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 as an example of easily accessible broad market index funds available to Australians, but feel free to use similar funds from other providers if they are available. Provided it tracks the index, there should be no difference between 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.

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 index (VGS) 90%
Emerging Markets index (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
Australian index (VAS) 50%
Non-AUD assets
Developed markets index (VGS) 40%
Emerging Markets index (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
Australian index (VAS) 30%
Non-AUD assets
Developed markets index (VGS) 60%
Emerging Markets index (VGE) 10%

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

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

Luckily there’s a solution, and this is where an global index that is AUD-hedged, such as 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 doesn’t have the concentration risk of Australian equities.

Your proportion of Australian equities to AUD-hedged global equities 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 Australian 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
Australian index (VAS) 30%
Developed markets index AUD-hedged (VGAD) 20%
Non-AUD assets
Developed markets index (VGS) 40%
Emerging Markets index (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.
  • Agency risk of having someone managing your portfolio and using their authority to benefit themself at your expense.

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
Developed markets index AUD-hedged (VGAD) 50%
Non-AUD assets
Developed markets index (VGS) 40%
Emerging Markets index (VGE) 10%

2. Leave out emerging markets (VGE)
Emerging Markets (VGE) has a low correlation with developed markets offering excellent diversification benefits, but being just 10% of your portfolio, it isn’t going to have an enormous effect on your portfolio returns to leave it out.

AUD assets
Developed markets index AUD-hedged (VGAD) 50%
Non-AUD assets
Developed markets index (VGS) 50%

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