Updated May, 2022

The Australian version of the 3-fund-portfolio

What is the 3-fund portfolio?

The 3-fund portfolio is a portfolio modelled on the idea of maximizing simplicity, diversification, and flexibility. The simplicity allows you to understand and manage your own investments. The diversification helps you lower the risk of any single asset’s underperformance becoming catastrophic. The flexibility enables you to set an allocation that suits your circumstances and financial stage of life.

The three-fund portfolio, which is often recommended for and by Bogleheads, consists of

  • A “total market” domestic stock index fund;
  • A “total market” international stock index fund; and
  • A “total market” bond index fund

With just three funds, you can

  • Have a globally diversified equities portfolio;
  • Control your level of market risk with your stock to bond allocation; and
  • Control your currency risk with your domestic to international allocation,

The Australian version

The Australian version is

Australian equities index
Developed world ex-Australia equities index
Aggregate bond index

Unfortunately, developed world ex-Australia equities is not a total market international fund. It is missing:

Emerging markets index
Small caps developed world index

Emerging markets are an excellent diversifier of risk, but there are arguments for and against small caps, so for simplicity, I’m going to leave it out, but feel free to include it. So, this leads us to a 4-fund portfolio.

Australian equities index
Developed world ex-Australia equities index
Emerging Markets index
Aggregate bond index

There is one more problem which is concentration risk.

Americans can get away with overweighting their home country’s equities because their market is incredibly diverse. Lowering ex-US stocks has shown to be sub-optional, but it is still a great option.

In contrast, the Australian market is extremely concentrated, with half the entire value in 10 companies and 2 sectors.

To overcome this, you can lower the amount of Australian equities, but then a high percentage of your assets are exposed to currency risk.
Instead, you can switch out some of your Australian equities for an AUD-hedged version of the developed world ex-Australia equities index, so that you’re still globally diversified but with less currency risk.

This leads to a 5-fund portfolio.

AUD based equities
Australian equities index
Developed world ex-Australia equities index – hedged to AUD
Non-AUD based equities
Developed world ex-Australia equities index
Emerging Markets index
Bonds
Aggregate bond index

Total market index funds on the ASX

At the time of writing, these are the available ETFs that are total market index funds.

  • Australian equities index — VAS, IOZ, STW, A200
  • Developed world ex-Australia equities index — VGS
  • Developed world ex-Australia equities index AUD-hedged — VGAD
  • Emerging Markets index — VGE, IEM
  • Aggregate bond index — VAF, IAF

There is also the option to switch out developed world and emerging markets and instead use total US market (VTS) and total non-US market (VEU), but even though they are cross-listed on the ASX, they are US-domiciled funds, and as such, have some potential issues around the US estate tax laws to be aware of.

A simpler option

While this isn’t overly complex, it’s not quite as simple as using 3 funds. One option for simplicity is a 2-fund portfolio of an all-in-one fund like Vanguard’s diversified funds, which includes all of the above asset classes and small caps in one fund. If you’re happy with the proportions, it’s a great solution to keep things simple yet flexible.

Summary

For more in-depth information explaining the fundamental concepts of passive investing expanding on the above allocation and guides on how to determine proportions to suit you, the first section of this site should be useful, particularly articles 1-12.