Tips for using ETFs in an investment portfolio

Exchange-traded funds (ETFs) are growing rapidly in popularity among Australian investors. The ~240 ETFs on the ASX hold nearly $70 billion in assets. Of course, not all funds are created the same. Like stocks, some of them have been utter duds and delivered poor returns as they track niche parts of the market or due to flawed and complicated methodologies. 

As the level of adoption and choice increases, so too does the need for high-quality information that can help investors make better choices with ETFs. That’s why we’ve brought together investment advisers James Whalan of VFS Group and Charlie Viola of Pitcher Partners. They discuss how to navigate the world of ETFs, what to look for in individual funds and how they use them in portfolios. They also each nominate the ASX-listed ETF they would hold if they had only a single choice of fund.

Click on the video below to watch the discussion or read an edited transcript below.

Topics discussed

• Pros and cons of ETFs
• Common mistakes retail investors make with ETFs
• Core and satellite positions
• How to use ETFs in portfolio construction
• Pure vanilla ETFs versus more complex synthetic or leveraged products.

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Edited transcript

Vishal Teckchandani: Welcome to Buy, Hold, Sell, brought to you by Livewire Markets. My name is Vishal Teckchandani, and today, we're going to take the WTF out of ETFs. Joining me on the show is Charlie Viola from Pitcher Partners and James Whelan from VFS group. Welcome to the show.

Vishal Teckchandani: James, let's start off with you. Every man, woman, and their dog is jumping on the ETF bandwagon, but are they doing it the right way? I'd love to know, as a pro, how do you use ETFs in your portfolio?

How the pros use ETFs

James Whelan: Two main ways that we use them, Vishal. One is through having a core holding that just buys general markets, buys general indexes. Then we have a thematic — we call them satellites — which are thematic ideas that take a position in a certain idea or certain markets, certain commodities, certain currencies and lets that grow from there. But overall, we use that core area to just buy a market and hold it on the way through, based on the underlying theory that markets usually go up.

Vishal Teckchandani: Okay. So you're thinking about what's going to be a core long-term theme, what's going to be a satellite theme that's going to perform, right?

James Whelan: Yes, that's right. For the most part, it's based on what we think has probably got a high likelihood of going up. But the core holdings that we would have would obviously be the Australian market. Most people with a super fund just want to have a core holding in that, and a core holding in the US market. You'd be crazy to miss out on the US market and the growth that that's shown and will continue to show in this environment.

Vishal Teckchandani: Okay. Core and satellites. Charlie, is that the same approach you take? You've got high net worth clients. How do you build your portfolios for them and where do ETFs fit in?

Charlie Viola: Yeah, we're very similar to James. We use it for core and satellites. I feel I might actually bore everybody because we actually tend to use most of the widely held ones. From a core perspective, we like to use lots of those that have broad market exposure, that'll give us the diversity that we need. We also use some satellite ones just so that we can get some sectoral exposure, pick up on some themes and pick up on some momentum. A bit like James, we like to pick the ones that go up and the markets that go up as well. We think it's a really cost efficient way and a really good way to generate diversity for clients. Make sure we pick up all the themes that we need to pick up and make sure that we're generating the revenues and the yields and stuff that markets are generally picking up.

Common mistakes to avoid

Vishal Teckchandani: Well, Charlie, like they say boring is beautiful. But the uptake of ETFs is increasing. Now in Australia, it's a nearly $70 billion market as far as assets under management goes. More than 200 ETFs are available on the ASX, so there's a lot of choice. I'd love to know what some of the common mistakes you see retail investors make when they're investing in ETFs?

Charlie Viola: I think the biggest thing is just making sure what you're actually buying. Is it real? Is it synthetic? Is what's on the label actually in the bottle? I think that the common mistake is buying things because you like the sound of it, as opposed to really being able to drill in and understand what's actually inside the ETF and what you are actually investing in.

