Index Managed Funds and ETFs outside Superannuation

I've been asked recently about Vanguard and other index managed funds outside super so decided to collect my thoughts.  In principle this should also be applicable to self-managed superannuation funds, although the tax implications will be different.  This post will be focused on products available in Australia more than general strategy (keep in mind that process is often more important than product: saving 0.1% in fees is no help if your strategy is one that you find too stressful and can't maintain).

There are two main investment vehicles that can easily be used for index investing in shares.  The more traditional managed funds are purchased by applying to the fund manager.  Minimum investments vary - Vanguard and Colonial First State have a $5,000 minimum.  However both offer regular investment investment plans from $100 per month which can be particularly useful when starting investing.  There are still 'trading' costs in the buy-sell spread (of the order of 0.1-0.3%) so it's still probably worth sticking with a product for a number of years (if moving investments around regularly those costs will mount up).   Canadian couch potato points out that when our balance is small, our contributions will have much more impact than investment returns. So having investments that allow for easy regular contributions at a reasonable cost may indeed be a better option than targeting the lowest annual fees (through ETFs) when your balance is low (particularly given brokerage costs).

An Exchange Traded Fund (ETF) is basically a managed fund which trades like a share on the ASX. Typically ETFs have lower ongoing management costs than an equivalent standard managed fund but you do need to pay brokerage to purchase them, just like a share.  The ETFs that align with the investment approach I've been talking about are again Index Funds.  Index ETFs typically trade very close to their Net Asset Value (NAV), the price of the underlying shares or bonds in the index.

Exchange Traded Funds (ETFs) have been around for a while, slowly gaining in popularity in Australia since the launch of the ASX200 SPDR fund (STW) in August 2001.  iShares and Vanguard have increased the range of offerings substantially over the past few years.

For traditional 'unit trust' managed funds, Vanguard charge 0.9% p.a. for share-based and diversified index funds up to $50,000 (and 0.7-0.75% for cash and bond funds, although many would not choose to hold these or hedged international shares outside superannuation due to their relative tax inefficiency.  Edit 7/10/2013: Now down to 0.75% p.a. for Australian Shares also).  Some comparable (as well as a couple of extra) Colonial Wholesale investments are listed below (Note the Realindex and Multi-Index funds may not be as tax-efficient due to likely higher portfolio turnover and bond holdings respectively):

Fund	MER
Colonial First State Wholesale Index Australian Share	0.41%
Colonial First State Wholesale Index Australian Bond	0.41%
Colonial First State Wholesale Index Property Securities	0.41%
Colonial First State Wholesale Index Global Share	0.53%
Colonial First State Wholesale Index Global Share – Hedged	0.53%
Realindex Wholesale Australian Small Companies	0.86%
Realindex Wholesale Emerging Markets	0.94%
FirstChoice Wholesale Multi-Index Conservative	0.61%
FirstChoice Wholesale Multi-Index Diversified	0.65%
FirstChoice Wholesale Multi-Index Balanced	0.70%

ETFs will typically have lower fees still (but require brokerage to purchase).  Some 'core' ETFs that may be of interest for the sorts of portfolio strategies I've been discussing are tabulated below:

Australian Large-Cap Shares		MER
Vanguard® Australian Shares Index ETF	VAS	0.15%
SPDR® S&P®/ASX 200 Fund	STW	0.29%
iShares MSCI Australia 200	IOZ	0.19%

Overall Vanguard have the best-diversified ETFs that I can find with the lowest costs.  I would have used VAS myself except it didn't exist when I started investing in index funds.  Note that VAS covers closer to 300 stocks, rather than the ASX200.

Note that at least the Vanguard International funds below (and I think some of the iShares ones also) are cross-listed US funds. That's a big reason why they're so inexpensive but this means that there is some withholding tax from their distributions (that you can hopefully use as a tax offset at tax time) and there may be other tax implications for US residents.  The SPDR products are more expensive but do offer the US and the rest of the world in a single product, as well as a hedged currency version.

