Should you invest in short or long-term government bonds?

Should you invest in short or long-term government bonds? post image

This article about time horizon and asset allocation is by former hedge fund manager Lars Kroijer, an occasional contributor to Monevator. He also wrote Investing Demystified.

Previously we’ve discussed how you should choose the minimal risk asset that will form the bedrock of your portfolio. The short version: If you have high-rated government bonds available in your base currency, they will typically be the best choice.1

Today we will look at the time horizon of your minimal risk investment, what returns you can expect to make, and how best to buy it.

Match the time horizon

In most discussions about minimal risk investments, the assumption is you’re talking about short-term bonds. Longer-term bonds have greater interest risk (i.e. they fluctuate in value with changes in the interest rate), and it’s not clear that all investors need to take that risk.

Consider a one-month zero-coupon bond and a 10-year zero-coupon bond that both trade at 100. (Zero-coupon bonds are a particular kind that don’t pay interest, only the principal back at maturity).

Suppose market interest rates suddenly go from zero to 1%. What happens to the value of these bonds?

A table showing how short-term zero coupon bonds are not vulnerable to interest rate risk, compared to longer-dated equivalents.

As you can see, the one-month bond declines only a little in value to reflect the higher interest rate of 1%. This bond matures in just a month, and at that point the bond holder will be able to reinvest their principle at higher prevailing rates if they want to.

In contrast, the 10-year bond declines to a value of around 90.5 as it reflects the higher interest rate. Clearly something that can go from 100 to 90.5 fairly quickly is riskier – even if the probability that you will eventually be paid in full has not changed.

The time horizon for the vast majority of investors exceeds the maturity of a short-term bond, however. Also, someone who is interested in maintaining a position in the minimal risk asset for five years will be taking an interest rate risk over that five-year time horizon, whether they’re buying new three-month bonds every three months, or buying a five-year bond and holding it to maturity.

Finally, the situation is dynamic. If your time horizon is such that you think five-year bonds make sense, you shouldn’t necessarily just buy a five-year bond and hold it to maturity. A year hence, your bond would only have four years to maturity and therefore no longer match your time horizon.

The best way to address these issues is not for you to constantly buy and sell bonds to get the right maturity profile (in my example selling the now four-year bond and buying another five-year bond), but rather to invest in the bonds through a product like an ETF or investment fund that trades the bonds for you.

Such funds offer exposure such as ‘Germany 5–7 years (to maturity) government bonds’, ‘UK 10–12 year government bonds’, and so on. Buying one or a couple of these products to match your desired minimal risk asset and maturity profile is a cheap and easy way to ensure you always have your chosen minimal risk exposure.

Investors with a longer time horizon should buy longer-maturing minimal-risk bonds. As a reward for taking the interest rate risk associated with longer-term bonds, you’ll typically enjoy a higher return than you’ll get from short-term bonds.2

Go longer to reflect your investment horizon

If you need a product that will not lose money over the next year, then you can pick short-term bonds3 that match your profile.

However if – like most people – you want a product that will provide a secure investment further into the future, choose longer-term bonds and accept the attendant interest-rate risk.

Here you should consider the time horizon of your portfolio and select the maturity of your minimal risk bonds accordingly.

If you are matching needs far in the future (such as your retirement spending) then there is certainly merit in adding long-term bonds or even inflation-protected bonds to your portfolio.

Long-term bonds compensate investors for interest-rate risks by offering higher yields. You also have the further benefit of matching the timing of your assets and needs.

You can also mix the maturities of your minimal risk assets. You may have some assets that you won’t need for decades, and others you think will be needed in five to seven years, say. In that case, there is nothing wrong with picking a couple of different products with different maturities to match that profile.

What will the minimal risk bond earn you?

Even people with only a peripheral interest in finance know that interest rates are near historical lows. Nobody should expect to make a lot of money investing in the minimal risk asset in any currency right now.

In fact, with nominal interest rates near zero, inflation means that investors in short-term government bonds will experience negative real returns.

While your $100 invested in a government bond will almost certainly become $105 in five years’ time, the purchasing power of that $105 will be less than that of your $100 today. This is, of course, still better than if you had held the $100 under the proverbial mattress for five years – in that case the purchasing power would be even lower.

