How to create a balanced fund with ETFs

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With the recent release of fixed income exchange-traded funds (ETFs), Australian investors now have all the major pieces they need to create their own cheap and transparent balanced investment funds from products listed on the Australian stock exchange.

The traditional balanced fund has a mix of cash, bonds, listed property and domestic and international equities. Investors or their financial advisors then allocate funds to each of these asset classes according to expected returns, volatility, and the risk and return preferences of the investor. Although opinions differ, most typical ‘medium-risk’ balanced funds have about a 60% allocation to listed property and equities, and a 40% allocation to cash and bonds.

One hypothetical balanced fund portfolio construction is provided below.

Managed funds vs. ETFs

It’s been typical for financial planners to construct such balanced portfolios from a range of either indexed or actively managed unlisted managed funds. And some fund managers provide balanced funds as a stand-alone product.

The question before us, however, is how can we construct such a balanced fund using the ETFs now available on the ASX? And how expensive would such a portfolio be to maintain?

Here’s an example of what’s possible using a range of ETFs that have relatively low management expense ratios (MERs) for their asset class – which are typically provided by Vanguard. Replicating the above balanced fund using ETFs would result in an annual management fee of only 0.17%!

This portfolio would be marginally cheaper moreover, if the high interest cash ETF (AAA) were simply replaced with a term deposit.

 A possible balanced fund using ETFs


Of course, using ETFs only guarantees returns in line with the benchmark performance of each asset class. In some cases, investors may wish to replace an ETF with an actively managed fund where they believe the investment manager has a good chance of outperforming the benchmark.

Investors may also wish to add further diversification and return opportunities by venturing into alternative assets, like commodities. In that regard, investors should note that there is a range of commodity ETFs also available. One popular choice is gold, with a gold ETF available that is either hedged against the Australian dollar’s movements (ASX code: QAU) or unhedged (ASX: GOLD).

This then begs the question of which asset classes are best suited to using ETFs, and which might warrant use of an active manager? Standard & Poor’s has been asking this question for years, with a regular survey detailing the per cent of actively managed funds that beat their benchmark within each asset class. The latest results are detailed below.

Percentage of managed funds beaten by the index


As should be clear, the evidence is not highly supportive of active management in most major asset classes – with, say, the exception of small-cap funds. In the fixed-income areas, for example, 80% of actively managed Australian funds were beaten by the benchmark over the past five years. For local and international large-cap equity funds, the results are not much better, with only around 30% of funds beating their benchmark.

ETFs don’t promise to beat their investment benchmark – but they can promise to at least match benchmark returns (something most fund managers can’t do) and at a fraction of the price. Our ETF-based balanced investment fund, for example, would cost investors an annual management fee of less than one fifth of a percentage point.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should, before acting, consider the appropriateness of the information in regards to their objectives, financial situation and needs and, if necessary, seek professional advice.

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