I think the other concern is those that are too thinly traded. We're big on using ETFs for what they were originally intended to provide: broad market exposure and diversity and ease of management. As you say, there are ETFs for everything now. It’s like there are ETFs for how many people are walking their dogs during COVID-19! Use them for what they are intended is my view. Make sure they're real, make sure you can drill in and see the underlying holdings and know exactly what you're investing in.

Vishal Teckchandani: Good tips. Common mistakes that you see, James?

James Whelan: I've got three general ones. And perhaps a fourth. Know who the provider is that's providing it. There are some small providers that you might not want to have too much to do with so make sure that it's a big, reputable name that you're going with. The second one is physical, operational and functional. Don't trade an ETF too early in the day. Try not to trade in the first half hour and definitely not on the close of the market. Those spreads are a little bit wild. People who aren't necessarily as experienced as they should be going into the market and throwing it off a bit. Don't trade until 10:30, Australian time, if you're trading in the local market.

Also, keep an eye on the spread at all times and try not to do too much. Occasionally, the spreads will widen out and market makers are actually the underlying facilitators for the ETF. Sometimes things go wrong, we're not all perfect, and the market makers won't be providing the exact spread that they should be. So really keep an eye on that and make sure that you don't just go straight across and hit the other side of the spread. If you're buying or selling that ETF, you might just get a little bit robbed. Thirdly, if you're looking at something that's going overseas, making sure if it's hedged or unhedged for currency is very important. Take, for example, if I can go into detail?

Vishal Teckchandani: Sure.

James Whelan: Take, for example, something that would be investing in the US market at the moment. If it's unhedged and you've owned it for the last three months, as the US dollar has massively depreciated against the Aussie, you'd actually see a fairly significant decline in the value of that ETF against the increase in your holding. So if it's hedged, then you don't have that currency depreciation kick in. That's really important to do as well. If you don't want to have a view on the currency, buy a hedge for currency ETF, then you can have the same view, if you have the luxury of choice. Very important.

Leverage is the last one as well. Try not to get into too many leverage things. You'll find that as the market swings around, it could be two times or three times as bad if you take it wrong. So just be careful on the leverage. Tends to cost a bit more too if you're buying something with a bit of leverage on it.

Filtering the universe of ETFs

Vishal Teckchandani: Okay. You raised some important points there, James. When you look at screening through the universe of ETFs for your client portfolios, what are some of the things that you're looking for? Are you looking at things like size? Are there things like the simplicity of the investment objective? What are you looking for as you screen?

James Whelan: We really like to have things that you can explain to a client quite easily. If you start to get too confusing, then it starts to get a bit too funny, as Charlie said. So we would probably take the position, if there's a thematic that we like, then we'll go into it, but it's got to be something that's easy to explain.

For example, there's a work from home ETF that just cropped up for obvious reasons because of COVID, and the code on it was WFH. It's got stocks that are linked to that work from home trend. That's easy to explain to the client. The provider has to be reputable, obviously, but there's some really good, big providers locally that will provide the access that you're after.

Vishal Teckchandani: Charlie, what about you? What are some rules that you live by when you're looking for ETFs? When you're thinking about them for your client portfolios, what are you looking for?

Charlie Viola: Yeah, so James stole my thunder a little bit on the equal-weighted piece. We like that as well, especially domestic markets where really, if you're buying the ASX 200 or 300, you're buying four banks, two miners, and two-fifths of not very much of everything else. We also agree with what James said before in terms of bigger is better. We tend to stick with a number of providers which provide liquidity and just the information sets. So when you, from our perspective, want to go in and do a bit of qual and quant research on what the underlying holdings are, you can make sure that you are getting what you think you're getting in terms of the exposure. And that liquidity piece is also really important because we've all got into something and then it's been an absolute punish to try and get back out of it when you wanted to get out of it.

I think the other one for us is we won't tend to trade anything that's synthetic. We want real because, again, what you don't want is to think you're taking a certain exposure. You know, you see the oil price go up, or you see the gold price go up or you see whatever commodity is that's the flavour of today, and then your ETFs kind not following the same trends. So, from our perspective, go with good providers, know exactly what you're investing in, and make sure that there's a good level of liquidity. Again, not to push the point I was making before, but use them for what they were intended, which is a simple, efficient, and easy way of trading momentum and things within a market.

