Updated Sep, 2019

Equity funds

equity funds

The world’s equities can be divided up into

Developed markets (23 countries) – 90% of total worlds markets
LC (large caps or large-sized companies) 70%
MC (mid caps or mid-sized companies) 15%
SC (small caps or small-sized companies) 15%
Emerging markets (23 countries) – 10% of total worlds markets
Not broken down because it’s too small

To keep it simple
» I’m going to use Vanguard’s funds, but feel free to use similar funds from other providers.
» I’m going to use Australian domiciled funds. More on this here.
» I’m going to leave out developed small caps because they’re highly correlated with developed mid & large caps, so they offer less of a diversification benefit, but feel free to add that.

Global funds (unhedged)
VGS Developed LC & MC
VGE EM (Emerging Markets)
Australian fund
VAS Australia
Global fund AUD-hedged
VGAD AUD-hedged version of VGS

When we accept that we cannot foretell which markets will do best in the future, we go with the market-determined cap weightings.

Developed Markets (VGS) 90%
Emerging Markets (VGE) 10%

This offers the broadest diversification to offset the concentration risk of investing just in Australia. It invests in 45 countries around the world. If any single country besides the US has a recession, our portfolio will not be affected significantly, with the other 44 countries picking up the slack. If the US is affected, the rest of the world will be affected anyway – as they say, “when the American economy sneezes, the rest of the world catches a cold”.

While this offers the broadest diversification to offset concentration risk, it introduces currency risk. The usual approach to mitigate currency risk is to have a significant Australian allocation (VAS).

Then you have your frequently cited VAS/VGS/VGE portfolio.

AUD assets
VAS 50%
Non-AUD assets
VGS 40%
VGE 10%

However, the problem with having a large portion of your equities in Australian equities is that when there is a recession, your property value, job stability, and now your stocks are all going to go down together because you have everything concentrated within the Australian economy.

As people are becoming more aware of concentration risk, I’m seeing people lower their allocation to something like this to mitigate this risk.

AUD assets
VAS 30%
Non-AUD assets
VGS 60%
VGE 10%

But of course, then we are back to currency risk issues.

Having too little VAS opens us up to currency risk, and too much opens us up to concentration risk.

Luckily there’s a solution, and this is where VGAD comes​​ in. It is AUD based, just like VAS, so it has no currency risk but is globally diversified throughout 22 developed countries, so it has no concentration risk.

Your proportion of VAS to VGAD will depend on how much concentration risk you’re willing to take on in exchange for franking credits. For instance, if we wanted a compromise between the two above portfolios, it would come out to this.

We have the same proportion of VAS to developed countries to emerging countries (30/60/10), but we also have half AUD based assets and half non-AUD based assets.

AUD assets
VAS 30%
VGAD 20%
Non-AUD assets
VGS 40%
VGE 10%

For your equities, there is no reason it should be any more complicated than this.

This mitigates the following risks

  • Upside currency risk (risk of AUD outperforming and having too little AUD assets).
  • Downside currency risk (risk of AUD underperforming and having too much AUD assets).
  • The concentration risk of too much of our assets in the same market as our income and other assets such as our house.
  • Idiosyncratic risk (single country risk) of having too much of our assets in the Australian market.
  • Manager risk of having someone selectively choosing specific assets to invest in and potentially making a mistake.

And we’ve done this with a portfolio that’s simple, easy to manage, and most importantly, easy to understand what we are investing in and the reasons behind it.

Even simpler?

If you really couldn’t be bothered with four funds, there are a couple of ways you could make it even simpler.

1. Only use VGAD for your AUD allocation
You lose franking credits, but as we will see in the next article, they are mostly priced-in anyway, so it isn’t much of a loss, and you avoid concentration risk altogether, so it’s a great solution.

AUD assets
VGAD 50%
Non-AUD assets
VGS 40%
VGE 10%

2. Leave out emerging markets (VGE)
I prefer to include VGE (Emerging Markets) because the low correlation between emerging markets and developed markets offer excellent diversification benefits. Still, it’s unlikely to cause any significant problems to your portfolio returns to leave it out.

AUD assets
VGAD 50%
Non-AUD assets
VGS 50%

Coming up next, we’ll explain about franking credits and then give some considerations into personalising your AUD to non-AUD allocation.