The GFC revealed the heavy asset allocation biases of many Australians who sustained heavy losses due to high allocations to (primarily domestic) equities. The events of the GFC led many Australians to look for a more conservative approach to investing. One such approach is to build a “balanced” portfolio, with allocations not only to equities, but also to defensive assets such as cash, commodities and bonds.
A balanced portfolio – according to prevailing investment wisdom – invests across a range of asset classes from cash, equities, bonds and commodities to name a few, in order to improve the risk/return of the portfolio by being “diversified”.
But does diversification work? After the shock of the GFC, many investors still question the benefits of diversification – so let’s take a quick look at what the evidence tells us:
The evidence suggests that approximately 90% of the return from a portfolio comes from asset class selection – eg picking the style of asset (shares or bonds etc) and picking the sector/s of the economy to be exposed to (resources stocks vs bank stocks is particularly relevant for Australian investors). For those interested in a seminal study on this topic see the following link.
In practice, Australian investors typically build their investments around cash and fixed income, domestic equities and property. These investments often are held long term and considered the “core” of the portfolio.
Over time, as other assets (both here and globally) start to perform well, such as international equities, commodities and currencies, these can be brought into the portfolio. Because these other investments do not form the core of the investment portfolio, they can be considered to be “satellites”. We can definitely see evidence that “satellite” investments can add value to the portfolio, building on the hopefully solid and consistent returns that the “core” delivers.
Because exchange traded funds (ETFs) are low cost and typically give exposure to large pools of underlying assets (like broad sharemarket indices), they can be an efficient way to obtain exposure to the asset class of your choice, whether as a core or the satellite of your balanced portfolio
ETFs are also liquid vehicles being bought and sold on exchange like any share which ensures ease in re-balancing portfolios when required; for example, to take profit or to reduce losses in the satellite component of your portfolio.
For these reasons, ETFs are compelling instruments with which to build balanced portfolios. Investors are able to add all major asset class exposures via ETFs available on the ASX and alter and switch their allocations at any time during the trading day. They can also obtain asset allocation advice from a financial adviser who can implement such advice using the simplicity of ETFs.