Our post entitled “What is a balanced portfolio and what does it mean for me” briefly explained “core and satellite strategies” using ETFs. In this Portfolio Construction post we look further into implementing a core and satellite strategy in an Australian equities portfolio.
Australian investors like to purchase domestic shares. Apart from the comfort of buying familiar stocks on the ASX, the addition of franking credits which are used to reduce Australian taxes also makes Australian shares an appealing investment class.
The question often asked by retail and SMSF investors is: what’s the best way to hold my Australian share investments? The three most common options are:
- direct share investing (eg picking a concentrated portfolio of 10-15 stocks which are held directly)
- share managed funds (where the fund is actively managed across Australian stocks)
- exchange traded funds (ETFs)
Before deciding which option is best, investors should understand the difference between sharemarket “alpha” and “beta”. At it’s simplest, beta is the overall return of the whole market: often in Australia this is measured by the S&P/ASX 200 index. Alpha is the excess return over and above market beta.
Separating the concepts of alpha and beta, each method of holding Australian shares has a different application for investors.
If an investor is looking to closely match the return of the market or “beta”, this can be achieved efficiently using an ETF which holds the underlying shares in the market index.
A concentrated portfolio holds a far smaller sample of stocks compared to the broad ASX 200 and is likely to be the portion of the portfolio used to generate “alpha”. An actively managed fund also aims for the same outcome.
However, for the more difficult task of generating investment alpha, care needs to be taken with the initial selection of stocks, and the ongoing holding or re-balancing of them. That is because a concentrated portfolio of individual stocks is likely to experience greater variability of returns from losses in one or a few of the stocks, at some time during the investment lifecycle. Selling out of stocks to take profit or to reduce impending risk is an important part of managing your direct stock portfolio.
Using ETFs as the core for your Australian share portfolio is a low cost/low turnover way to achieve market beta. Using direct stocks as the satellite component allows you to focus your energy on the more difficult task of creating alpha.
At BetaShares, the product which our clients tend to use most for the “core” investment is our FTSE RAFI Australia 200 ETF, which uses the ASX code QOZ. This product seeks to tracks an index that provides access to the largest 200 stocks on the Australian market based on their fundamental size (or their economic footprint on the economy). This methodology aims to outperform traditional cap-weighted index methodologies (and has done since its inception of this index) while still maintaining the benefits of index funds (transparency, diversification, low turnover).