By Michael McCarthy

Financial year end approaches rapidly. Despite the ongoing headlines of doom the Australian share market advanced pleasingly over 2016/17. An investor holding an index portfolio is up around 9% in capital terms, and has collected another 5.5% in dividends and franking credits. An annual return of 14.5% is credible in any environment let alone the current low growth and low interest rate environment.

Investors who achieved 14.5% or better on their share portfolios are likely pleased. However it’s frustrating to work hard on investing - reading the reports, examining the recommendations and implementing the strategy – only to receive lower returns than the “market portfolio”. One possible contributor to underperformance is the composition of the index itself.

Local investors face a particular challenge. The sectors of the Australian share market vary significantly in size. The financial sector is large and represents around 37% of the total value of the Australia 200 index. On the other hand, the Information Technology sector is much smaller, coming in at around 1%. This means Australian investors whose portfolios are broadly in line with the index, or who have passive share investments like index ETFs, are overweight financials and underweight IT in global terms.

This graph shows the sector weightings for the Australia 200 index alongside major global indices. 

Note how financials and materials stocks comprise half of the value of the ASX 200. The only other index with this large a sectoral skew is Hong Kong’s Hang Seng index. Comparing the Australian index to Germany’s DAX and the US S&P 500 and Nasdaq indices, there is an argument that it is severely underweight IT stocks, and underweight consumer related and healthcare stocks.

These sector skews are not necessarily a bad thing. Investors who want to overweight banks and miners may find an index investment alone is a good choice. However those holding substantial portfolio or fund index exposures not seeking this balance of sectors need to act.

What can investors do?

The central issue is the need to diversify across sectors. The best way to diversify depends very much on an individual investors existing holdings, so the right choice is specific to each situation. Nonetheless there are many suitable tools available to Australian investors.

Local choices

A simple response for those with existing portfolios is to re-weight across the sectors, going overweight under-represented sectors and underweight in financials and materials. The problem with this approach is the lack of enough suitable choices in the smaller sectors.

 Another possible approach is to invest a portion of capital in an actively managed fund. The style of the fund should diverge from the index. Suitable candidates include absolute return and value investor offerings. On a similar theme, ETF’s that offer sector, industry, commodity or geographic exposures could suit.

Direct investment in international share markets is an increasingly popular choice. Leveraged traders have dealt in CFDs over global giants such as Apple, Amazon, Barclays and Volkswagen for many years. Experienced investors who study the potential risks and benefits of these instruments also use them to shape the exposures of their portfolio.

Direct investment in international shares is also on the increase now that trading costs are more reasonable and service offerings are improving, admittedly from low levels. There are challenges here as well, particularly as Australian investors are used to registry or individual registration of shares, whereas many international markets operate with share custodians. Just like any other field of endeavour, investment markets reward hard work.