There’s not a lot you can do about this. If you are after securities with minimal risk then the yields are just very low at the moment. At the time of writing, cash with FSCS protection may be a better option for private investors, as we discussed last time. (Over the long term, returns from cash have historically been lower than from bonds, on a market wide view).

Elsewhere, instruments that offer much higher returns come with more risk of not getting paid. Anyone who tells you otherwise is not telling you the whole story.

A charting showing US Government Bond Yields and Real Yield

The chart above shows what US government bonds (so in $) will currently earn you, by maturity, both in real and nominal terms (you can easily find it for other currencies if you Google ‘£ Government bond yield curve’, and so on.).

You can see, for example, that if you buy a 20-year US government bond, you can expect to earn just under 1% real return per year . Likewise, for a five-year bond you can expect just over a zero percent real return per year. (Five-year US government bond returns yields have actually been negative for much of the recent past.)

While the outlook for generating very low-risk real returns is fairly limited at present, these are continuously moving markets. Keep an eye on them as rates change.

Nominal yields, real yields, inflation, and taxes: The previous chart also shows you the current market expectation for future inflation. (It’s the difference between the two lines.) If the markets are assuming there will be roughly 3% annual inflation in the US for the next 25 years but only around 2% for the next five years, this suggests higher inflation in the longer term. Inflation is bad for many things, one of which is tax. While the benefits you get from your investments are based on real returns and the future purchasing power of your money, you pay taxes on the nominal return. Suppose you invest $100 for a nominal return of 2% the following year. You could be liable for tax on your $2 gain, even if 2% annual inflation had eroded the real gain4. Compare that to a zero inflation rate environment. With a 0% nominal and real return, your $100 would still be $100, both in real terms and nominally, at the end of the year. And there would be no gains to be taxed on!

If the previous chart gave you the sense that the return you’ll get in any one year from owning US government bonds is stable, reconsider.

The next chart shows the annual return from holding very short-term (less than one year) and long-term (more than ten years) US bonds since around the Depression.

A chart showing Inflation adjusted US government bond returns since 1928

As you can see the annual returns move around a fair deal for both kinds of bonds – but far more for the long-term bonds. This is because such bonds will move in value much more as the interest or inflation rate fluctuates.5

Some takeaways from the two graphs:

  • Real return expectations from these minimal risk assets are currently near historic lows.
  • Returns from these minimal risk assets have fluctuated quite a bit, because of changes in inflation and real interest rates, and can reasonably be expected to do so in the future.
  • You can generally expect higher returns from investing in longer-dated bonds. If that matches your investment horizon, then hold your minimum risk bond portfolio through an ETF or index fund. But be prepared that particularly for longer-dated bonds, the yearly fluctuations in value can be significant.

Buying the minimal risk asset

Because of the costs involved in trading bonds, most investors in short-term bonds have to accept that in most cases the bonds in their portfolios will not be super short term6, and that you will be taking a little bit of interest rate risk as a result.

The most liquid short-term bond products like ETFs or index funds have average maturities of 1–3 years. The slight interest rate risk that comes from holding such bonds is a reasonable compromise between the theoretical minimal risk product and one we can actually buy in the real world.

For most investors with longer-term investment horizons, there are funds with different ranges of maturities like 5–7 years, 7–10 years, and so on, to suit your preferences.

How much of the minimal risk asset you should have in your portfolio and what maturities it should comprise depends on your circumstances and attitudes towards risk.

If you’re extremely risk averse, you might put your entire portfolio into short-term minimal risk assets, but you should not expect much in terms of returns. As you add more risk – mostly by adding equities – your potential returns will increase, and vice versa.

Varying the amount of minimal risk asset you hold in your portfolio adjusts the risk profile.

In the simplest scenario, where you only choose between the minimal risk asset and a broad equity portfolio, you could weigh the balance of those two according to the desired risk. The minimal risk bonds would have very little risk, whereas the equities would have the market risk. How much risk you want in your portfolio would be an allocation choice between the two (in a future post I will discuss adding corporate bonds).7

For some investors, putting 100% of their money in the minimal risk asset is their optimal portfolio. This would be appropriate if you are unwilling to take any risk whatsoever with your investments – and if you accept this means very low expected returns!