Pros and cons of ETFs

Vishal Teckchandani: I think you summarised the points there nicely. Staying with you, Charlie, I guess the thing with ETFs is they're talked up as almost the perfect solution. Maybe tell me about what you like about them, but also what you don't like about them.

Charlie Viola: Yeah. What we like about them has already been covered a little bit: accessibility, ease and, generally speaking, low cost. Often, you're getting experts to put the stuff together for you. So it's not easy if you want to run a domestic equities portfolio, trying to equal weight and keep that equal weighting in place over a period of time. If you're running a US portfolio or something like that, it's clearly not easy to go on to Pershing or UBS or whoever and go and settle a whole stack of trades in a 4000 plus stock market. Ease and accessibility is clearly very important.

What we don't like is harder to answer because we tend to stick to a tight knit group of ETFs. I would say again we don't like ETFs which are synthetic, where what's on the label is not in the bottle. As you said before, there are 200 or so listed on the ASX. There's probably 25,000 listed on the US exchange and various other exchanges around the world. People could throw away a lot of money searching for these things and thinking they're getting a certain exposure that they're not. I think that the biggest thing for us is pick your market, pick your sector, pick your theme, and then go and find the absolute best ETF that is going to do exactly that job.

Vishal Teckchandani: Okay, James, I take it you concur with that sentiment, but maybe, anything else you want to point out as far as likes and dislikes?

James Whelan: Yeah, we do. Going right down to more of a granular level about the way we work, because we're a smaller boutique wealth manager, which means that we can stay close and be active. But it also means that, because we're smaller, there's no big research team that can cover 200 stocks and we can pick out from a universe of that. So therefore, the ETF seems like an amazing idea for us, because it means that we don't have to go and pick out every single one. You can pick a manager, that manager will do the work for us, and we can keep costs down and also stay closer to our clients. It's the convenience of having that and the ability to keep those costs down that we really appreciate as well.

What I dislike about them is sometimes the concessions that you have to make in an idea that you need to do. For example, if you want to buy a European ETF, it may not be specific to the theme that we want to buy in Europe. If I wanted to buy European tech, it's very difficult to find a specific European tech ETF that we actually want to be invested in. Sometimes the range just isn't going to be there, which is funny because Charlie just pointed out that there are more ETFs than there are listed stocks in the USA. There's an ETF for everything, but sometimes you just can't find the exact one that you want to have.

So one of the downsides is that you can't always get the exact one that you're after. Some people tend to dismiss that. We tend to say, "Look, if it's not exactly what you want or it's not 90% of what you want, it's probably best not to go into it because that 10% might kill you. "If it's not as perfect as it can be, it's probably best to stay away from it.

ETFs to avoid

Vishal Teckchandani: Okay. Let's turn to an area where, in terms of avoiding ETFs or ETFs that you don't want to be investing in. I think this is where things get pretty spicy in the industry because there's advocates for pure vanilla ETFs, just keep it simple, keep it low cost, but then there's other people who say, "Hey, if you're an active investor and you understand the risks, feel free to use synthetic products, go for leverage, go for commodities." Do you guys believe, and I'll start off with you, James here, there's an ETF that doesn't belong in a retail investor's portfolio?

James Whelan: For a retail investor, I would say a short position is a very bold thing to do. Don't worry about leverage but taking a short position in a portfolio is fairly bold thing to do based on the fact that, as we said, markets usually go up. So if you've got a short ETF in there, take what happened in August, we had the best August in US markets in 34 years. You were going to hold a short ETF all the way through that, thinking that the economy is going to collapse. This is the worst economic conditions that we've ever seen, and yet the market is still rallying. So you could be right fundamentally on why the market will correct and that short ETF will lose a whole lot of value and you'll miss out on all of that upside. It's best to take the position, either be in or be out. Don't be short.

