When Risk Is Where The Home Is

Bank shares and residential property have been the poster children for Australian investors for most of the past decade.

So understandably it may be disconcerting for some investors at the moment when hardly a day goes by without a headline or two pointing to:

1. stretched valuations
2. lower earnings outlook
3. index risk
4. all of the above

Now investors have been well rewarded by the price and dividend growth in our large banks and it is hard to imagine an SMSF share portfolio without a large representation of banks with their fully franked dividends.

But global regulatory trends aimed at de-risking the financial system in the wake of the global financial crisis will require banks to hold more capital which analysts forecast will crimp future earnings growth. Arguments by the Australian banks against higher capital adequacy requirements largely fell on deaf ears with the Financial System Inquiry chaired by David Murray recommending that our banks need to be "unquestionably strong" and endorsing moves to require higher levels of capital.

The banks are also in the spotlight when it comes to residential property with increasing public pressure from regulators and the Reserve Bank to tighten lending practices to slow price growth particularly in major population centres like Sydney and Melbourne.

So it is not surprising there is plenty of commentary around the outlook for the banks and along with it the broader Australian sharemarket index.

Now a degree of focus on the Australian index and the inherent risk within our local market is sensible given the heavy concentration in two sectors – financials (banks) and materials (miners).

If we look at the portfolio held by Vanguard’s Australian share ETF that tracks the S&P/ASX300 index you can see that when you break it down then about 40% is in financials and 14.4% in materials while the weightings of sectors like industrials, consumer staples and telcos all represent less than 7.5% of the portfolio holdings.

Where some of the recent commentary goes off point is to suggest that suddenly the index has got riskier. It is true that the index composition has changed over the past 30 to 40 years and it will certainly change again over the next three or four decades.

But the index represents the market and it is an efficient, low-cost way investors – both large and individual -capture the returns of our sharemarket.

All markets come with risk so the question is what do you do if you are concerned about the level of Australian market risk within your portfolio?

The answer probably lies overseas.

If you contrast and compare two international share ETFs with the Australian share ETF portfolio the differences – and therefore the diversification benefits – emerge.

The US Total Market Shares ETF provides broad exposure to the largest developed sharemarket in the world. In the US market financials are still the largest sector but represent a more modest 18.9%. More importantly the diversification benefit flows from the strong representation of companies in the technology, industrials, health care, consumer goods and services sectors.

For example technology is almost 16% of the US market index and when you look at the top 10 shares in the portfolio it includes companies like Apple, Google and Microsoft.

The All-World (ex-US) Shares ETF tells a similar diversification story. Again financials are the largest sector at 19% of the portfolio but the technology, health care and consumer discretionary sectors each represent more than 13% of the index portfolio.
When you take it down to company level then the list of top 10 holdings includes names like Nestle, Shell, Toyota and Samsung.

While investors cannot do anything about the highly concentrated nature of our local sharemarket the growing international ETF market at least brings the counterbalancing power of broad global markets much closer to home.

Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.