some of the other types of investment products available for inclusion in a client’s portfolio.
Step 3: Determine the portfolio strategy
The third step involves implementing a portfolio strategy and populating the strategy with various investment products. Some of the different portfolio strategies include core plus satellite and, in the case of a pension portfolio, drawing income from a cash bucket.
The core plus satellite structure may involve anchoring the portfolio with a broad based index or ETF investment product (core) and adding actively managed funds, direct equities or non-broad based ETFs, or a combination, as satellites. These satellite products are added, or their weighting increased, until a point where it gives the highest probability of the client achieving their risk and return objectives.
The second approach is typically used by retirees as a means of addressing both longevity and investment risk in their pension portfolio. In this strategy, two to three years worth of income (essential and discretionary) required from the portfolio is placed in a cash portfolio that is not affected by market downturns and is secure in nature. The required income drawdown is made from this cash portfolio. The remainder of the portfolio is invested in a diversified growth based portfolio to generate the potential for capital growth over the longer term. The income generated from this growth portfolio is reinvested in line with the diversified asset allocation. The Australian share ETF comprises the growth component of this portfolio strategy.
Another variation on this strategy is to place two to three years worth of essential income needs only (that is, excluding discretionary income needs) in the cash portfolio, as above, with the remainder in the diversified growth based portfolio. The difference here is that the essential income needs represent only a portion of the client’s total income needs, and hence a larger portion is placed in the growth portfolio. The growth portfolio includes growth assets that have an income bias, such as the income strategy Australian share ETFs. The income generated from this growth portfolio is then used to meet the client’s discretionary income needs.
Step 4: Determine the weighting of investment products in the portfolio
The client’s return and risk objectives will not only decide the investment strategy, investment structure and what type of investment products will be included in their portfolio, but also the weighting of the investment products in the portfolio.
