Portfolio Construction The benefits of portfolio diversification with ETFs
2 ETF Securities Investment building blocks for a changing world
Portfolio Construction 3 In a world where investors are seeking intelligent solutions to protect and grow their wealth through quality, low cost investment options, ETFS Australia provides the building blocks to enable investors to achieve their investment goals. ETFS Australia s range of exchange traded funds (ETFs) are a cost effective, secure and transparent way to access investment opportunities that are normally hard to reach, including local and global equities, commodities and FX investments. ETFs can be used to build a new diversified portfolio, or enhance an existing one, to achieve a range of investment objectives including: Growth Income Wealth protection This document explores the benefits of using ETFs within an investment portfolio and explains some common portfolio diversification techniques. This document is for information only and does not consider your individual needs. You should seek independent advice prior to making any investment. For more information, contact your financial adviser or visit the ETFS Australia website: www.etfsecurities.com.au
4 ETF Securities The benefits of portfolio diversification with ETFs What is portfolio diversification? Diversifying a portfolio means investing in a range of different investments with the aim of reducing the overall risk within the portfolio. By spreading the risk, your investments may be less affected by shorter-term market movements. If one investment loses value, your other investments may help to make up the difference. Not Diversified Moderate Profile Growth Profile Australian equities Global equities Australian property sector Global property sector Australian fixed interest Global fixed interest Cash The overall approach to portfolio diversification will depend on the investor s risk profile and their investment objectives e.g. growth, income and/or wealth protection. Exchange traded funds (ETFs) can provide investors with access to investment solutions that meet their portfolio diversification objectives, e.g. Conservative Preserve existing income, low tolerance for portfolio risk. Moderately conservative Seek reasonable levels of income stability while retaining the potential for some capital growth. Growth Achieve income growth, with income security second to wealth accumulation. Aggressive growth Achieve higher capital growth than a balanced portfolio, more accepting of higher risk during the holding period. Balanced Achieve a balance between seeking capital growth and wealth preservation.
Portfolio Construction 5 Risk versus return based on investor profile Target Returns Conservative Moderately conservative Balanced Growth Aggressive growth Target Risk/Volatility Source: Stockspot, Online Investment Portfolios, hypothetical example. Investors seeking high growth may invest more in domestic and overseas equity markets while conservative investors may find that maintaining more of their investments in cash and bonds helps them to achieve their income goals. Below are sample allocations based on three risk profiles: Conservative Profile Moderate Profile Growth Australian equities 11.73% Global equities 6.93% Australian property sector 0.00% Global property sector 1.94% Australian fixed interest 24.01% Global fixed interest 16.10% Cash 39.29% Australian equities 20.86% Global equities 25.06% Australian property sector 0.00% Global property sector 5.73% Australian fixed interest 16.88% Global fixed interest 12.50% Cash 18.97% Australian equities 33.99% Global equities 36.90% Australian property sector 0.00% Global property sector 5.86% Australian fixed interest 9.22% Global fixed interest 6.73% Cash 7.30% Source: ANZ Wealth Lifestage Investment Options, March 2015
6 ETF Securities Why is portfolio diversification beneficial for Australian investors? Most Australian investors tend to have a high proportion of their investments in Australian equities. This approach to investing is acceptable when the Australian market and currency are performing well, but leaves Australian investors portfolios vulnerable to losses should the Australian market or currency suffer a period of poor performance. ETFs can help investors to reduce this risk through investing in other markets, currencies or asset classes. For example: Australia represents only 2.4% of the global equity market, so it makes sense for investors to expand their horizons beyond the Australian Stock Exchange (ASX). International ETFs allow investors comprehensive exposure to overseas equity markets for a fraction of the cost of going direct or using a managed fund. Investing in US equities via an ETF enables Australian investors to complement their portfolio with access to over 50% of the international equity market. Australian investors often hold individual company shares (equities), which can provide excellent returns if those companies are performing strongly. However, holding a small number of individual companies does not allow an investor to spread their risk. To remove the risk of holding a small number of stocks, an investor may choose to buy a basket of stocks which spreads their risk over many different companies. An ETF allows investors to adopt this strategy, as they hold a large number of equities that can be purchased in a single trade without the expense involved in trading in individual stocks. For example: If an investor holds five companies and two of those perform poorly, then that could have a big impact on the overall performance of their portfolio. However, if those two companies were part of a portfolio of 20 or 30 companies, then the impact on the overall portfolio would be reduced. To trade a large number of companies can be expensive, so ETFs can be used to reduce single company risk as an ETF allows an investor to buy a large number of companies in a single trade. An ETF tracking the S&P/ASX 100, for example, can be bought using normal brokerage accounts by only paying brokerage once, and then an investor has exposure to the 100 largest companies in Australia. If an investor tried to buy the companies individually, then they would need to pay brokerage 100 times. For a retiree, or an investor seeking income from their investments, receiving income from multiple sources reduces the reliance on a single source to maintain their income levels. ETFs can help investors to reduce this risk by allowing them to invest in other income producing assets or markets. For example: If the Australian market suffers a downturn, investors who generate most of their income through investing in Australian equities could find their income levels reduced. By investing in other income producing assets, or in international equities that also produce an attractive level of income, an investor can spread the risk of their income level falling should the Australian stock market experience a downturn.
