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Why ETFs are a great investment

Fund manager skill is an elusive quality. It is not only difficult to demonstrate but even harder to assess.

But with interest rates at historic lows and a drawn-out global economic recovery underway, a dose of outperformance can provide some much-needed power to a portfolio.

However, it is asset allocation which remains the most significant factor behind generating returns rather than fund managers which outperform the broader market by, for example, picking the best stocks.

A rare skill

Many academic studies have cast doubt on the ability of managers to outperform most – but not all – markets. It remains an area of much debate although the literature suggests that a very small subset of managers possess skills that enable them to outperform. Selecting them, and divining skill from luck, is another matter.

The Standard & Poor’s Index Versus Active (SPIVA) report revealed that more than half of Australian large-cap equity funds underperformed the S&P/ASX 200 index over the 12-month period ending June 2015. Worse yet, over the five-year period, more than 70 per cent of funds were beaten by the benchmark.

It is particularly challenging to outperform “efficient” markets, where information is quickly circulated and reflected in asset prices although some asset classes present more opportunity than others. For example, the majority of active Australian small-cap managers do outperform the S&P/ASX Small Ordinaries Index over time – this may be partly because there is less quality information about these stocks in the market allowing investors to make better stock selection decisions.

However, a fund manager’s future performance is an unknown, unlike the investment fees they charge. Thanks to the magic of compounding, higher fees can strip a significant amount from long-term total returns.

Fees are an important way to assess value. However, unlike most purchases, higher fees do not signify a higher quality product – in fact, some research suggests there is an inverse relationship between the level of fees and performance.

The average Australian equity unlisted fund charges well over 1 per cent a year in management fees, according to Morningstar data.

It is a different story when it comes to exchange-traded funds (ETFs).

The benefit of ETFs

ETFs hold a broad basket of assets and track the performance of a particular market. They are listed on the Australian Securities Exchange and provide a transparent and simple way for investors to gain exposure to investments such as shares, property and bonds.

For example, the Vanguard Australian Shares ETF charges a management fee of just 0.15 per cent and holds the 300 largest listed stocks in the country (listed in the S&P/ASX 300 index). Active fund managers attempt to outperform this type of index but, as we have seen, rarely do so on a consistent basis.

This is one reason why the Vanguard Australian Shares ETF forms part of Ignition Wealth’s model portfolios. In late-November 2015, this particular ETF comprised 14 per cent of Ignition Wealth’s balanced investment option (investments above $25,000) and 24 per cent of the balanced investment option (investments below $25,000).

Ignition Wealth also uses a range of other ETFs to create well-constructed portfolios which are well diversified by asset class and by geography. These include ETFs such as the Vanguard MSCI Index International Shares ETF and the Vanguard Australian Property Securities Index.

Ignition Wealth, with advice from research house Lonsec, blends these ETFs to create the optimal asset allocation in its portfolios. It is this combination of different asset classes which generates the most value for investors – not outperforming the market.