Which Vanguard ETFs are best to diversify into?

Welcome to Finance and Fury, The Say What Wednesday Edition

This week the question is from Dan

I am 21 and have about 70k in a term deposit and 5k in VHY and VGS ETFs. I am wondering whether over a period of 20~50 years I would be better diversifying into VAE or VGE and VAP or whether you’d stick to VAS and ETFs which have a franked dividend and not just potential capital gains. You have mentioned in previous podcasts bubbles, though these ETFs have much larger market caps and therefore are less likely to default.

Thanks for the great question – Break down investing in ETFs, diversification issues with ETFs – Feedback loops and self-fulfilling prophecy –

Global asset managers, Vanguard and iShares continue to dominate the ETF market in Australia.

1. Account about 56% of all money invested in ETFs – BetaShares is the third-largest
2. Low-cost passive vehicles have gained popularity on Main Street.
3. Passive investments have now taken over nearly half of the stock market as more investors shun stock pickers and flock to index funds, according to Bank of America Merrill Lynch. Equity passive funds alone have ballooned to a more than $3 trillion market in less than 10 years, according to Morningstar 

Aus – largest is Vanguard – can’t tell you what to invest in – but can give a breakdown and comments on them

Vanguard ETFs – six mentioned in the email and Start date for each:

1. VHY – Vanguard Australian Shares High Yield Fund – 62 shares – May 2011 – Higher FF divs
2. VAS – Vanguard Australian Shares Index Fund – 296 shares – May 2009 – ASX300 whole index, good FF shares
3. VGS – Vanguard International Shares Index Fund – 1,590 shares – Nov 2014 – International market access – 14% top 10
4. VAE – Vanguard FTSE Asia ex Japan Shares Index – 1,176 shares – Dec 2015 – 28% top 10
5. VGE – Vanguard Emerging Markets Shares Index Fund – 4,729 shares – Nov 2013 – still has 24% top 10
6. VAP – Vanguard Australian Property Securities Index Fund – 28 shares – October 2010 – 84% in top 10, large loss potential

All very new investment vehicles

VAS won’t provide much additional diversification if you are already invested in VHY:

VAP – Doesn’t provide much diversification – 10 companies make up over 80% of the index – in it and the index lost over 70% in 2009 –

VAE and VGE – almost the same investments as well except one has 3000 more companies which make up a tiny allocation

1. Some of the largest holdings are in Communist Party run banks – China Construction Bank, industrial & commercial bank of china, etc.

If you are looking for the most diversified version of Vanguard funds, they have the multi-asset ETFs available now such as the following: Vanguard Diversified Growth Index ETF (VDGR) – or Vanguard Diversified High Growth Index ETF (VDHG) –

The bubble topic is about the nature of buying ETFs and how Central Banks are buying these, as they are price taking and not price making.

Index Funds and Price Discovery

1. Firstly – Central banks and Basel III have more or less removed price discovery from the credit markets
   1. Risk does not have an accurate pricing mechanism in interest rates anymore
   2. On top of this – now passive investing has removed price discovery from the equity markets
2. If it is in the index – it is purchased – bubble in markets – due to the rise of inflows into ETFs – pushing the shares at the top in the index up further regardless of the performance of companies –
   1. Example – the bubble in synthetic asset-backed CDOs before the GFC
   2. Price-setting in that market was not done by fundamental security-level analysis – but massive capital flows based on Nobel-approved models of risk created a similar ‘if everyone is doing it’ mentality
3. The Rise of ETFs and Market Distortion
   1. Index funds are only relatively new – 2009 to 2017 created – growth in index funds is creating a valuation distortion in the market.
   2. In one of the longest bull markets – I think a lot due to the technology platforms and apps making index investing easier and cheaper than ever –
   3. Passive phenomena is being viewed by rating agencies like Moody’s as the adoption of a new technology
   4. Investor adoption of passive low-cost investment products will continue irrespective of market environments
4. The ETF industry has attracted almost US$3trn in new business since the start of 2009 – coinciding with one of the longest bull markets in US history
   1. Among Professional investors – Record surge into ETFs fuels fears of stock price bubble – Michael Burry, one of the first investors to call and profit from the subprime mortgage crisis started talking about this just last month
   2. Personal Example – NWH – saw the price go up by about 12% – checked the news and it was a 3.8m share purchase by vanguard as it made the ASX200 index – no other news

