Chapter 09 – How to create an index-tracking portfolio

There are two ways for a direct investor to create an index-tracking portfolio. The very simple way, and the simply simple way.

The very simple way – Exchange Traded Funds

The very simple way to invest in an index-tracking portfolio is to buy shares in a listed investment vehicle that tracks the index. These companies are typically a form of investment known as exchange-traded funds (‘ETFs’) and there are several available on the ASX. (Please note: there are also some ETFs that are not index-tracking). 

As an investment, buying shares in the ETF is easy. The investor decides simply to buy the shares and executes the trade. Selling the portfolio is not hard, either. Once again, the investor simply executes the trade. 

The following is a list of some of the more prominent index-tracking ETF’s, and the management fee that applies to them. (A fuller list can be obtained directly from the ASX).

iShares S&P/ASX 20 ETF

ETF ASX Code Benchmark MER% Admission Date
ANZ ETFS S&P/ASX 100 ETF ZOZI S&P/ASX 100 Index 0.24 Jun-15
iShares S&P/ASX 200 ETF IOZ S&P/ASX 200 0.15 Dec-10
iShares S&P/ASX 20 ETF ILC S&P/ASX 20 0.24 Dec-10
SPDR 200 Fund STW S&P/ASX 200 0.19 Aug-01
SPDR 50 Fund SFY S&P/ASX 50 0.28 Aug-01
UBS IQ MSCI Australia Ethical UBA MSCI Australia ex Tobacco ex
Controversial Weapons Index
0.17 Feb-15
Vanguard Australian Shares Index VAS S&P/ASX 300 0.15 May-09

As the list shows, these funds track the major indices on the ASX. Investors pay a management fee ranging from 0.15% to 0.28% of the value of the holdings within the ETF.

Advantages of index-tracking ETFs

The main advantage is simplicity. The investor makes one investment and gains access to the index performance. This makes things like brokerage costs as cheap as possible, and also makes the receipt of dividends simple: the investor receives a single dividend and (where provided) a single franking credit.

Buying shares in just one company then becomes a simple way to use dollar cost averaging to diversify over time and thereby mitigate a large amount of timing risk.

Disadvantages

The main disadvantage – and it is not a big one – is cost. The 0.15% or so that is deducted from an investment can add up over time. For example, a $200,000 investment growing at an average rate of 5% per annum will lead to fees of $3,962 over a ten year holding period. In some ways this fee will be hidden from the investor as it is an expense of the ETF and will not be reported separately.

The ‘simply simple’ way – a simple portfolio

The simply simple way to create an index-tracking portfolio is to buy shares in companies such that the whole portfolio acts in concert with the index. Once again, this means using an online broker to buy shares in a set number of companies. It is a slightly more complex strategy than simply buying ETFs – but not much more complex. It is also perhaps not quite correct to refer to the portfolio as index-tracking. ‘Index-approximating’ is a better description. 

For example, an investor might look at an index such as the ASX200, and realise that 32% of the total index is accounted for by the largest five companies within the index. The investor could then buys shares in each of these companies in proportion, as shown in these tables:

As of December 23 2015, the five largest companies within the ASX200 were:

Company Sector Market Capitalisation Weight
(% of ASX200)
Commonwealth Bank of Australia Financials $140,258,000,000 9.69
Westpac Banking Corporation Financials $107,279,000,000 7.41
Australia And New Zealand Banking Group Limited Financials $78,437,800,000 5.42
National Australia Bank Limited Financials $76,920,800,000 5.31
Telstra Corporation Limited Telecommunication Services $66,813,200,000 4.62
Total percentage of ASX200 Index represented by these companies 32.45

Suppose an investor has $100,000 to invest. He or she might choose to invest this as follows:

Company Weight Amount
Commonwealth Bank of Australia 29.86% (9.69/32.45) $29,860
Westpac Banking Corporation 22.8% (7.41/32.45) $22,800
Australia And New Zealand Banking Group Limited 16.7% (5.42/32.45) $16,700
National Australia Bank Limited 16.3% (5.31/32.45) $16,300
Telstra Corporation Limited 14.2% (4.62/32.45) $14,200

Given the relative size of these companies in the market, this portfolio will act in concert with the largest 32.45% of the ASX200 index. In this way, the portfolio return should approximate the index. 

If the investor wants to manage timing risk, he or she could divide the amount to be invested by the number of periods in which they need to invest. For example, if the investor wants to invest at four different points in time, he or she can simply divide the total amount to be invested by four and make the investments over time. 

The calculations used above could be adjusted if, for example, the investor wanted to diversify away from the financial stocks (Australia’s four largest companies are all banks). The investor could use every second company in the index, for example, or choose the largest company from each sector. If the investor prefers to own shares in more than five companies, the logic can be applied to the largest ten companies (for example) in the index.

The point is that constructing an index-approximating portfolio is not hard. As long as the companies held constitute a sizable percentage of the index, then the portfolio will act broadly in concert with that index.

Advantages of the simply simple approach (compared to ETFs)

This approach, over time, would be expected to be slightly cheaper than the ETF approach. This is because the annual management fee paid to the manager within the ETF is avoided. This reduction is slightly offset by increased brokerage, but if the shares are held for the long term the brokerage costs is minimised as a percentage of the investment – and it was not high to start with.

As shown above, even a management fee as low as 0.15% will, over time, add up to some thousands of dollars on any reasonably-sized holding. Owning the individual stocks directly means that this fee does not have to be paid. 

Disadvantages of the simply simple approach (compared to ETFs)

The investor’s portfolio is slightly more complex. Instead of one group of dividends and franking credits, there will be five (or more) groups of each. This may lead to an increase in annual administration costs for the investor.

This approach will not be as diversified as the ETF approach. It is not really viable for an individual shareholder to acquire a portfolio that is as diversified as an ETF. 

There will therefore be some divergence with the index each year, although over time the net effect of these divergences would be expected to be neutral (that is, in some years the portfolio will beat the index by some small margin, in others it will lag the index by some small margin, but over time it will approximate the index).

Dollar cost averaging may also be more difficult (although not all that much harder). Whereas with ETFs there is one share purchase to be made at each point in time, with this approach there are multiple purchases to be made. For smaller investment amounts, this also increases the amount of brokerage that is paid in total. 

The Dover Group