Ships are but boards, sailors but men.

There be land-rats and water-rats, water

thieves and land thieves, I mean pirates,

and then there is the peril of waters, winds and rocks.

Shakespeare, The Merchant of Venice

Equities have historically been the most reliable and effective wealth-generating asset class, and provide the main impetus – or centre of effort – for my current journey to financial independence.

The success of this journey relies heavily on equities continuing to provide, over the years and decades ahead, consistently high market returns on a risk-adjusted basis.

The financial independence portfolio is built on a passive index approach to Australian and global equities. This means investments in equity market index funds automatically occur in proportion to the market capitalisation of each company, sector and market.

Until recently, this led to benign neglect in the details of just what structurally made up the equity component of my portfolio. This neglect can no longer be justified – especially as the equities investments continue to make up around 70 per cent of the overall portfolio.

The exploration of the bond portfolio late last year has provided both an impetus and a model to better understand both the individual components and overall shape of the equity portfolio.

This longer read article explores the make up of Australian and global equities within the financial independence portfolio. It looks beneath the individual investment vehicles and analyses exactly how and where it is currently invested.

Here, in the equities area, the goal is to simply observe, rather than to identify areas for changes for future investment. In short, to understand broadly where the dollars in the equity portfolio are actually invested.

Short history of equities in the financial independence portfolio

Equities were the first part of the financial independence portfolio, and they have been its strongest focus over the entire journey. Whilst the first equity investments were in individual shares (e.g. Telstra, IAG), the focus quickly shifted from around 2000 to equity-based managed funds, and then in 2001 to Vanguard indexed retail funds with a significant equity component.

Across the journey the allocation to equities has averaged around 67 per cent. On an annual basis, it has stayed within a band of around 59 to 72 per cent of the portfolio since 2007, with the higher figure achieved earlier this year, and the lower figure reflecting a temporary elevation in value of Bitcoin holdings.

The equity portfolio has steadily grown from $99 000 in 2007 to just under $1.2 million in the middle of June 2020, as set out in Figure 1.

The overall trajectory of equity investments has been affected by two main decisions.

The first is a conscious targeting of higher equity allocations over time. This was the result of adjustment to the portfolio plan, with the most recent movement being to a target of 75 per cent equities in early 2019. This recognised the superior historical returns of equities over other asset classes, making it a cornerstone of the planned journey to financial independence.

The second is a rebalancing towards a mixture of 60 per cent Australian equities and 40 per cent international equities, a process which is now largely complete.

Progress through the course of last year saw the equity holdings in the portfolio reach and exceed $1.0 million for the first time, where it has so far remained. Recent falls have pushed equity holdings to just below the peak in the chart above.

Approach to reviewing the equities manifest

Despite representing the largest part of the overall financial independence portfolio, I have never previously conducted a full breakdown of what actually sits within the equity part of the portfolio.

The fact that the equity portfolio was invested in market capitalisation based indexed funds and exchange traded funds meant that I had confidence that its allocation at least approximately matched the relative sizes of major listed Australian and global equities.

From existing worksheets used for monthly portfolio updates a picture of the split between Australian and global equities emerges each month, enabling targeting of the 60/40 Australian and international shares split in the portfolio plan. Beyond that, I was aware of the the approximate weighting of the United States in market capitalisation based international funds and exchange traded funds – but little else.

Due to the number of different funds and exchange traded funds forming part of the portfolio, taking this analysis deeper involved the creation of new detailed spreadsheets, drawing on public allocation data from Vanguard and the underlying index benchmarks.

For simplicity, the analysis only includes the Vanguard retail funds (High Growth, Growth and Balanced) and exchange traded holdings (A200, VAS and VGS) – as these constitute around 98 per cent of equity holdings.

Ships are but boards: the structure of the equity portfolio

Conducting this review and looking beneath the labels to the underlying components of the index funds and individual exchange traded funds showed that the equity portfolio actually has just four major distinct indexed parts. These are:

1. Australian equities – with benchmarks of the ASX300 (for the exchange traded fund VAS) and an equivalent to the ASX200 (created by Betashares for the A200 ETF).
2. Global equities – with the benchmark of the MSCI World ex Australia index
3. Small market capitalisation global equities – using the MSCI World ex Australia Small Caps index.
4. Emerging market equities – with allocations benchmarked to the MSCI Emerging Markets index.

The figure below sets out the composition of the overall equity portfolio taking into account these component parts.