  • If your base currency has government bonds of the highest credit quality (£, $, €) then those should be your choice as the minimal risk asset.
  • If your base currency does not offer minimal risk alternatives, you have the choice of lower-rated domestic bonds where you take a credit risk, or higher-rated foreign ones where you take a currency risk. Keep in mind that any domestic default would probably happen at the same time as other problems in your portfolio, and your domestic currency would probably devalue. That would render foreign currency denominated bonds worth more in local currency terms.
  • If you want the lowest risk you should buy short-term bonds. If you have a longer investment horizon, then match the maturity of your minimal risk bond portfolio with your time horizon. You will have to accept interest rate risk, even if you avoid inflation risk by buying inflation-linked bonds.

Video on your low risk portfolio allocation

Here’s a video that recaps some the things I’ve discussed in this article. You will also find other relevant videos on my YouTube channel.

Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating any to medical research. He also wrote Confessions of a Hedge Fund Manager.

  1. Private investors may also want to consider cash as part or all of their minimal risk asset allocation. Please see my previous article for more details. This article will focus on the traditional minimal risk building block – high rated government bonds.
  2. There are cases where the yield curve is reversed and shorter-term bonds yield more than longer-term ones, but these cases are less frequent.
  3. Or cash. See the previous article on the minimal risk asset.
  4. i.e. The purchasing power a year hence would still be $100 in today’s money even if the nominal amount had become $102.
  5. The market view of credit worthiness will also have played a role.
  6. Imagine the scenario where you want to hold one-month government bonds. Tomorrow the bonds are no longer one-month to maturity, but 29 days. Is this ok? How about 2 days hence? How much you are willing for the maturity to deviate from exactly 30 days is up to you, but in reality there is a trading and administrative cost associated with trading bonds. It would simply not be feasible to stay at exactly 30 days to maturity at all times.
  7. Certain corporate bonds trade with lower risk premiums than many governments. The view is that these corporate bonds are lower credit risk than many governments – not hard to believe – and although they do not have the ability to print money, nor do governments in the eurozone. The reason I believe that you should not consider these bonds as the minimal risk asset is more practical. Compared to government bonds, the amount of corporate bonds outstanding for any one company is minuscule and you would probably not be able to trade them as cheaply and liquidly as government bonds.

from Monevator

Weekend reading: Some thoughts on the upcoming General Election

Weekend reading: Some thoughts on the upcoming General Election post image

Yes, this is the inevitable post on the upcoming General Election. I won’t mind at all if you skip to the links below.

Like most of you, I spent Easter wondering why there’s so little political debate in our lives these days. Such a cosy consensus! Everyone just getting on with the important things in life like laughing, cooking good food, dancing, comparing low-cost investment platforms, and curing cancer.

Thank goodness Theresa May divined again the mood of the nation and called a snap General Election.

Less than a week in and politics is already all we’ve heard about since. Which hardly makes a change from the past 10 months. (How I chortle when I think back to readers telling me the EU Referendum was old news and to move a week after the vote. One problem with people being newly engaged in politics is many of them don’t understand how it works. See also D. Trump.)

The months since the Brexit result have been interesting. While I can make my excuses for why the economy hasn’t missed a beat – specifically the delay in triggering our formal exit – the reality is I was wrong-footed by its ongoing strength. (I console myself that I at least had the flexibility to see that as early as September.)

Will my longer-term misgivings prove equally wide of the mark, too? Economically it will be hard to tell. I was never predicting doom – that’s a straw man, really – rather worse than we would have otherwise had. Socially and culturally, how bad things get may depend on how far politicians go in implementing the self-destructive Will Of The People.

As Brexit-fan Merryn-Somerset Webb writes in the FT this weekend [Search result]:

The rise of populist sentiment (which we can define as parts of the electorate asking for things that mainstream politicians think are both stupid and impossible) pretty much never leads to populist policies being implemented (they are often indeed stupid and impossible).

But it does have a long and useful history of changing the direction of mainstream politics.

Merryn deserves plaudits for being one of the Liberal (-ish) Elite who came out for Leave before the vote, and whose predictions to-date have been better than most.

