Buffett’s advice holds true, unless it's this one piece

Few things hold true in this world. Or specifically, the wonderful world of finance and investing. The first being that Warren Buffett is an extraordinary investor we can all learn a lot from. The second is that the ETF industry has evolved dramatically from its simple index origins and if you can dream it, an issuer can build it.

Buffett famously recommended that the average investor would be best putting their money in a simple index like the S&P 500 and leaving it to accrue and reinvest over many years. In fact, it is said that Buffett’s will stipulates that 90% of his money after death be invested in the S&P 500 and the remainder in government bonds. That’s commitment for you.

Kathleen Gallagher, head of SPDR ETF Australia at State Street Global Advisors, gives the example of an investor putting $10,000 into Australia’s first ETF, the SPDR S&P/ASX200 Fund (ASX: STW) when it first launched on 24 August 2001. Assuming all dividends were reinvested, that investment would have been worth $50,662 at the end of 2021, net of fees.

But does that mean there isn’t a place for the more sophisticated offerings of the ETF industry today? And is an investor best ignoring the more sophisticated products of today and sticking with the old faithfuls per Buffett’s suggestion?

To quote Kanish Chugh, head of distribution at GlobalX ETFs:

“We have the likes of Warren Buffett to thank for bringing index investing to the fore and creating a better understanding of how ETFs can be used in portfolios… However, as more products have come to the market, it has enabled investors to create more sophisticated portfolios.”

The evolution of the ETF industry – a quick history

When you bought your units of an ETF on the stock exchange, you were effectively buying into a managed fund that would physically have purchased all the companies on a specified market index, like the ASX200, weighted according to that index. Predominantly this weighting was by market capitalisation.

Over time, technology helped things get a bit fancier. Partial physical replication got a look in. This is where the ETF purchased the underlying index companies which best represented the index as a whole rather than buying the entire index. Synthetic replication started to appear using alternatives to purchasing companies to offer similar index returns.

Soon, more asset classes started to appear in the ETF remit.

All these traditional ETFs aimed to replicate the performance of an index for investors.

Traditional ETFs are often referred to as vanilla ETFs. While the term can be a bit disparaging, it really shouldn’t be. These have been and continue to be highly valid and reasonable investment exposures.

Then ETFs evolved further with a new aim.

Smart-beta ETFs wanted to largely replicate an index with a caveat – they wanted to do better in certain circumstances. Heading towards active territory but using set algorithms and rules to manage allocations.

For example, a smart beta ETF might also incorporate style factors like quality and volatility filters on top of a broad-based index with the aim of smoother returns in volatile periods. Or there might be dividend filters on the S&P/ASX 200 to create an income focus.

“The theory is that investing in factors can provide a more targeted approach to portfolio investing, and thereby enhance overall portfolio diversification” says Gallagher.

The point is that today’s ETF industry is quite vast compared to its humble beginnings. So, what’s an investor to do? Follow the Oracle of Omaha or jump into the wilderness? It’s not necessarily as simple a choice as it sounds, especially for an Australian investor.

To Buffett or not to Buffett?

Gallagher points out that despite concentration and other risks, broad-based indices have largely held up to shocks, such as the GFC or the COVID-19 pandemic. Buffett continues to be as relevant as ever. However, this is not to say Gallagher is recommending anyone put all their wealth in one ETF and leave it for the long term.

Cameron Gleeson, senior investment specialist at BetaShares, believes Australians need to consider our own market in its entirety.

“Warren’s argument may hold some water for US investors, but Australia’s equity and fixed income markets are far narrower than the opportunity set in US capital markets. This creates particular skews or biases within traditional broad-based indices,” he says.

To highlight this further, look at the sector breakdown of the S&P/ASX 200. It is clear that we are underweight compared to the globe when it comes to sectors like technology or utilities and heavily overweighted to financials and materials. What this means is that an Australian investor hopping in now could be missing some of the major market's driving returns going forward.

So does that mean we should be investing in the S&P 500 instead?

Well… that has problems in itself.

An Australian investor then needs to worry about foreign income and tax, currency and they might be missing out on that great perk of Australian shares – franking credits!

Both Gleeson and Chugh advocate a core-satellite portfolio of ETFs, rather than one holding.

“Our view is the best approach for building a core portfolio is to use a combination of low cost, broad-based index funds, complemented by low-cost smart-beta index funds,” says Gleeson.

Chugh also points out that for certain investors, using smart-beta variations on broad-based indices might be more sensible depending on their investment horizon, risk tolerance, and objectives. While the long-term gains on the S&P 500 can’t be sniffed at, if you need to draw down in volatile periods, you might be best looking elsewhere.

To put it in a nutshell, both Gleeson and Chugh are advocating you take the time to have your portfolio of ETFs, or otherwise, tailored to you rather than going with a one size fits all model. Sounds pretty reasonable to me.

If you want a starting point, I’d suggest you revisit this excellent piece by my colleague Ally Selby on the five ETFs you need in your portfolio.

Working a bit harder on that portfolio

You might be wondering now if this argument is saying Buffett’s advice on ETFs is wrong. It’s not. You really could do a lot worse than popping your money in a broad-based index-tracking ETF for the next 20 years. But an Australian investor should take that advice with a grain of salt. Our market is after all, different and popping your money in one index fails to account for your financial situation. Plus, there is something to that old adage about all your eggs in one basket.

So, rather than taking Buffett’s advice completely literally, here’s a way to look at it.

1. Vanilla or broad-based index tracking ETFs are still a highly valuable tool for exposure in your portfolio and you don’t need to avoid them just because they are more simple structures.
2. Diversification. Diversification. Diversification. Even Buffett has used more than one asset class in his alleged will – which to be fair, none of us has ever seen so may be considerably more detailed than the S&P 500 and government bonds.
3. Your portfolio is about you, so it needs to meet your needs and objectives. That might mean a combination of ETFs or other investments. Smart-beta investments have their place in a carefully constructed portfolio, just as broad-based indices do.

I like to think of Buffett’s recommendation as a springboard. It’s a great way for investors to start their journey, but it doesn’t need to be the whole journey. At least not for Australian investors anyway.

Planning on building out your ETF portfolio? Start your search here.

Want more content like this?

This is the first in a three-part series on ETFs featuring Kathleen Gallagher, Cameron Gleeson, and Kanish Chugh. You'll also be learning about where the ETF flows have headed in the current markets and the upcoming trends for the industry.

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