Each of these indices represents a widely diversified set of equity holdings. For the equity portfolio at any given time this means:

• A wide diversification within Australia – Australian equity holdings of around $700 000 are spread across around 300 domestically listed firms.
• With massive diversification added by international equities – Global equity of around $460 000 is invested in around 5 666 different listed global firms.
• Resulting in widely spread risks and returns – Overall equity holdings are diversified across nearly 6 000 individual listed firms.

This represents a broad level of diversification that can be expected to significantly reduce risk from company-specific or even sector-level events. It will also provide exposure to effectively every major – and many smaller – listed companies across both developed and emerging markets.

In the next section, the equity holdings are reviewed in more detail to answer the question: where precisely are the equities actually held, and in what?

The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages.

J M Keynes, The Economic Consequences of the Peace, 1920

With an understanding of the broad component parts, closer analysis of the actual detailed shape and nature of the equity portfolio is feasible.

Close to port: analysing the Australian equity portfolio

The Australian equity holdings – currently valued at approximately $700 000 – are held essentially in line with the ASX300 index, and with the sector weightings below.

From this it can be seen that the largest proportion of Australian equities – consistent with the index weightings – are held in Australian financial and banking companies, followed closely by listed firms in the materials sector (which includes mining, resources, and commodity-related manufacturing activities).

In fact, fully a quarter of Australian shareholdings – or nearly $200 000 – is invested in banks and other financials. Breaking the Australian equity holdings down by the value actually held as of June 2020 helps show the pattern of concentration more starkly.

A quick review of the top ten holdings of the ASX300 reinforces this picture of relative concentration. Through the equity index holdings, over $120 000 is held in the largest four Australian banks alone.

The largest single exposure through this index is CSL Limited – representing the equivalent of a single shareholding of $65 000 in the health care technology sector alone. Other major holding exposures include BHP Group ($40 000), Woolworths ($22 000) and Transurban Group ($17 000). The top ten holdings in this index represent around 43 per cent of the value of all Australian listed equities.

Circling the globe: reviewing the international equity portfolio 

The global equity portfolio current totals around $460 000, and its overall allocations are largely – though not wholly – driven by MSCI index weightings.

The limited differences that do arise are due to holdings in small companies and emerging market wholesale index funds that arise as parts of my diversified Vanguard retail funds.

The overall allocation of the global equity portfolio is set out below in Figure 5.

From this analysis some observations can be made:

• United States equities dominate all other foreign equity holdings – The majority of the global portfolio is invested in US listed securities, representing over 60 per cent, or $280 000 by portfolio value.
• Leaving all other developed economies behind – Beyond this the international exposure is highly fragmented across foreign markets, with the next largest being Japan (8 per cent and around $37 000) and the United Kingdom (4.3 per cent and $20 000).
• US exposure is, however, still slightly below market weighting – The small companies index holdings have the general effect of lowering US exposure below the MSCI world market capitalisation benchmark weighting, whilst increasing exposure to other developed economies, largely in Europe.
• With a relatively small exposure to China – The emerging markets index holdings pushes up exposure to China – to around 3.5 per cent of the global portfolio, or $15 000 – relative to what would otherwise be held.
• Diversification is truly global – There is broad investment across dozens of countries, with many smaller countries making up less than one per cent of the total international equity holdings.

An important benefit of international investing is increased diversification through exposure to different market sectors.

Weighing the balance of the global equity portfolio

To illustrate the diversification benefits of exposure to the range of sectors in the international portfolio, Figure 6 below sets out the current sector weightings of the global equity portfolio.

It can be immediately seen that this part of the portfolio brings with it better diversification across different market segments than the equivalent for Australia (See Figure 3). This means it can be expected to perform differently – and potentially more stably – across market cycles.

Notably, the global equity portfolio has a much higher exposure to technology and consumer discretionary and staples sectors, and a much lower materials and financials exposure than the Australian benchmark.

Examining the major holdings of the global equities portfolio turns up some interesting facts. For example, the financial independence portfolio collectively owns around $50 000 of global technology giants Apple, Google, Facebook and Microsoft.

Given the global exposure, the level of concentration within the top holdings and sectors is much lower than the Australian equities market. This is reflected in the actual sector holdings by value in the Figure 7 below.

In terms of concentration, the top ten holdings of the MSCI world index makes up less than 20 per cent of total market capitalisation of the index.

With nearly 1 600 firms in the MSCI index, supplemented by another 1 400 held through the emerging markets index, a myriad of known and unknown firms across the globe contribute to overall returns and risk reduction.

Hedging of the international equities

The international equity portfolio is largely unhedged – with effectively only around 30 cents in each dollar of value held being hedged back to Australian dollars. This means that the international portfolio can and does get affected by fluctuations in major currency movements, most particularly the relative values of the Australian and US dollars.