She is also one of those who believe May called the election to strengthen her hand against the Brexit extremists in her own party. Get this done properly, Merryn argues, and we can have a fairly decent trade deal, fairly free movement of people (with tougher welfare caps), an acceptable exit bill, and the all-important regaining of parliamentary sovereignty.

I hope Merryn continues to be right. And the pound has already rallied on this sort of thinking, reversing some of the windfall gains I talked about when I suggested it might be time to investigate currency hedged ETFs back in January.

Deciphering the new doublespeak of politics

But whatever kind of Brexit we ultimately get, as I’ve said before I don’t think the ends – of which taking back full control of UK law was by far the most legitimate – will justify the means.

The dog whistle politics, the NHS bus boast, the telling people they can have what they can’t.

So even if people like me should be pleased the Prime Minister has called an election that could ultimately lead to a softer Brexit, the ratcheting up of the populist rhetoric in her speech is another black mark on the UK’s political record.

Savvier people than me are keeping tabs on this stuff. The New Statesman published an annotated transcript of May’s speech that dissected its Orwellian rhetoric before noting:

Sometime in the 17th century, Louis XIV is said to have told a gathering in Paris, “L’etat, c’est moi” – I am the nation.

Whether he ever actually uttered that phrase is disputed, but it sums up his unshakeable belief in the divine right of kings – that there was no difference between the interests of France and those of himself.

Well: today we learned that Theresa May feels exactly the same. To convince the world she has brought Britain together, she must find a way of dismissing those who disagree as somehow illegitimate. Opposing her is opposing Britain. Voting for anyone but the Tories is thus unpatriotic.

I wouldn’t mind so much, except she’s going to win in a landslide.

The theme was also taken up by Steven Poole in The Guardian. The author of the prescient book on deceptive language Unspeak wrote that:

May’s speech announcing the election was, paradoxically, profoundly anti-democratic.

“At this moment of enormous national significance, there should be unity here in Westminster, but instead there is division,” she complained. “The country is coming together, but Westminster is not.”

This rather charmingly combined a totally made-up fact (the country is coming together) with a bizarre whine that parliamentary democracy is functioning as it should.

Any persistent total unity in an elected assembly, after all, would signal that it had been hijacked by a fascist.

If there were no “division” in Westminster, we would find ourselves in a de facto one-party state, in which the wisdom of the dear leader is all – a vision of “strong leadership” at which Vladimir Putin would nod sagely.

Poole noted it’s a speech that Lenin would be proud of. Which makes the Daily Mail take ironic as well as depressing:

Daily Mail cover on May calling General Election 2017

When this cover went viral many people assumed it was a parody, which shows how far we’ve traveled (down) in a few months.

Panic the ballot box

This is supposed to be a General Election about a range of issues. But barring some kind of campaign trail gaffe it’s going to be Brexit, Brexit, Brexit.

Needless to say the Labour party opposition is so poor that even avowed floating voters like me despair. A tactical voting spreadsheet spread like wildfire across my left-leaning Liberal Elite echo chamber. It purported to explain how to vote to get the Tories out of power.

But I am torn. Labour are sort-of pro-Brexit anyway. I take Merryn Somerset-Webb’s point (also made by others, of course) and I’d ideally want a softer Brexit. Particularly when I see the likes of Jon Redwood posting on Twitter:


True, I could vote for the Liberal Democrats if I took this ‘second referendum’ at about-face value. But where I live my vote would be wasted. Meanwhile my local Labour MP is thankfully more New Labour than Corbyn’s Old Labour, I’m in a swing seat – and playing game theory with May’s secret motivations only gets me so far.

I have voted Conservative in the past (I’ve voted for all the main parties) but I have no appetite for a right-wing coronation right now.

Many people like me will  be playing this sort of mental Jenga in this election. Hardly ideal.

It’s not the economy, stupid

What are the personal finance and investing consequences?

I joked to a friend a couple of weeks ago that the Conservatives might have to call a General Election if their ‘no mainstream tax rises’ pledge proved crippling in the face of bad Brexit. I can’t help wondering if the fiasco over National Insurance in the recent Budget helped tip May’s hand towards the red button.

Some Tory hardliners are already panicking at the prospect of tax rises to come, but the reality is the pledge itself was a panicked move in the last election. Governments need to be able to adjust the tax base at the best of times, and the next few years are unlikely to be that.