Global Large-Cap Shares		MER
SPDR® S&P® World ex Australia Fund	WXOZ	0.42%
SPDR® S&P® World ex Australia (Hedged) Fund	WXHG	0.48%
or approximately split into US/non-US
Vanguard® US Total Market Shares Index ETF	VTS	0.05%
Vanguard® All-World ex-US Shares Index ETF	VEU	0.15%
iShares Core S&P 500 ETF	IVV	0.07%
iShares MSCI EAFE ETF	IVE	0.34%

I'm personally wary of Australian Small-Cap without some control for 'value' due to the weighting towards smaller mining and mining services companies, but this may not be entirely rational

Australian Small-Cap Shares		MER
Vanguard® MSCI Australian Small Companies Index ETF	VSO	0.30%
SPDR® S&P®/ASX Small Ordinaries Fund	SSO	0.50%
iShares S&P/ASX Small Ordinaries	ISO	0.55%

Australian Listed Property		MER
Vanguard® Australian Property Securities Index ETF	VAP	0.25%
SPDR® S&P®/ASX 200 Listed Property Fund	SLF	0.40%

As mentioned above, Bonds may be more suitable to hold in Superannuation depending on your specific taxation circumstances

Australian Bonds		MER
Vanguard® Australian Fixed Interest Index ETF	VAF	0.20%
Vanguard® Australian Government Bond Index ETF	VGB	0.20%
iShares UBS Composite Bond	IAF	0.24%
iShares UBS Government Inflation	ILB	0.26%
iShares UBS Treasury	IGB	0.26%
SPDR® S&P®/ASX Australian Bond Fund	BOND	0.24%
SPDR® S&P®/ASX Australian Government Bond Fund	GOVT	0.22%
Russell Australian Government Bond ETF	RGB	0.24%
Russell Australian Semi-Government Bond ETF	RSM	0.26%
Russell Australian Select Corporate Bond ETF	RCB	0.28%

Those cover the major asset classes. While there are many other ETF options available, some more specialised ones that I am reviewing for my own use are below.  If the paragraph explaining below makes no sense, I'd skip these funds and stick to the major asset classes.

iShares: Small-Cap US and Emerging Markets		MER
iShares Core S&P Small-Cap ETF	IJR	0.17%
iShares Russell 2000 ETF	IRU	0.24%
iShares MSCI Emerging Markets ETF	IEM	0.69%

Value-Tilted and Fundamental Index Funds
BetaShares FTSE RAFI Australia 200 ETF	QOZ	0.30%
Russell Australia Value ETF	RVL	0.34%

These ETFs cover segments and 'tilt' that is often more challenging to find in low cost index funds and Superannuation in Australia. Unfortunately we don't yet have access to the breadth of products available in the US. If you have been reading about Asset Allocation you might have come across the "Three Factor Model".  You might also notice that there's very little in the way of International Small-Capitalisation exposure. While there aren't general International Small-Cap index ETFs available in Australia yet we can at least get access to US Small-Cap indices (both the S&P and the Russell 2000).  Similarly there aren't many options to get access to 'value' tilted index funds.  I'm not sure either the BetaShares or Russell fund are perfect from this perspective but they are at least low cost.  Note that the Russell fund only holds a subset of the ASX, so may experience more turnover (and hence distribute more capital gains when it comes to tax time) than a pure capitalisation-based index fund tracking the ASX200 or the entire Australian stock market.

As always, I appreciate any comments.  And if you've found other low-priced index funds available in Australia, let us know.

Discosure: the author has holdings in VTS, VEU, STW and RVL.

Links:
Vanguard ETFs
Vanguard Retail Managed Funds (<$500,000)
State Street Global Advisors ETFs
iShares ETFs
Colonial First State 'Wholesale Investments'
Tips for trading ETFs
Choosing between ETFs and traditional index funds
Vanguard paper on home bias

19/09/2013 Additional Note: Regarding the cross-listed US funds I recently emailed Vanguard about VEU "Vanguard® All-World ex-US Shares Index ETF".  The fund is US-listed but receives dividends from other countries.  Some of those countries apply their own withholding taxes.  I'm told US taxpayers are able to take these into account as tax credits but Australian resident taxpayers are only able to take into account the US withholding tax (so this shouldn't be a problem for VTS and other funds with US companies).  While the headline Management Expense Ratio is lower than most Australian domiciled funds with International Shares, some of that benefit may be lost by taxation.