Liquidity Risk – Further Explanation Needed

1. The dirty secret of passive index funds — whether open-end, closed-end or ETF — is the distribution of daily dollar value traded among the securities within the indexes they mimic

Daily Turnover and volumes

2. In the US – Russell 2000 Index has better data on it as an example –
   1. Vast majority of shares are lower volume shares – of the 2000, 1,049 shares trade less than $5 million per day
      1. 456 shares traded less than $1 million during the day
   2. But through indexation and passive investing, hundreds of billions are linked to these shares
3. The S&P 500 is no different — the index contains the world’s largest shares – but 266 shares (over half) – trade under $150 million per day
   1. $150m sounds like a lot – but trillions of dollars globally are indexed to these shares
   2. Analogy of a theatre – packing more and more people into one – keeps getting more crowded, but the exit door is the same as it always was

Concentration risks – fuelling bubble

4. ASX one of the most concentrated indexed – Large-cap –
   1. Purchasing an index = 65% of funds to the top 20 shares and 40% to the top 8 shares – 8% of ASX300 is CBA alone – every purchase of the index (super funds, Raiz, etc.) = 8% inflow into CBA pushing price up
   2. The fear is that there is the potential for a liquidity squeeze in the event of a market correction or crash which will start within the Financial sector –
   3. GFC – banks lost 68% of values without the outflows of index funds –

Exit door – Selling and NAV

5. An ETF is listed on the ASX and its price will be determined by a number of factors –
   1. In theory, will always trade at it’s reported net asset value adjusted for tax and dividends
   2. So the net asset value is the value of the fund – take the assets and the liabilities, and you compute a per share price – But the market price is where you’re able to transact in the marketplace for the ETF.
   3. And ETFs are really structured so that the market price can be very close to the net asset value, but it could deviate a little bit over short periods of time given certain supply and demand characteristics.
   4. The reality is that an ETF, LIC etc can trade at either a premium or discount to valuation.
6. In the event of a market correction or crash an ETF will likely trade at a steep discount to valuation as investors run for the exits – but we don’t know as ETFs haven’t gone through a mass selloff – simply working of human behaviours and myopic risk aversion – well documented
   1. The market maker will probably step in to ensure liquidity but it won’t stem the flow. The market maker, after all, has to fund the purchase by selling the ETF assets.
7. Sale process –
   1. First NAV is the weighted average price of all the shares – but is worked out at close of trade
   2. ETF purchases have to be closed out intraday – if you do a price limit and doesn’t trade – order cancelled
   3. Example – if everyone is selling ETF – have to sell at market price to sell – take what you get – might be big discount to the actual NAV which you will find out after 4pm
   4. The concern is the untested potential for a liquidity crunch. If the market is falling and you are selling assets to fund the exit of investors then who is buying the underlying shares? Well probably the underperforming high fee active manager who is seeking to take advantage of the misallocation of price and the eventual normalisation of the market price for the assets.
8. It Won’t End Well – passive investments are the same story again and again – very easy to sell
   1. Become a self-fulfilling prophecy (prices go up the more people buy, so people buy more) – also algorithm trading kicks in for buys – also money managers are pushing Funds into ETFs
   2. What makes it worse? the impossibility of unwinding the derivatives and naked buy/sell strategies used as part of ETFs
      1. Fundamental concept is the same one that resulted in the market meltdowns in 2008
   3. Nobody knows what the timeline looks like – but like most bubbles, the longer it goes on, the worse the crash can be

So what does work?

9. Warren Buffet has told us all to go and buy index funds – Yet his portfolio of assets is nothing like an index fund
   1. Buffet and most wealthy investors are high conviction investor – don’t just buy shares but buys the whole company
   2. The active managers who have actually managed to outperform over longer periods of time you will probably find them to be high conviction managers with concentrated portfolios – Such as Magellan

Summary

10. An index manager will buy everything in the reference index – those shares go up
    1. It isn’t an asset allocation decision based on your own investment goals and tolerance to investment risk
    2. Michael Burry – called it a “herding behaviour” and it has reached “mania status” in price misallocation
11. Nothing wrong with ETFs as a part of an investment portfolio – but diversification is not just the number of shares held –
    1. I use index funds as a core – but only about 20-30% – replacement of large-cap active managers who buy 50-60 shares
    2. Active Vs passive – active managers are underperforming on the large-cap side of things –
12. Investing in active has to have a purpose – in the next correction there will be widespread deep value that has arisen with the sell-off