5 steps to build a smarter ETF portfolio (plus 6 funds I like)

"If you think I'm burning out, I never am. I'm on fire. I'm on fire. I'm on fire." - Pitbull, "Fireball" lyrics.

If any part of the Australian investment market is on fire, it's the ETF industry.

There are now over 400 funds listed across the ASX and Cboe, and barring a market shock, assets under management will soon top $300 billion. This is an astonishing leap from the early 2000s, when choice meant four funds from State Street and The Perth Mint.

But while abundance is often a good thing, it can lead to decision paralysis. In a recent Livewire poll, 31% of readers felt there is "too much choice" and another 29% worry that most new strategies are just "gimmicks that won't last."

That frustration is understandable, but I believe as investors, we should welcome more products and use them to our tactical advantage.

Think about it for a second: thanks to competition between iShares, Vanguard, Betashares, Global X, VanEck, Monochrome and a growing cast of active managers, you can:

• Buy the whole Australian market for ~0.04% p.a. — no more headaches of deciding between CBA vs NAB, CSL vs Sonic, BHP vs Rio; you own them all
• Own broad U.S. equities for ~0.03% p.a. — cheap, clean, instant diversification to the world’s most important growth engine
• Trade momentum — if a trend breaks out, use a thematic or sector ETF and skip single-stock risk; gold miners, crypto and Asian technology are recent examples of hot trends
• Plug portfolio gaps — underweight healthcare? Look at DRUG; geopolitical hedge? Add GOLD; defence tilt? Consider DFND. There's a solution for virtually anything
• “VDHG and chill” — popularised by Gen Z's on Redditt, it entails dollar-cost averaging into the Vanguard Diversified High Growth ETF as a cheap, one-stop-shop to build wealth

More choice is an opportunity if you're disciplined. Competition drives fees down; innovation opens doors to asset classes, themes, sectors, strategies and managers previously hard to reach.

Below is the framework I use, adapted from how ETF-savvy advisers build an Approved Product List, plus six funds currently on my watchlist. Let’s get started.

1. Define your portfolio's goal

Every portfolio needs a clear objective, and every investment within it should serve a purpose.

Too often, investors end up with sprawling, 30-plus line-item portfolios that still lag a plain ASX 200 index - partly because beating the market is hard, and partly because constant dollar-cost averaging across so many products racks up fees.

As Morningstar's Director of Personal Finance, Mark LaMonica, penned in an editorial: "We are programmed to think being a great investor is having a complex portfolio. Get out of this mindset."

"Being a great investor is accomplishing your goals. You don’t lose any points for doing that in the simplest way possible."

Veteran stockbroker Marcus Padley runs a timing-based approach using 5-10 ETFs, aiming to capture global themes as sentiment and price momentum turn or strengthen. As he puts it:

“ETFs allow you to exploit themes that you can’t get in Australia. And in my humble opinion, themes are far easier to get right and time than individual stocks.”

Education

Marcus Padley reveals the secret sauce of timing markets

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While everyone's goals are different, I do believe many of us cluster around one of the following three at different stages of life:

1. Growth investing - Growth investors aim for high capital returns by targeting fast-growing companies or parts of the market showing momentum. They're not too concerned about current income.
2. Income investing - Income investors, on the other hand, want portfolios that generate high, regular and sustainable dividends to support their lifestyle.
3. Hybrid: These are investors who like generating growth and cash flow, and tend to balance growth stocks with income equities.

2. Create your "approved product list"

Just as a professional adviser curates a select list of strategies for clients, you can create your own "approved product list" (APL) by researching and vetting ETFs. Ultimately, you want to treat ETFs like individual companies; if you don't understand it, don't buy it. 

Factors to consider include:

• Goals and roles: Is the fund designed to offer growth, income, or play a specific role in your portfolio?
• Cost: Compare the management expense ratio (MER) to ensure it's a cost-effective product.
• Yield and distribution: If cash flow is a priority, consider the payout frequency - monthly, quarterly, semi-annually etc.
• Methodology: For index funds, understand the benchmark and rebalancing rules. For active and smart-beta funds, understand their investment process and constraints.
• Ratings: Companies like Morningstar rate ETFs bronze, silver and gold based on factors such as costs and process, and could be a valuable data point to consider.
• Track record and size: How long has the product been around? How much money does it have? If it's <$100 million and less than five years old, the issuer may close it.

Laying out your lineup of approved ETFs in a simple table (see below) can help you visualise your game plan. This way, when you spot a market opportunity, you'll know which tool to use to meet the moment.

ETF providers are very good at wrapping new launches in glossy marketing. The good news is their incentives are partly aligned - when your investment grows, so do their fees. Still, take every pitch with a grain of salt.

