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The secret to building a low-cost portfolio

by James Dunn

One of the greatest weapons that investors have at their disposal is the magic of compounding returns, or earning a return on your return, as well as on your original investment. This is the same principle as compound interest, but compound returns are not earned at the same rate. Each year, if your investments go up, they earn a rate of return which increases the investment. Next year, you earn a return on the increased amount, and so on. The rate of return may not be the same every year, but if the average return that your portfolio earns over the long term is higher than inflation, you are building ‘real’ wealth.

Over time, compound returns can produce impressive growth. An investment earning 7% a year will almost double in 10 years. If you want to speed that rate of potential wealth creation up – for example, you want your investment to double in less than ten years – you need to take more risk.

The flip side of compounding returns

Unfortunately, there is a flipside to the magic of compounding – it works on your investment cost, too.

Every investment that you own that is managed on your behalf has a cost, and over time the compounding of costs works to erode your returns.

Investment fees – the transaction fees and the annual management costs – are the silent assassins of investment returns because they can compound in exactly the same way that returns do. Over the long term, what may seem like only small differences in percentage points in terms of costs can put a significant dent in your returns.

The good thing about costs, however, is that they are entirely within your control. Keeping your investment costs low is a very important weapon for the serious investor. The long-term effect on your investments of paying lower fees is just as impressive as that of compound returns. The lower your costs, the more of an investment’s return you keep – as opposed to paying away.

The importance of being diversified

The other main weapon that investors have is diversification, which should be a basic concept of any investment strategy. Diversification is so important that it is often referred to as “the only free lunch in investment”. The idea is to spread your money among different assets in order to distribute, and hopefully contain, the risk.

Spreading invested funds across a number of different assets reduces the overall risk for your portfolio, since you’re not relying on just one asset as your investment.

Diversification is not just a protective measure; it also allows you to generate a higher rate of return for a given level of risk and open yourself up to more potential sources of return.

Low-cost exposure to the asset classes

One of the biggest recent revolutions in investment markets is the advent of exchange-traded funds (ETFs), which are low-cost, simple and passive vehicles offering exposure to a wide range of Australian and global asset classes, indices and sectors, currencies and commodities, as well as a variety of investment strategies. ETFs are much cheaper than actively managed funds and indexed funds, with no entry and exit fees. Investors only pay normal brokerage when buying and selling the ETFs. There is no commission, upfront or trailing, paid to an investment adviser.

There are two main ways in which investors use ETFs. Firstly, to build a very cost-effective ‘core’ portfolio holding in an asset class (usually less than 40 basis points, or 0.4% a year.) For example, buying just a couple of ETFs can give you effective underlying exposure to thousands of stocks in your domestic and international equities allocation.

The other major use is as a tactical tool: using a passive vehicle (that is, one that delivers index performance) to make ‘active’ investment decisions.

ETFs are simple instruments but they provide very effective diversification benefits. They represent an extremely efficient way to allocate assets with just one ASX transaction, and to get in or get out of a market rapidly with a small cost profile. The ASX now hosts ETFs over all of the main asset classes of a balanced portfolio.

Australian investors can build a global balanced portfolio of different asset classes through the local ETF menu, in ASX-listed securities, denominated (mostly) in Australian dollars. ETFs particularly suit the SMSF sector, which has consistently demonstrated that it prefers direct holdings in liquid, listed securities.

Building blocks for the heart of a portfolio: iShares Core

Some ETF providers have even started to package their ETF offerings to make it easier for investors to establish a well-diversified portfolio across a variety of markets and assets. For example, iShares’ Core suite of ETFs are designed to form a strong foundation for an investment portfolio by offering access to five key share and bond exposures, backed physically by the underlying securities. The range has been designed to address six main challenges that face investors:

  • Gaining high-quality market exposure
  • Lowering the cost of investing
  • Simplifying portfolio construction
  • Achieving instant diversification
  • Making investing more transparent
  • Accessing international opportunities while managing currency risk

The iShares Core ETF range comprises local Australian shares, international equities, and bond markets to give investors a solid foundation for their portfolio.

Interest in ETFs has sky-rocketed over the past few years and all the signs point to this growth continuing, which suggests there is plenty more to come for the ETF story.

Published on: Friday, June 17, 2016

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