Having said this, the international portfolio has also been gradually acquired over a period of around 20 years, during periods of both low and high Australian dollars, which has had the overall impact of smoothing out temporary currency effects.

Counting the cargo: the equity portfolio reassembled

The analysis above has separated the domestic and global equity portfolio to provide a closer view of both.

The equity portfolio, however, operates as a single part of the overall financial portfolio and so any analysis should also examine the equity portfolio as whole.

The sector allocation of the entire equity allocation is – unsurprisingly and mathematically – just a weighted average of the Australian and global equity sector weighting (see Figure 8).

Another way to consider this same information is to identify the total actual dollar exposure to the sector categories, as set out below (Figure 9).

This shows that relatively high absolute amounts of the equity portfolio are invested in banking and financial firms – at around $250 000 – as well as companies involved in consumer products supplies and health care.

It also shows that exposure to technology companies is relatively low, at around 10 per cent of the equity portfolio and around 7 per cent of the total financial independence portfolio.

Winds and rocks – reflections on the equity portfolio 

This review of the equity portfolio has provided a way to better understand the true nature of risk and diversification across the core of the financial independence portfolio.

These were previously largely uncharted waters, with decisions being simply and automatically based on a ‘market capitalisation weight neutral’ (i.e. holding different equities strictly in proportion to their total market value) approach.

Yet this passive, and efficient, approach should not be a reason to shun real knowledge of the geographic, sectoral and company characteristics that it introduces into my equity holdings. Understanding the benchmarks and their fundamental natures and implementation helps fill out and give practical reality to the terms diversification and spreading of risk.

From the review a few useful points and key lessons have been reinforced. To summarise these:

• The ability to diversify equity investments at low cost is a modern wonder. It provides the power to harness the creative energies of thousands of workers, managers and companies across a myriad of different business environments, towards the goal of financial independence. This can be purchased for between 0.70c to $1.80 for every thousand dollars invested for Australian and international markets.
• Building on indexed Vanguard retail funds and exchange traded funds has led to a widely diversified equity portfolio. The equity portfolio is already well-diversified across around 50 different economies, a dozen or so major sectors, and around 6 000 individual companies. Use of these indexed funds has kept holdings tolerably close to actual world market capitalisation weightings.
• The targeted ‘home bias’ for Australian equities does introduce some concentration risks compared to a global portfolio. The Australian equity market is smaller, and has concentrations in some sectors that potentially introduce some greater risk, however, this can be managed and reduced by global exposure. This is further discussed here.
• As an indexed portfolio grows sizeable individual holdings are created. With investments in CSL Limited and individual Australian banks representing major holdings in their own right. Another example is a holding of approximately $8000 in Alphabet, the listed entity for Google.
• Diversification subtly entwines our investments and daily lives. As an example, within the global and Australian equity portfolio are represented almost every major publicly listed brand which my daily life brings me into contact with, from the daily groceries to even the passenger aircraft flown in regularly (at least until recently).
• There is psychological value in understanding risk exposures. Even where these exposures are the result of taking an efficient, market-neutral, passive approach to investing, comprehending the breadth of different exposures gives an appreciation of what diversification actually means.

So while both investing in equities – and especially global equities – inevitably involve encountering the perils of water, wind and rocks, this review helps to achieve a better focus on their important role in pushing the journey ahead to its destination.

Sources and further reading

Dimson, E., Marsh, P. and Stauton, M. Triumph of the Optimists: 101 Years of Global Investment Returns, 2002.

Mathews, T. Research Discussion Paper: A History of Australian Equities, Reserve Bank of Australia, June 2019.

Steinfort, R and Gray, A. The role of Australian equities and the impact of home country equity bias, Vanguard Research Paper, December 2012 (pdf).

Note

1. For the purposes of the analysis, VAS and A200 ETF holdings are treated as invested based on the weightings of the ASX300, which introduces some minor inaccuracy for the benefit of simplifying the analysis. For comparison, the effect of daily and weekly price movements of individual funds or ETFs on measurements are likely to introduce greater errors than this approach. 
2. The small equity holdings in Raiz and Spaceship, as well as small direct legacy holdings (Insurance Australia Group, NIB and Telstra) are excluded from this analysis, as they would increase complexity without materially altering the results.

Disclaimer

This article does not provide advice and is not a recommendation to invest in Australian or international equities, or any specific fund, share or exchange traded fund. Its sole purpose is to discuss equity investment issues relevant to my personal circumstances.