Your job is to separate durable themes from fads or ideas that sound out of touch with market sentiment or seem confusing. We’ve had ASX products tied to themes such as “future of food" and “green infrastructure" get the chop as they didn't appeal to investors.

Here are some tips to discern what could work from what probably won't:

For example, in 2024, the launch of defence ETFs by Global X, VanEck, and Betashares was a strong vote of confidence on surging defense spending. Several issuers also launched Bitcoin ETFs last year on the prospect of the asset class achieving legitimacy. 

These products have delivered one-year returns of over 60-95% as the issuer timed their launches with positive catalysts.  

4. Understand portfolio overlap

One of the hottest topics in the ETF world is about a common mistake known as "portfolio overlap". This is when you buy a number of different ETFs and think you're diversified, but they largely contain the same companies and exhibit similar return and volatility profiles.

For example:

• The S&P 500 and MSCI World Index - The latter's weighting is ~80% to the former, and they have the same top 10 holdings
• The ASX 200 and ASX 300 - Passive ETFs linked to these indices have identical return, income and volatility profiles as majority of returns are driven by the ASX 50

If cost-effective global diversification is the goal, it may be better to think of your portfolio as professional sports team. Each player should have a specific role and their skills should compliment each other.

As such, your APL could contain US, ex-US and emerging markets funds for global diversification; ASX large and small cap ETFs; REITs; gold products and various complimentary fixed income strategies.

But how does one calculate duplication of holdings? In the absence of calculators such as those available for U.S. investors, our friend ChatGPT can do the math. You can simply upload Excel files of holdings provided by ETF issuers and run an overlap calculation.

As an example, I recently compared the A200 and A300 and it stated: "~98.74% of the ASX 200 (by weight) is included in the ASX 300, based on the files you uploaded."

5. Passive vs. smart beta vs. active

Lastly, how much should you pay? Should you stick to only cheap, index-trackers or consider something more? ETF management styles can be divided into three categories:

• Pure passive: These are the cheapest and simplest funds. They follow a market-weighted methodology and track markets and sectors. Fees range from 0.03% to 0.69%.
• Smart beta: This is the middle ground. Smart beta funds use a rules-based approach to select and weight securities. An popular example is the "quality" factor, which aims to invest in companies with characteristics such as strong balance sheets and stable earnings. Fees range from 0.35 to 0.95%.
• Active: These are the modernised managed fund. An active manager buys and sells stocks with the goal of outperforming a benchmark. Fees range from 0.50% for bond funds and are typically more than 1% for equity funds.

I prefer to stick with pure passive funds for broad market exposure and use genuinely skilled active managers for specific areas, such as small caps and fixed income sectors.

Putting it together: four funds I like, and two I’m watching

You don’t need an army of ETFs to execute a strategy. Because ETFs are inherently diversified, fewer (but more targeted) positions can do the job. Fewer products also mean lower brokerage if you’re dollar-cost averaging, and it’s easier to stay on top of what you own.

As an illustrative example, here are my top ETFs on my APL for a mix of growth and income - plus a couple of opportunistic plays I've been researching.

Core portfolio

• SPDR S&P/ASX 200 ETF (ASX: STW)  – A low-cost value play on Australia’s economic pillars (banks, miners, healthcare, consumer stocks). The Michael Bevan of the portfolio, it quietly accumulates steady runs through quarterly distributions. Indicative gross yield ~4.5% p.a.
• Betashares Nasdaq 100 ETF (ASX: NDQ) – Exposure to the world’s tech heavyweights, from NVIDIA to Microsoft. High growth potential, but with higher risk — the Adam Gilchrist of the side, capable of explosive innings that change the game. Pays a yield of ~1% p.a.
• Macquarie Subordinated Debt Active ETF (ASX: MQSD) – A defensive income workhorse in bank and insurer debt, rotating as spreads move. The Steve Waugh of the portfolio: reliable and built to deliver when the rest of the team is under pressure. Yield-to-worst ~4.9%.
• iShares Enhanced Cash ETF (ASX: ISEC) – Invests in short-dated, high-quality instruments for returns slightly better than cash. It's the Ian Healy of the lineup; a safe pair of hands during drawdowns. Indicative yield ~4.35%.

Watchlist: opportunistic ideas

• Firetrail Australian Small Companies - Active ETF (ASX: FSML) — small caps are back with a bang, and this is where having a human at the wheel can matter. A concentrated book from a team that has delivered double-digit returns over the years. Pays a yield of ~0.5% p.a.
• Vanguard Australian Property Securities ETF (ASX: VAP) - a broad A-REIT play positioned to benefit as commercial vacancies tighten, funding costs ease, and industrial heavyweights like Goodman push deeper into data centres - one of the market’s faster-growing property sectors. Indicative yield of ~3.1% p.a.

Final words