Optimal Portfolio Allocation between Australian and International Shares

In this blog post, we will explore the optimal allocation between Australian and international shares to minimize risk and maximize returns. We will specifically look at the historical returns of the managed fund versions of VAS and BGS, which are popular investment options for Australian investors.

About VAS and BGS

VAS and BGS are two ETFs that together provide exposure to all developed markets around the world. VAS represents the top 300 companies in Australia, while BGS represents 1500 companies across all developed markets excluding Australia. These ETFs have low expense ratios, making them attractive options for investors.

Historical Performance

Using historical data from the real returns of VAS and BGS, we can plot the performance between 2009 and 2019 using the efficient frontier method. The graph shows different portfolio allocations between VAS and BGS, with each dot representing a different allocation. The x-axis represents the standard deviation, which indicates risk, and the y-axis represents the mean, which indicates returns.

Based on the chart, international shares outperformed Australian shares between 2009 and 2019. A portfolio comprised of 100% international shares would have provided the highest returns, while a portfolio of 100% Australian shares would have provided the lowest returns and the highest risk. The optimal portfolio allocation that balances both risk and return is 55% international shares and 45% Australian shares.

When looking at a different time period, such as 1999-2009 and 1997-2022, the optimal portfolio allocation may vary. For example, in the 1999-2009 period, the optimal allocation is still 45% Australian shares and 55% international shares, but the Australian share market outperformed the international share market. Similarly, in the 1997-2022 period, Australia outperformed the international share market, and the optimal allocation shifted to 40% Australian shares and 60% international shares.

Research on Australian Share Market Performance

Research conducted by Credit Suisse between 1900 and 2018 supports the claim that the Australian share market has outperformed the rest of the world. However, this research did not consider the benefits of franking credits, which are tax offsets provided by Australian companies to Australian investors. When including franking credits in the analysis, the optimal allocation of Australian shares increases.

Morningstar has conducted an analysis that includes franking credits, and it confirms that the optimal allocation of Australian shares is around 45%. This finding strengthens the argument for a heavier allocation towards Australian shares, especially considering the tax advantages they offer. However, the optimal allocation may vary depending on an investor’s risk tolerance and life stage.

Factors to Consider

When determining your portfolio allocation, there are other factors to consider:

• Tax advantages and disadvantages: Investing heavily in the Australian share market may not be tax-efficient for high-income earners due to higher distribution yields and taxes. On the other hand, retirees can benefit from franking credits.
• Concentration risk: The Australian share market is highly concentrated in the financials and materials sectors, which can increase exposure to adverse events in those sectors.
• Cost of investing: While VAS has a low management fee, BGS is more expensive. Consider cost-efficient alternatives, such as the beta shares equivalent of A200 and the newly released BGEBL ETF, which offer similar exposures with lower fees.

In conclusion, an optimal portfolio allocation between VAS and BGS would be around 45% Australian shares and 55% international shares. However, it is important to consider individual factors such as tax advantages, concentration risk, and the cost of investing when determining the optimal allocation.

Extra 100 companies only make up around 3-4% of the total portfolio for VAs. It’s up to you to determine the portfolio allocation that suits you based on your circumstances. Hopefully, I provided insight and data to help you make an informed decision.