DIY Portfolio: ETFs to invest in the Australian and International markets
When trying to choose index funds for an Australian, you can decide to either use an all-in-one ETF or create a DIY portfolio. If you choose to do a DIY portfolio, what are some of the things to consider? There are three main considerations:
- How much should I allocate to the Australian and International markets? Refer to this article.
- What ETF should I choose to get exposure to the Australian market?
- What ETF(s) should I choose to get exposure to the International market?
Before I compare some ETFs, keep in mind of the following terminology:
- Management Expense Ratio (MER) – the annual cost of an ETF that gets taken from the performance of the ETF. Therefore, this cost is the same regardless of what broker you use to buy the ETF.
- Total cost before tax – This will be MER – securities lending income (%). It is not necessary to know what securities lending is (u/UnnamedGoatMan goes through what it is in this post), but all you need to know is that it makes Vanguard ETFs a little cheaper. Transaction and indirect costs are assumed to be negligible.
- Assets Under Management (AUM) – The AUM of a fund is the total amount of money invested by all its investors. To avoid the risk of a fund closing down due to insufficient assets, a general rule of thumb is for the fund to have at least a $100 million or $0.1 billion AUM. A higher AUM tends to mean higher liquidity and thus a lower buy/sell spread, which is how much the buy price and sell price differ from how much the fund is worth, a.k.a. the Net Asset Value or NAV.
- Index – Contain instructions on what companies to invest in that the ETF follows.
Australian market
The objective of these ETFs is to gain exposure to the Australian market by investing in the largest Australian companies through a market-cap weighted index. Key differences are summarised in the table below:
| A200 | VAS | IOZ | STW | |
|---|---|---|---|---|
| Management Expense Ratio (MER) | 0.04% | 0.07% | 0.05% | 0.05% |
| Total cost before tax | 0.04% | 0.03% | 0.05% | 0.05% |
| Assets Under Management (AUM) | $9.73 billion | $23.32 billion | $8.66 billion | $6.48 billion |
| Index | Solactive Australia 200 Index | S&P/ASX 300 Index | S&P/ASX 200 Index | S&P/ASX 200 Index |
| Inception date | 07/05/2018 | 04/05/2009 | 09/12/2010 | 24/08/2001 |
International market
The international market can be broken down into the following sub-markets:
- Developed countries – large and medium cap companies (could be further broken down to US and ex-US)
- Developed countries – small cap companies
- Emerging Markets
The bare minimum is large/mid cap companies from developed countries with the rest considered optional given they’re only around 10% to 15% of the global market.
The below table summarises key differences for ETFs to get exposure to large/mid cap companies from developed countries:
| BGBL | VGS | |
|---|---|---|
| Management Expense Ratio (MER) | 0.08% | 0.18% |
| Total cost before tax | 0.08% | 0.17% |
| Assets Under Management (AUM) | $3.83 billion | $14.65 billion |
| Index | Solactive GBS Developed Markets ex Australia Large & Mid Cap Index | MSCI World ex-Australia |
| Replication strategy | Representative sampling | Full replication |
| Inception date | 09/08/2023 | 18/11/2014 |
The two ETFs use different replication strategies. I don’t believe this makes a meaningful difference, but you can read below for more info.
More info on replication strategy
There are two main methods of tracking an index: full replication and representative sampling.
- Full replication: owning every stock in the index at its specified proportions. This strategy can be challenging to implement as it can require adjusting thousands of stocks, especially those that are costly to trade.
- Representative sampling: only invests in a sample of the companies in the index while still trying to match the performance of the index. Sampling the index creates the potential to not properly follow the index because of the more active approach. But the strategy hopes to reduce trading costs by reducing the number of companies it needs to hold.
So, how do these strategies compare against each other? Dyer and Guest (2022) sought to answer this question, finding that sampling generally performs worse than full replication both before and after fees. On top of performing worse, sampling also had slightly more volatility. However, the exception the authors found was for indexes that contain a large number of companies. They found that for indexes that contain somewhere between 1000 and 3000 stocks, the performance between sampling and full replication is very similar.
Since the indexes that VGS and BGBL track are around 1,500 companies, the performance should be very similar when only considering their replication strategy. As a side note, the paper also found that sampling does not translate into a lower MER, so BGBL sampling the index does not explain its low MER.
For information on emerging markets, refer to this article: Passive Emerging Market ETFs for Australians. If you do include emerging markets, you can refer to its current market-cap weighting, which is currently around 10%. You could then choose to slightly overweight to increase its diversification benefits.
An alternative way to get exposure to the international market is through VTS and VEU, which have the following characteristics:
- MER: VTS (0.03%) and VEU (0.08%).
- After-tax Cost: Cheaper than alternatives, first calculated by HockeyMonkey and have calculated here.
- Domicile: BGBL, IWLD, and VGS are Aus-domiciled ETFs, intended for Australian citizens. Although VTS and VEU are available on the Australian Stock eXchange (ASX), they hold US-domiciled ETFs, which are VTI and VEU respectively. The consequences of US-domiciled ETFs are US estate tax issues, which involve sending a W-8BEN form every 3 years (a relatively straightforward process), an extra 15% tax penality if you forget to fill out the W-8BEN form, the possibility of tax law changes negatively impacting you, and tax drag adding a hidden layer of costs. PassiveInvestingAustralia goes into more detail in this article.
- Exposure: VTS invests in the US (large, mid, and small cap) while VEU invests in developed countries (large and mid cap) + Emerging Markets.
- Distribution Reinvestment Plan (DRP): DRP is the ability to reinvest distributions back into the ETF automatically. VTS and VEU do not offer DRP as they are US-domiciled ETFs.