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Eight Bays believe in using ETFs as core investment instruments for investors wishing to hold a balanced equity portfolio across sound companies and industries with good long term growth prospects. However, structuring a portfolio of ETFs has pitfalls that should be flagged. Here are three potential issues faced by the portfolio manager.

1. Beware of increasing sector and stock concentration risk.

Quite often the same stock can be found in different ETFs, therefore buying another ETF with those same stocks can increase stock and sector bias, thus negating diversification benefits. Tesla, for example is held by 244 US listed ETFs ranging from broad index based ETFs such as SPY (S&P500) to BITQ (Bitwise Crypto Innovators ETF). When considering sector exposures – adding a sector or industry ETF to a broad index ETF will result in excess sector concentration risk. For example, if your core ETF holding was the STW (ASX S&P 200 ETF), adding a financial sector ETF such as the MVB (VanEck Vectors Australian Bank ETF) will drive up sector bias/risk of the portfolio as you are doubling up your position in Aussie banks. The only way to avoid stock duplication and sector concentration risk is to conduct a full look-through analysis of all stocks held in the portfolio. To make matters even more complex, the composition of stocks within an ETF change as do individual stock weights, so it is necessary to monitor ETF constituents at least quarterly. Rebalancing of ETFs can also occur and understanding the ETF rules should be part of the investing process.

It is worth pointing out that a well-constructed portfolio of ETFs has significant advantages over a portfolio of managed funds in terms of eliminating sector and stock concentration. Typically, there is little transparency through to stock holdings in a Managed Fund. The investor often only sees the top 10 holdings of the fund and rarely do you see the active weights of the strategy. Rarely are portfolios of Managed Funds are constructed on the basis of a bottom up analysis to all securities held by each of the Managed Funds. An investor that holds three managed funds benchmarked to the ASX200 could unwittingly be exposed to excess sector or stock specific risk if the managers of the Funds are all overweight the same sector or stock. For example, if all three managers held large active positions in say BHP, your underlying exposure to BHP is excessive. ETFs offer full transparency to the underlying portfolio holdings which enables the investor the opportunity for avoid this portfolio construction risk

2. Be mindful of correlations across ETFs.

Some ETFs are highly correlated, so adding an ETF in a similar sector doesn’t necessarily lead to better portfolio performance and can diminish diversification benefits. For example, VGT (Vanguard Technology ETF) and QQQ (Invesco Nasdaq ETF) rolling correlation is 0.982. Whilst the FINX (Global X Fintech ETF) has a 0.90 correlation to the VGT. Thus, owning all three of these ETFs potentially adds little to performance or may deliver little in the way of diversification benefits. Observing correlations across your portfolio is an essential discipline of portfolio management. When considering buying an additional security (ETF or stock) one should ask; does this new position a) enhance the overall fund’s performance or b) provide a diversification benefit (ie lower risk) or c) deliver a similar return to a security I already own?

3. Additional EFTs can lead to higher portfolio costs both directly and indirectly.

Diversification is a good thing and portfolios of ETFs can deliver outperformance relative to broad indices, however achieving this must be done efficiently. A lot of thematic ETFs are very expensive relative to a broad index ETFs such as IVV (0.03%). Many thematic and country ETFs have expense ratios exceeding 0.5%. In addition, some of these funds are less liquid and often incur greater spreads (ie buy/sell range) and often the ETF will trade at a discount to net assets under volatile market conditions. LIT (Global X Lithium & Battery Tech ETF) has an expense ratio of 0.75%, its average buy/sell spread 0.05% and it has traded at a 3.5% discount to NAV. That compares to IVV with an expense ratio of 0.03%, an average spread 0% and maximum traded discount to NAV of -0.10%. Calculating the total expense ratio of a portfolio of ETFs is another essential discipline in structuring ETF portfolios. Whilst holding a portfolio of ETFs can increase the total cost of the portfolio, typically the total cost of ownership is lower than holding a portfolio of actively Managed Funds. Actively Managed Funds have higher expense ratios – typically 1% and often charge performance fees. In addition, Managed Funds also incur a buy/sell spread around the fund NAV (typically ~0.3%) when units are bought and sold. Calculating the total expense ratio of a portfolio of ETFs is another essential discipline in structuring ETF portfolios and for that matter any Fund of Funds (FOF) strategy.

George Clapham

Director, Eight Bays Investment Management

October 2021

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