A question that comes up for many investors at the beginning of their ETF investment journey is whether they should invest in a diversified ETF or an individual asset class ETF.
A diversified ETF as the name suggests provides access to a range of asset classes and market sectors in the one product.
For example, the Vanguard Diversified Balanced Index ETF (VDBA) is named as such because it is diversified across multiple asset classes including Australian shares, International shares, Cash and Fixed Income.
How much of the fund is allocated to each asset is determined by Vanguard based on the objective of the diversified ETF. VDBA is designed for investors seeking a balance between income and capital growth, and therefore allocates 50 per cent to income asset classes (i.e. bonds) and 50 per cent to growth asset classes (i.e. shares).
Vanguard Diversified High Growth (VDHG) for example focuses more on capital growth so allocates 90 per cent of the fund to growth asset classes and 10 per cent to income asset classes. Despite the difference in allocation to VDBA, the fund is still diversified across different assets and therefore less exposed to the performance fluctuations of individual classes.
On the other hand, the Vanguard Australian Shares Index ETF (VAS) tracks the return of the ASX 300 and as such, is comprised only of one asset class (domestic equities).
The advantage of a diversified ETF is that it provides investors instant exposure to various asset classes (such as fixed income) without them having to select multiple asset-specific ETFs (and thus paying more fees) to achieve the same diversification.
The importance of diversification across asset classes was most evident in the earlier days of the COVID-19 outbreak. When shares plunged into negative territory in March, bonds on the other hand experienced only a muted dip, allowing it to cushion losses for investors who held both asset classes.
Vanguard's 2020 index chart also shows that asset class performances vary year on year, and that no one asset class consistently provides the best returns over time. Spreading investments over multiple asset classes will help smooth out returns.
That's not to say however that asset-specific ETFs do not have an important role to play. For investors – particularly those with their own SMSF who generally want more direct control over the portfolio – individual asset class ETFs provide powerful building blocks to allow you to tailor the portfolio to suit your individual goals and investment plan.
Individual ETFs give investors greater control over their portfolio as they can pick and choose within each asset class. For example, if environmental, social and governance matters are a priority for you when you are assessing equity investments, then an ETF that is screened for ethically conscious shares might meet your preferences.
Similarly, if you have a preference for international shares over the Australian market then selecting an ETF that focuses on global markets may fit the bill.
Is there room for both?
One investment strategy is to build up the core (say 40 per cent to 50 per cent) of your index portfolio with diversified ETFs so that you have adequate diversification cross asset classes, and then allocate your remaining investments to ETFs that tilt the portfolio to align with your goals and beliefs.
Just remember no matter which strategy you choose, it's always wise to keep an eye on fees and build a portfolio that is cost-effective and sustainable in the long-term.
Robin Bowerman, Vanguard Australia