Simple investing ideas in a volatile market

Too much oil and dramatically reduced demand due to global lockdowns has added to equity market volatility this week.

Deciding on whether to invest, especially in uncertain markets, is a difficult decision. Perhaps the market will move lower and you will lose money but what if this is the bottom of the cycle and share prices start to rise? You may miss out on the gains.

Like the hoards waiting at the doors for Myer's Boxing Day sale, we all like a bargain. But this market is like nothing I’ve seen. Massive global quantitative easing, historic low interest rates, steep rises in unemployment and an uncontrollable virus, shutting businesses, forcing us to change the way we live.

Still, the projected price earnings ratio of the ASX200 is 14 times as at 31 March 2020. Instinctively, this feels too high. I have no idea if I’m right or wrong, but what I can guarantee is that volatility is our unwanted guest and is sure to outstay it’s welcome.

Agonising over the timing to invest can be eased by dollar-cost averaging. Instead of investing a lump sum in one hit, simply invest smaller amounts over time. This makes sense in any market whether it’s in an individual share, bond or Exchange Traded Fund (ETF).

One of the advantages of an ETF is exposure to a broader market and diversification can be achieved from a relatively small $500 to start.  

ETFs saw big inflows last year as investors sought to diversify holdings, by accessing different asset classes, sectors and geographies at low minimum amounts and in a cost-effective manner.

But, how have equity ETFs performed compared to the index? Has there been the same sea of red, with declines across the board? Is now a good time to think about buying into the market? Are they still paying dividends? Could investing through an ETF cushion the blow?

Equity ETF basics

ETFs are designed to replicate an index, so it’s important to understand what the index contains and the percentage weight of the index to any one investment. For example, the S&P/ ASX 200 Index references the price of the top 200 shares on the ASX. However, each share has a different weighting on the index depending on its float adjusted market capitalisation.

Source: ASX

The top 10 companies on the index by weight account for 46.7 per cent of the total. So, if you invest in an ETF that tracks the S&P/ASX200 index, almost half of your investment will be in the top 10 companies.

Equally, if you already own some of the shares below, an ETF that aims to replicate the S&P/ ASX200 may not be right for you.

Source: S&P Global

There are other Australian equity indices. If you are thinking about investing in an ETF, you need to consider the index it references and what investments it makes.

Three large Australian equity ETFs

Each of the three equity ETFs under review are benchmarked against slightly different indices:

• The SPDR S&P/ASX200 Fund (STW) references the S&P/ ASX200 Index
• Vanguard Australian Shares Index ETF (VAS) is benchmarked against the S&P/ ASX300 Index
• The iShares Core S&P/ASX 200 ETF (IOZ) is benchmarked against the S&P/ ASX 200 Accumulation Index. This index is the price index adjusted for the notional reinvestment of dividends as from the date each stock in the index is quoted on the ASX as ex-dividend.

It’s worth noting performance of all three closely tracks the benchmarks but slightly underperforms them.

How do they compare against each other?

Over one, three and five years performance of the three funds is similar, with Vanguard performing best over five years by a mere 0.11 per cent, returning 1.28 per cent and since inception in May 2009 6.83 per cent. Fees charged are minimal, with the youngest fund, IOZ, charging 0.09 per cent, VAS 0.10 per cent and STW 0.13 per cent. Theoretically, over time, despite slightly different benchmarks, you would expect the ETF with the cheapest fees to outperform.

Source: ETF provider’s websites

STW is the only fund to report one, and three month returns being -20.68 per cent and -23.15 per cent respectively. Significant falls in value, but keep in mind the return for the index last year was 23.40 per cent, so losses to date have practically wiped out gains in 2019, not good if you bought into a fund on a single date, late last year.

All three ETFs paid a distribution in April, for the quarter ended 31 March 2020, or thereabouts. If we go back to the distribution made for the same quarter in 2019, it’s clear that all three have reduced the distribution by a significant amount.

The lowest cut was by VAS, reducing the distribution by 26.5 per cent, then STW by 32.9 per cent with IOZ cutting by 39.3 per cent, which may have something to do with it operating for a shorter time and thus having lower reserves.

If we add the last four distributions and use the unit price of the fund at the last distribution date, we can calculate an estimated rate of return for the last 12 months.

Surprisingly, VAS has the lowest annual return of 5.07 per cent, with IOZ at 5.13 per cent and STW the highest of 5.55 per cent. The variable here is, of course, the unit price!

If we go one step further and simply extrapolate the last quarter return and multiply by four, we can estimate an implied rate of return for 2020.

This has plenty of variables, with some companies likely to cut dividends - think of the banks, who may even suspend dividends. However, my simple calculation shows IOZ with an estimated rate of return of 3.55 per cent, STW 3.94 per cent and VAS 4.15 per cent.

I wouldn’t expect any of the ETFs to suspend distributions given the diversity of holdings, but annual returns may well be lower. Potentially, they could soften the blow of an investor holding shares in companies that all chose to reduce or suspend dividends.

Note: IOZ is used in the InvestSMART portfolios

Another interesting option – VanEck Vectors Australian Equal Weight ETF

The VanEck Vectors Australian Equal Weight ETF (MVW) is benchmarked against the MVIS Australia Equal Weight Index. Companies in the Index are weighted equally and this is demonstrated in the top 10 holdings of the ETF, which combined equal just over 15 per cent of the total fund compared to the circa 45 per cent of the three large equity ETFs above.

MVW fees are considerably higher at 0.35 per cent, and returns over the short term are worse – one month -22.42 per cent, one year -18.83 per cent, three years -1.43 per cent. But almost double the large funds over five years at 2.58 per cent.

MVW has underperformed its index over all periods but has outperformed the S&P/ ASX200 index over five years and since inception.

Summary

Economic forecasts are notorious for being wrong. Experts can help guide you in your decision making, but timing the market is extremely difficult.

When investing, you need to think about what you hope to achieve. The risks you are prepared to take and the time you are prepared to put aside your funds.

I think any market has its opportunities. Broad-based ETFs make a lot of sense if you are new to the market. More experienced investors can use ETFs to target specific strategies.

Next week I’ll start to review ways you can hedge your equity holdings.