A back of the envelope calculation I did for my own benefit: if we expect around 2% p.a. in dividends then at a withholding tax rate of 15% we'd lose 0.3% while with 30% withholding it would be 0.6%.  If this is half our International Shares exposure (with the other half in the US) then we're talking 0.15%-0.3% difference which is less or about the same as the fee difference (50% VTS/50% VEU would have an average MER of 0.10% while WXOZ has an MER of 0.42% for a 0.32% fee difference).  Depending on the dividend distribution it may even be that WXOZ has a slight edge at times when it comes to the combination of fees and taxes, albeit without quite the level of diversification offered by the two Vanguard funds.  I suggest professional advice be sought on the taxation implications if you have any concerns about tax treatment.

Asset Allocation Part 2

I have a confession to make.  I suffer from 'home bias'.  What is 'home bias'?  Read on:

In my last post I discussed asset allocation between 'growth' assets such as shares and 'defensive' assets such as cash.  This post is a tricky one, perhaps with no 'right' answer.  Let's say we've decided on an allocation to growth assets, be it 20% or 80%.  How will we then split that amongst different growth assets? Let's start with Shares from different countries and regions.

Back in the early days of finance theory some would have suggested we hold the global market proportionally.  This would mean holding approximately 2-4% in Australian shares.  Yet we see most balanced funds have somewhere between 50-75% of the growth assets in Australian shares and property.

There are a few reasons I think this is the case, some of them good reasons for this 'home bias'.  I won't go into finance theory but will focus more on the practical reasons:

• Australian residents (and our super funds) are usually eligible for franking credits from dividends.  In our superannuation funds this will often reduce the overall tax paid on earnings of the fund and so increase after-tax returns
• Currency fluctuations can also impact international share returns in Australian dollars.  However in an international fund hedged to the Australian dollar, imperfect currency hedging can be a drag on returns (and lead to increased tracking error: make it more difficult for a manager to track their index)
• Australians may just be more comfortable with local shares, making a 'home bias' more marketable

Having some international exposure is likely to be beneficial over the long term.  The key reason is diversification - when they're not perfectly correlated (don't always move together in the same direction) diversification of volatile assets with similar expected returns can actually lead to higher returns with lower risk.  For more on the conceptual details of this I strongly recommend reading one of the books below by William J. Bernstein.

Unfortunately we can't know ahead of time which combination of assets will perform best over the next year, 5 years, 10 years, or 30 years.  So some criteria I see as important are:

• Having a sufficiently diversified portfolio to smooth possible outcomes
• Having a portfolio containing a balance of assets which still allow you to sleep at night!

The latter criteria may not seem entirely rational.  My key point with it is that making constant changes to your asset allocation (for example purposely lowering your allocation to US shares when they're doing badly relative to Australian shares, say) is paradoxically a good way to lose money (as we're selling low and buying high).  And if you're not comfortable with, say, more than 50% international shares it greatly reduces the chances of 'staying the course' during the inevitable ups and downs.

Personally, I'm now comfortable with somewhere around the range 35-50% of my share allocation in international shares and 50-65% in Australian shares.  This may or may not be optimal but is a plan I can handle and will hopefully give me sufficient diversification over the years.  What are your thoughts on asset allocation - have you been able to overcome 'home bias'?

Links:
Vanguard paper on home bias
I'd greatly appreciate any comments with good guides to asset allocation in Australia. I haven't found an Australian book that comes close to the William Bernstein books below:

The Four Pillars of Investing: Lessons for Building a Winning Portfolio

The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between

I'm currently reading The MoneySense Guide to the Perfect Portfolio.  It's a very short book, costs $4.99USD on Kindle/iPad and provides a nice first introduction to Asset Allocation with index funds.  While the Bernstein books above are written from a US perspective, this one is Canada-focused.  So the specific products are different (e.g. we have Super, not RRSPs) but many of the challenges are similar: Asset Allocation in a country with a relatively small, undiversified local stock market (skewed towards Financial and Commodity stocks)

If you'd like to see how different combinations of assets have performed over the last 40 years, Vanguard have a calculator.  While past performance need not be reflected in future performance it's some comfort to know that over reasonable time periods there hasn't been so much difference between 55%/45% Australian/International shares and 65%/35% Australian/International shares.
Rick Ferri also points out that getting close to the right asset allocation is usually best, rather than worrying down to that last 3%

Why I can't recommend Vanguard for Australian Superannuation (yet)

I've been asked a couple of times about using Vanguard as a core provider of retirement investments. Almost everything you read on the Internet on index funds will quite reasonably mention Vanguard, the originators of index funds.  However most of these articles are focused on US investors and US products.

