Exchange-traded funds (ETFs) have gained significant popularity due to their flexibility, lower costs, and ease of trading. A specialised category within this space is the diversified ETF, which itself invests in a variety of other ETFs, providing an extra layer of diversification.

This method of investment contrasts with directly investing in the underlying ETFs that make up the portfolio of a diversified ETF.

Investing in a diversified ETF

A diversified ETF is essentially a fund of funds, meaning it holds a portfolio of other ETFs. This structure allows investors to gain exposure to a wide range of assets, markets, and investment strategies through a single investment vehicle.

Advantages of diversified ETFs:

1. Simplified diversification: Diversified ETFs enable investors to access a wide array of markets, including stocks, bonds , commodities, and real estate, among others, without the need to research and invest in each area individually.
2. Reduced volatility: By spreading investments across various asset classes, diversified ETFs typically reduce the overall volatility of the portfolio, as the performance of different asset classes can offset each other.
3. Professional allocation and rebalancing: These ETFs are managed by experienced professionals who are responsible for asset allocation and rebalancing, working to ensure the portfolio aligns with its investment objectives.
4. Reduced research time: Investors don't need to research and select individual ETFs, as this is managed by the diversified ETF.
5. Accessibility and convenience: They offer a convenient solution for investors looking for a diversified portfolio without the hassle of managing multiple investments.

Disadvantages of diversified ETFs:

1. Additional layer of fees: Investors in diversified ETFs bear the expense ratios of both the diversified ETF itself and the underlying ETFs. Even so, these are usually lower than those of actively managed mutual funds.
2. Limited customisation: Investors cannot adjust the individual holdings or the weightings of the underlying ETFs, making it difficult to tailor the investment to specific needs or preferences.
3. Potential for duplication: There could be overlap in holdings among the underlying ETFs, leading to inefficient diversification.
4. Market-driven price fluctuations: The trading price of diversified ETFs can be influenced by market demand and may deviate from the net asset value (NAV) of the underlying assets.

Investing directly in underlying ETFs (DIY)

Direct investment in underlying (or constituent) ETFs involves selecting and managing individual ETFs that make up the diversified ETF’s portfolio. This do-it-yourself approach allows investors to build a customised portfolio tailored to their specific investment goals and risk tolerance.

Advantages of direct investment in underlying ETFs

1. Lower costs: By investing directly, investors save on the additional layer of management fees associated with diversified ETFs
2. Flexibility: Investors have the flexibility to adjust the weightings or change the ETFs in their portfolio as they see fit.
3. Targeted investment strategies: Direct investment allows investors to handpick ETFs based on their investment strategy, such as focusing on certain sectors, regions, or asset classes that the investor believes will outperform.
4. Dynamic management: Investors have the ability to adjust their portfolio in response to market changes, economic developments, or changes in investment goals.
5. Transparency and control over risk: Investors have complete transparency and control over the risk and return profile of their portfolio, as they select each ETF individually.

Disadvantages of direct investment in underlying ETFs

1. Complexity and time investment: Managing a portfolio of multiple ETFs requires more time, effort, and investment knowledge compared to investing in a single diversified ETF.
2. Risk of under-diversification: There is a risk of under-diversification if the portfolio is not properly balanced or if too much emphasis is placed on certain sectors or asset classes.
3. Higher transaction costs: If frequently adjusting the portfolio, the transaction costs can be higher due to multiple trades.
4. Tax considerations: Directly managing a portfolio of ETFs might lead to less favourable tax implications, especially if frequent trades result in short-term capital gains. If tax issues are a consideration, always speak to a qualified tax professional.
5. Rebalancing requirements: Unlike a diversified ETF where rebalancing is managed by professionals, direct investors need to actively monitor and rebalance their portfolio to maintain the desired asset allocation.

Diversified ETF and DIY examples

Vanguard Diversified High Growth ETF (VDHG) and DIY examples

VDHG is Pearler's most popular diversified ETF, blending 90% growth with 10% defensive assets. It gives investors a taste of global markets, Aussie shares, and emerging areas.

The approximate composition is:

• 36% Australian shares
• 26.7% International shares
• 16% International hedged shares
• 6.6% International small cap shares
• 5% Emerging markets shares
• 7% Global aggregate bonds
• 3% Vanguard fixed interest fund
  

If you wanted to invest in this exact mix, you could either invest in this fund, or you could invest in the underlying funds:

• Vanguard Australian Shares (ASX:VAS): 36%
• Vanguard International Shares (ASX:VGS): 26.7%
• Vanguard International Shares (Hedged) (ASX:VGAD): 16%
• Vanguard International Small Companies (ASX:VISM): 6.6%
• Vanguard Emerging Markets (ASX:VGE): 5%
• Vanguard Global Aggregate Bond (ASX:VBND): 7%
• Vanguard Australian Fixed Interest Fund (ASX:VAF): 3%

Or, if you wanted the control of investing directly but wanted a simpler portfolio, two good options could be:

1. VAS and VGS: Pearler's two most popular Australian and Global share ETFs respectively. VAS gives you a slice of Australia's top 300 companies. VGS expands your reach to major international markets. This combo offers a balance between Aussie familiarity and global diversification in one neat portfolio.
2. A200, VTS & VEU: The lowest management fee option to invest in Australian and Global share ETFs. A200 provides a stake in Australia's top 200 firms. VTS dives into US stocks, and VEU provides broad international exposure minus the US (emerging markets). It's a mix of Aussie roots, US giants, and global variety.
   

If you wanted to go deeper into this particular comparison, here’s a thorough article by Passive Investing Australia .

BetaShares Ethical Diversified High Growth ETF (DZZF) and DIY examples

DZZF is Pearler's most popular ethical diversified ETF, and is as close as you can get to the ethical equivalent of VDHG. 90% growth and 10% defensive assets, but filtered for ESG criteria.

The approximate asset allocation is:

• Australian (ethical) equities: 35%
• International (ethical) equities: 55%
• Australian & International (ethical) bonds: 10%

As above, if you wanted to invest in this exact mix, you could either invest in this fund, or you could invest in the underlying funds:

• BetaShares Australian Sustainability Leaders ETF (FAIR): 35%
• BetaShares Global Sustainability Leaders ETF (ETHI): 55%
• BetaShares Sustainability Leaders Diversified Bond ETF - Currency Hedged (GBND): 10%
  

Or, if you wanted to invest directly with a similar asset allocation but optimise for even cheaper management fee ETFs, you could invest in IESG and IWLD which are the two lowest management fee options to invest in ethical Australian and Global share ETFs. They’re offered by iShares/BlackRock – another reputable ETF provider.

Conclusion

Investing in a diversified ETF can offer a hassle-free way to achieve broad diversification with professional management, making it potentially suitable for investors who prefer simplicity and ease of management. On the other hand, directly investing in the constituent ETFs of a diversified ETF can provide more control and potential cost savings but requires more effort, knowledge, and active management. The choice depends on the investor's commitment to portfolio management, investment knowledge, and specific financial goals.

Ultimately, if an investor wants granular control of their investment portfolio and is happy to invest the additional time and effort, directly investing in underlying ETFs is probably the most appropriate strategy.

If, on the other hand, the investor wants to streamline investment management as much as possible, diversified ETFs could be the right choice.

Competitive market returns can be achieved using both strategies. As always, what tends to have the most significant impact on your wealth is how much and how consistently you invest over the long-term.

If you’re interested in learning more about Diversified ETFs, check out this article: The ultimate guide to diversified ETFs for Australians

Happy investing!

Kurt