Why ETFs are a better option to diversify a <$100K portfolio
To invest in a diversified portfolio of Aussie stocks, there are two options:
- Exchange Traded Funds (ETF Portfolio); or
- Buy a selection of large companies listed on the ASX (Stock Portfolio)
Both options have merit, so we turned to the numbers to decide the best path. We looked at the performance of the two options over a 10 year period (Jan 2005 - Apr 2015). The data showed that ETF portfolios make more sense for portfolios <$100K in value because:
- minor difference in returns (after fees and brokerage);
- less time to manage;
- negative tax implication of the Stock Portfolio;
- problems with picking stocks (and Survival Bias).
Based on a $20K starting portfolio, the ETF Portfolio provided higher returns (8.8% p.a.) over 10 years vs the Stock Portfolio (8.0% p.a.) after fees and brokerage. As the value of the portfolio increase, the Stock Portfolio provided higher returns - the inflection point is at around $45K. At $100K starting portfolio, the Stock Portfolio returns 3.4% higher over 10 years (or $7,859).
The 2 diversified portfolios
Our approach to diversification is to achieve the return of the broader Aussie sharemarket. To compare apples with apples, we focused on the 50 largest companies listed in Australia.
1) ETF Portfolio: owning one ETF - the SPDR S&P/ASX 50 Fund (SFY), the oldest ETF in Australia.
2) Share Portfolio: Prior research showed that to create a diversified portfolio of stocks in Australia, you need to own 38 stocks. So we selected 38 oldest companies currently (as at Apr 2015) in the ASX 50 Index.
We bought stocks based on an allocation strategy of sector weighting. We looked at the size of each sector in the ASX 50 Index as at Dec 2005, then allocated cash to the sector based on their proportion. We then allocated equal amount of cash to each company within a given sector.
For example, banks were 27% of the Index at the time, so we allocated $5,467 (of the $20,000 initial portfolio) to banks. As there were 4 banks in the Index (CBA, ANZ, Westpac, NAB), $1,367 was invested in each bank.
Being discipline and reinvesting
Since both the Stock Portfolio and ETF Portfolio paid dividends, there was a constant build up of cash over the years. The ETF Portfolio paid out $13,575 in dividends, compared to $16,017 by the Stock Portfolio (18% higher). In reality, the average person (like us) would want to spend the dividend on a holiday or buy cool toys (hello Apple Watch). For this analysis, we decided to reinvest the cash every year.
For the ETF Portfolio, this was simply buying more units in the SPDR Fund. For the Stock Portfolio, we invested based on the same allocation approach per above.
Over a 10 year period, both portfolios more than doubled in value. The $20,000 ETF Portfolio grew to $46,388 (132% return), whilst the $20,000 Stock Portfolio grew to $44,922 (124% return). On a yearly basis, the ETF Portfolio achieved 8.8% return vs 8.0% by the Stock Portfolio (after fees and brokerage).
When we flexed this analysis across different starting portfolio values, we found that the larger the portfolio, the better the Stock Portfolio would perform. Once the starting point surpasses around $45,000, directly owning stocks provides a higher return than an ETF Portfolio (with a few caveats below).
Fees & Brokerage
The major reason why ETF or Stocks perform better is due to the fees & brokerage to create / maintain the portfolios.
For the ETF Portfolio, there are two fees: 1) brokerage to buy the ETFs (11 trades x $15 each = $165) and 2) the management fee charged by SPDR (@ 0.28% as at April 2015).
For the Stock Portfolio, the only admin expense is brokerage. Due to the reinvestment strategy (holding 38 stocks), there were 290 trades totalling $4,920.
There are two key shortfalls in this analysis which makes the Stock Portfolio look better than the ETF Portfolio:
1 - Survival Bias: We only selected stocks in the ASX 50 Index that are still trading after 10 years. Their survival indicates that they have been strong companies over this time. If we picked any 38 stocks from today’s ASX 50 Index, a few might not survive in 10 years, hence would make returns worse.
2 - Taxes: we didn’t consider returns on an after tax basis. The Stock Portfolio paid out 18% more dividends than the ETF Portfolio. The ATO will tax each $ of dividend paid out. The Stock Portfolio is likely to have to pay more tax over the 10 years, making returns worse.
What does it all mean?
ETFs are a better option in building a diversified portfolio of Aussie stocks unless your portfolio is a lot larger than $100,000 in value:
- Much less effort to maintain the portfolio, you only have to buy 1 thing
- No need to determine the right asset allocation, and no risk in stock picking (see Survival Bias above)
- ETFs will generate a similar or better returns (note: the SPDR ASX 50 is around 30% more expensive than another ETF that will do the same job)
- Tax implications is likely to make Stock Portfolio perform worse than on paper