Portfolio Construction 7 Reducing single stock risk As outlined on the previous page, investors can reduce single stock risk by investing in a diversified portfolio. However investors may still choose to invest in single company stocks as well, as the returns from picking a strong performing company can be great. Combining those companies with a broad diversified basket of investments the single stock risk can still be reduced, this strategy is referred to as Core-Satellite Investing. The core-satellite approach involves separating portfolios into two distinct segments: 1. Core comprising long-term, strategic investments 2. Satellite comprising shorter-term, tactical investments Hedge Funds This common approach to investment strategy allows investors to construct a diversified portfolio. As ETFs are easy to trade, they can be a more cost effective way for an investor to move in and out of short term investments. Commodities Bonds ETFs can be used to trade both strategically (Core) and tactically (Satellite). Active Funds Source: ANZ ETFS, hypothetical example. Strategy ETFs Broad Based ETFs Currency Shares CORE SATELLITE Index tracking ETFs, offering a diversified exposure to benchmarks like the S&P/ ASX 100, are an efficient way of building Core positions in a portfolio. Sector, commodity based, currency, regional and other alternative ETFs that offer exposure to Satellite asset classes can then be used to support the Core exposure. The core-satellite approach also allows investors to combine different approaches to investment management in one portfolio. Investors might choose to blend both active and passive solutions. Active managers aim to outperform the market using their expertise, picking specific securities that they believe will deliver greater returns. Investors may therefore choose to use active funds or alternative ETFs for their satellite exposure and blend that with a lower cost diversified ETF for their core exposure.
8 ETF Securities Reducing the risk of over exposure to the Australian stock market Australian investors can diversify their portfolio of Australian equities by also investing in overseas equity markets. For example: if an investor adds American companies to their portfolio they will be able to benefit from the growth of the American market, which may be enjoying better performance than the Australian market. Sector Allocation 31 March 2015 Investment in overseas markets allows investors to gain access to sectors that may be underrepresented in the Australian market for example, Australian equities concentrate heavily on financials and materials, while US equity exposure provides access to IT and utility stocks, as demonstrated in the following chart. Investors should note that investing in overseas equity markets will also introduce foreign exchange risk. 45 40 35 30 25 20 15 10 5 0 S&P 500 Low Volatility High Dividend S&P/ASX 100 Source: Bloomberg, S&P Dow Jones Indices LLC Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Informtation Technology Materials Real Estate Telecommunication Services Utilities
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10 ETF Securities Reducing the risk of over exposure to equities In addition to diversifying their equity exposure by looking at international equities markets, investors can also diversify their portfolios by looking at different asset classes, e.g. commodities, bonds and currencies. This strategy is often referred to as Strategic Asset Allocation. As ETFs allow investors to easily invest in a wide range of different asset classes, such as commodities, bonds and currencies, investors can use strategic asset allocation to construct their portfolio. Investments in commodities like gold, for example, have been traditionally used by investors as a way to protect their portfolio from a market downturn. The reason that gold offers protection is because it is not correlated to equities this means that gold tends to perform well when equities are performing badly. So if an investor adds gold to their portfolio of equities and equities start to perform badly, then they would hope that gold will perform well, which will reduce the overall losses within the portfolio. The flip side to this approach is that should equities be performing well, then gold may tend to perform badly. This is why investors may only allocate a small proportion of their portfolio to gold (typically 5% to 10%) to offer protection when equity markets fall without overly constraining growth when equity markets are rising. The following chart shows the improved risk adjusted return of a portfolio of Australian equities and bonds, with an allocation to physical gold. Risk vs Return March 2005 to March 2015 Annualised Return 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 40% Domestic Equity + 40% US Equity + 20% Gold 50% Domestic Equity + 50% US Equity 100% Gold 100% Domestic Equity 0.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0% 22.0% * Portfolio scenarios are given as examples only and are not intended as investment advice. Investors should consider their own circumstances before investing. Past performance is not an indication of future performance. All annualised returns in AUD; Domestic Equity = ASX 100; U.S. Equity = S&P Low Volatility High Dividend; Gold = LBMA AM Gold Price; risk free rate = 3.0%; Source: Bloomberg Annualised Risk Risks Please note: as with all investment products, there is risk involved when investing in ETFs, these include: ETFs replicate the price movements of their underlying benchmark or asset so their performance is affected by the volatility of their underlying markets. The structure and cost of an ETF means its returns may vary marginally to its underlying benchmark. As with the majority of investments, ETFs will usually incur some form of taxation. Each investor should obtain independent tax advice. All ETFs incur costs, whether internal costs (related to the product) or external costs (incurred in trading the product). Any investment involving a non-local currency will be affected by exchange rate fluctuations. The ETF may fail to replicate their underlying benchmark or asset due to tracking error. This list is not exhaustive. Prospective investors should review the risk section of the applicable ETF product disclosure statement prior to making an investment.
Portfolio Construction 11 Disclaimer This document is communicated by ETFS Management (AUS) Limited ( ETFS ) (Australian Financial Services Licence Number 466778). This document may not be reproduced, distributed or published by any recipient for any purpose. Under no circumstances is this document to be used or considered as an offer to sell, or a solicitation of an offer to buy, any securities, investments or other financial instruments and any investments should only be made on the basis of the relevant product disclosure statement which should be considered by any potential investor including any risks identified therein. This document does not take into account your personal needs and financial circumstances. You should seek independent financial, legal, tax and other relevant advice having regard to your particular circumstances. Although we use reasonable efforts to obtain reliable, comprehensive information, we make no representation and give no warranty that it is accurate or complete. Investments in any product issued by ETFS are subject to investment risk, including possible delays in repayment and loss of income and principal invested. Neither ETFS, ETF Securities Limited nor any other member of the ETF Securities Group guarantees the performance of any products issued by ETFS or the repayment of capital or any particular rate of return therefrom. The value or return of an investment will fluctuate and investor may lose some or all of their investment. Past performance is not an indication of future performance.
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