How Many ETFs Should You Invest in Australia?

When it comes to investing in Exchange Traded Funds (ETFs) in Australia, you might be tempted to think that more is always better. However, this approach can lead to unnecessary complexity and potentially lower returns. To make the best decision, let's explore how many ETFs you should consider, and why diversifying wisely is crucial. In this comprehensive guide, we’ll examine the optimal number of ETFs, delve into the benefits and pitfalls of ETF investing, and provide actionable strategies for building a robust investment portfolio.

Understanding ETFs
Before diving into the optimal number of ETFs, let’s start by understanding what ETFs are. ETFs are investment funds that trade on stock exchanges, much like individual stocks. They hold a collection of assets, such as stocks, bonds, or commodities, and are designed to track the performance of an index or sector.

The Case for Diversification
Diversification is a key principle in investing, and ETFs offer a simple way to achieve it. By holding a single ETF, you gain exposure to a broad range of assets, reducing the risk associated with individual securities. However, having too many ETFs can lead to over-diversification, where the benefits of diversification are diluted.

Optimal Number of ETFs
The optimal number of ETFs for your portfolio depends on various factors, including your investment goals, risk tolerance, and time horizon. Generally, a well-diversified portfolio can be achieved with 5 to 10 ETFs. Here’s why:

1. Core and Satellite Approach
   The core and satellite approach is a popular strategy where you allocate the majority of your investments to core ETFs that cover broad market indices. Satellite ETFs then complement this core with targeted exposure to specific sectors, regions, or themes. This approach ensures a solid foundation while allowing for additional growth opportunities.

2. Asset Allocation
   A diversified portfolio typically includes ETFs across different asset classes, such as equities, bonds, and real estate. Within these asset classes, you might choose ETFs that track various indices or sectors. By limiting the number of ETFs, you can simplify asset allocation while maintaining adequate diversification.

3. Cost Considerations
   Each ETF comes with management fees, known as expense ratios. Holding a large number of ETFs can increase your overall costs. By focusing on a manageable number of high-quality ETFs, you can keep fees in check and potentially enhance your net returns.

4. Performance Tracking
   Monitoring and rebalancing a portfolio with numerous ETFs can be cumbersome. Fewer ETFs mean easier tracking of performance and simpler rebalancing processes. This efficiency is crucial for maintaining your desired asset allocation and ensuring that your portfolio remains aligned with your goals.

Benefits of ETF Investing
Investing in ETFs offers several advantages:

• Diversification: As mentioned, ETFs provide exposure to a wide range of assets, reducing the risk of any single security affecting your overall portfolio.
• Liquidity: ETFs trade on stock exchanges, making them highly liquid and easy to buy or sell at market prices.
• Transparency: ETFs disclose their holdings regularly, allowing investors to see exactly what assets they own.
• Cost-Effectiveness: ETFs generally have lower fees compared to actively managed funds, making them a cost-effective investment option.

Pitfalls to Avoid
While ETFs are a powerful investment tool, they are not without potential pitfalls:

• Over-Diversification: Holding too many ETFs can lead to over-diversification, where the incremental benefits of additional ETFs are minimal.
• Complexity: Managing a large number of ETFs can add complexity to your investment strategy, making it harder to track and rebalance your portfolio.
• Hidden Costs: Some ETFs have higher expense ratios or trading costs, which can erode returns over time.

Strategies for Selecting ETFs
When choosing ETFs, consider the following strategies:

1. Define Your Investment Goals
   Clearly outline your investment objectives, such as growth, income, or capital preservation. Your goals will guide your choice of ETFs.

2. Evaluate Expense Ratios
   Compare the expense ratios of different ETFs to ensure you are getting good value for your investment. Lower fees generally translate to better long-term performance.

3. Assess Liquidity
   Look at the trading volume and bid-ask spreads of ETFs to gauge their liquidity. Higher liquidity typically means lower trading costs.

4. Consider Tracking Error
   Tracking error measures how closely an ETF’s performance matches its benchmark index. Lower tracking error indicates better index tracking.

5. Diversify Across Asset Classes
   Ensure that your chosen ETFs cover a range of asset classes to achieve a balanced portfolio. This diversification can help manage risk and improve returns.

Practical Example: Building an ETF Portfolio
Let’s create a sample ETF portfolio with a focus on Australian and international markets. This portfolio includes a mix of core and satellite ETFs:

1. Core ETFs

   • Australian Broad Market ETF: Provides exposure to a wide range of Australian stocks.
   • International Broad Market ETF: Offers exposure to global equities, excluding Australia.

2. Satellite ETFs

   • Australian Sector-Specific ETF: Focuses on a particular sector, such as technology or healthcare.
   • International Regional ETF: Targets specific regions, such as emerging markets or developed Europe.

Monitoring and Rebalancing Your Portfolio
Regularly review your ETF portfolio to ensure it remains aligned with your investment goals. Rebalancing involves adjusting your holdings to maintain your desired asset allocation. This process helps manage risk and capitalize on market opportunities.

Conclusion
In summary, investing in ETFs can be a highly effective way to diversify and build a robust investment portfolio. While there is no one-size-fits-all answer to the number of ETFs you should hold, aiming for 5 to 10 well-chosen ETFs can offer a balance between diversification and simplicity. By carefully selecting and managing your ETFs, you can optimize your investment strategy and work towards achieving your financial goals.