Going further with that, if you're going into a leveraged ETF, you better be right very soon, because if you're not, that will really start to hurt you on the way through. If you're taking a position that's going to be a strong position, knowing what it is and timed well to go into a leveraged ETF, so at two-time or three-time leveraged ETF. For example, you take a short ETF, a three-times leveraged short ETF on the NASDAQ. Good luck! Over the last week, it might've gone quite well. So for every point that the NASDAQ comes off, your ETF will increase by three points. That's wonderful. However, like I just said, for August, that would have almost completely obliterated your holding. If you're not real right, real quick, it'll start to cost more because they do cost a little bit more and it'll really start to hurt the portfolio.

Vishal Teckchandani: Be real right, real quick, don't get caught short. Charlie, what's an ETF or type of ETF that you want to completely stay clear off?

Charlie Viola: Yeah, we're exactly the same. Like I said right at the top, we use them for large, broad-based core exposures and satellite where we're looking for kind of sectoral and looking for that diversity. So I tend to exactly agree with James. We don't want anything that's thinly traded, anything that's synthetic, and by synthetic, I mean that the underlying manager is kind of manufacturing an outcome to match something. To James' very salient point, we would never have invested in the ETF bear index or whatever it is, which seeks to do the opposite of what the market is actually doing. We take a 10, 15, 20, 25-year view of markets. We look for the best exposures we can, and they're the ones that we invest in. That's where we think, especially retail investors, people who don't have huge amount of knowledge of what's going on in markets and the intricacies, they should be investing in those kind of large cap, world traded, broad-based ETFs.

2 ETFs to own forever

Vishal Teckchandani: We're going to finish off with a fun and final question. Before I ask this, please, don't try this at home. This is just an exercise in long-term thinking. Now, Charlie, 10, 15, 25-year view. If you could just own one ETF, which one would it be?

Charlie Viola: VTS, which is Vanguard US Total Market Shares. It does all the things that we want it to do. Which is to hold large cap, mega cap, good quality companies in the right exposures, given what's in the market. If you look at the top 10 holdings, and I'm going to cheat, they are: Apple, Microsoft, Amazon, Alphabet, Facebook, Johnson and Johnson, Berkshire Hathaway, Proctor and Gamble and Visa. And if you looked at the allocations —technology, financials, consumer services, healthcare — it does all the things that we want an ETF to do, gives us all the exposures that we want in the biggest economy from a global perspective. It does the job for us and I think it costs about three basis points, easy to trade on the market, very liquid, one of the biggest ones on the market. That's the one that I would hold and, don't do this at home, but I've got a reasonably large position in that in my own personal portfolio and will forever, it's set and forget.

Vishal Teckchandani: You've got conviction. Nice one. He makes a pretty compelling case. James, what's your counter pick?

James Whelan: I think I may be able to beat him for conviction on this one. If you said, what would you want to do for the rest of your life? I would say I would buy some safes and I would fill them with gold. I can't really do that but with an ETF I can do that. So I'll do the next best thing and I would buy a gold ETF. That is pretty much what I would have in the portfolio. Portfolios, I think, are underweight gold. Just buy a good, simple gold ETF. The gold price will go, I believe, through $3,000, probably $5,000 ...

Charlie Viola: But is that the only asset that you ever want to hold?

James Whelan: He’s asked me for one ETF. So that's the only one that I would want to hold. It gets through any of the muckiness or the volatility of actual markets and it's just buying the gold. I think that where the global economy is moving, like I said, the price of gold will go to 3,000, probably 5,000. A lot of people are saying 20,000, which would be fascinating if it happened. Economies could rise and fall in that time, while that is all happening, gold will always be gold. I'm not a gold bug by any means. Although I think I probably just put myself on the record as being one.

Vishal Teckchandani: Well, if anything, your ETFs offset each other because if the US market blows up, the gold's going to fly away. Well, the world of ETFs is a lot to get your head around, but hopefully you found that session to be a good exchange.

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