Vanguard are a great company with some great products.  So why don't I think they're suitable for many Australian investors as the core of their Superannuation?

Unfortunately their lowest-cost funds are only available in self-managed superannuation funds, direct investment options like ING Living Super and some wrap accounts.  ING Living Super comes with additional fees for ETF investment and restricts customers to 20% within a single exchange traded fund, so a Vanguard ETF-focused asset allocation is quite restricted in terms of options (although mixing with iShares and other index ETFs makes this a viable strategy).  Self managed superannuation funds and wrap accounts do not have this limitation but tend to be quite costly unless you have a larger account balance.

The largest drivers of recommendations of Vanguard elsewhere are their wide diversification and low costs. In Superannuation in Australia there are similarly diversified index funds at substantially lower cost. So until Vanguard are able to offer better pricing over here, the only Vanguard products I'll be purchasing from them are their ETFs (in my case, outside of Super). If my balance was large enough I might include some of those ETFs in my super to complement other index funds with their low fees. But looking at the alternatives, their retail ("unit trust") managed funds just aren't price-competitive over here.

Links:
ING Living Super: ETFs
Vanguard ETFs
Vanguard Retail Managed Funds (<$500,000)

Asset Allocation Part 1

Somewhere between 40% and 100% of a fund's return is determined by Asset Allocation.  The key thing, though, is asset allocation is actually something we can control: we can't control whether the Australian share market will go up or down over the next year, we can't control if a particular manager will underperform or outperform an index.  What we can control is asset allocation.

Asset allocation is simply the proportion of assets we allocate to different investments.  At a high level this can be the split between growth assets (such as shares) and more defensive assets (such as cash).  At a detailed level we can think about how much of our share allocation we want to allocate to Australian shares vs. international shares, or even more granular such as separating our allocation to emerging market country shares against more developed nations.

Today I'm going to link to some of the sources that have helped me think about asset allocation and start by discussing the high-level split between growth and defensive assets.

Larry Swedroe has some advice on high-level Asset Allocation in his book The Only Guide You'll Ever Need for the Right Financial Plan.  Some of the tables are reproduced in a blog post by Canadian Couch Potato

I'd recommend checking out the post (or the book).  The key message is to take risk based on your "ability, willingness and need to take risk".  Ability to take risk has a lot to do with timeframe: if you have a stable income, are saving for retirement and aren't planning to retire for another 25 years you have a greater ability to take risk than someone already in retirement.  This is often what is taken into account when prescriptions such as 'your age in bonds' are made.

The willingness and need to take risk are sometimes neglected in this analysis.  For example, on the willingness to take risk, if the possibility of a 40% or 50% short-term loss will prevent you sleeping at night then a 90% or 100% asset allocation to shares is probably unwise (if nothing else because there's a chance of panic in the face of a loss, leading to selling when the market is at a low).  On the need to take risk, if you already have enough savings to last your lifetime then you can afford to take a more conservative allocation even if relatively young.  If your long-term goals require a higher return then a more aggressive allocation may be required to reach those goals.

There are some interesting approaches based on these principles.  Rick Ferri proposes starting with a reasonably conservative asset allocation when young, until you become better informed and more experienced with your degree of comfort with the ups and (more importantly the) downs of the share market. William Bernstein's short book The Ages of the Investor (a more challenging read) is in-line with this when younger.  For retirement, he focuses on having enough to cover 20-25 years worth of your usual living expenses (over and above that provided by any pension you are eligible for) in a low-risk "liability matching portfolio" and once you have "enough", your remaining assets in a "Risk Portfolio".

Some more useful sources of information include my favourite books on Asset Allocation, by William J. Bernstein:
The Four Pillars of Investing: Lessons for Building a Winning Portfolio
The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between

Other links (which I may continue to add as I think of them):

Bogleheads wiki on Asset Allocation
Rick Ferri points out that getting close to the right asset allocation is usually best, rather than worrying down to that last 3%