But again, who really knows? Perhaps if the talks drag on for five years, the pound stays low-ish, and we stay in a fast-recovering EU for much longer than expected then the economy will continue to boom. Not much use if you’re a poorer Brexit-voter facing rising prices caused by the weak pound and a falling real income, true, but not so bad for the majority of Monevator readers.

No, much like the past year or so, the frontline of this battle will be fought on emotional territory, not economic matters – whatever people on either side of the fence may believe about their cold-headed analysis of the facts.

Divided we fall

I will admit that I’ve had to learn a few things in the post-EU Referendum climate. I thought I was ahead of the game in noticing how inequality was setting up fault lines in our society. However I underestimated the emotional divisions wrought – or at least brought out – by globalization.

In particular I hadn’t noticed what’s since been well-documented – to massively oversimplify the deep differences between those who believe that you should get up and go, and those who think we should stick to what we know and support those who do so.

Both impulses have their place in fashioning a society that works. But it was (and is) much easier for me to empathize with Claudia, an Eastern European immigrant and reader who despaired that having traveled to an unfamilar country to crowd into over-priced accommodation far from her job and a plane ride from her friends and family and now working long days at the sharp end of the service industry, she was being scapegoated as part of the problem by people who won’t move from one ex-industrial town to the next.

Claudia wrote:

I think we can agree that these relatively low-paid service jobs will not magically move up to Northern England after Brexit, hence the poor people there who were willing to vote out immigrants of the UK because they supposedly make everything worse, will actually have no gain out of the situation.

As somebody who left home for London and who has swapped careers/industries twice to keep myself moving forward, I’m still on the same page as her.

Yet months of reading has helped me understand better those who don’t like the direction that society is going. The people who are upset or alienated by the rate of change, the erosion of previous values, by too many unfamiliar voices or faces on their High Street, or by the opaque (if in my view concrete) benefits even to them of globalisation and integration.

The trouble is there’s not much to be done with this new understanding. I now see better that people can feel that way, but that still doesn’t make their argument logically correct as far as I’m concerned. And they would say the same about me.

I don’t believe Brexit can deliver what many of those people want deep in their hearts. It’s near-impossible, short of some new Dark Ages that reverses at the least technological progress and I doubt they’d really want that. Perhaps stopping immigration and erecting trade barriers would soften the blow emotionally (although not economically) but it probably still wouldn’t be enough.

Yet even in its softest form, Brexit will leave the other half like me unhappy.

It’s like we’re in a marriage where one partner has confessed to an affair and we’ve decided to make a go of staying together, but something has changed forever.

A landslide win could give Theresa May the mandate – and votes – to overwhelm the extremists on the fringes of her party and deliver some sort of workable Brexit.

But I am not quite sure what – except perhaps time, economic growth, more conversation, and perhaps more redistribution – can start to fix the deeper issues.

Note: I’ve been as temperate as I can in the article above – within the limits of being a writer who has to produce something vaguely readable. I think we’d all benefit if anyone who wants to comment below tries to do the same. Thanks!

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Product of the week: If you told people a decade ago that in 2017 you’d be able to get a mortgage charging just 0.89%, they’d have assumed we’d be living in a second Great Depression. With inflation over 2%, in real terms the bank is paying you to take its money! Yet as The Telegraph reports, that spectacularly negligible charge is exactly what’s being levied by Yorkshire Building Society. Catches abound: It’s a variable not fixed rate, you must have 65% equity in your home, there’s more than £1,500 in fees to pay, and also a 1% early exit penalty. (While I’m here, remember that super-cheap Atom Bank mortgage flagged up a fortnight ago that I said wouldn’t last? Well, it didn’t. It was withdrawn after just nine days! Be nimble if you can with these challenger banks).

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

  • Another big strike against active management – Morningstar
  • The world is running out of frontiers for the frontier index – Bloomberg
  • Swedroe: Top investment consulting firms fail to beat passives, too –

Active investing

  • The fearless market ignores perils ahead [Search result, deep dive on VIX]FT
  • Sure, US stocks are overvalued. Now what do you do? – Bloomberg
  • The government has almost finished selling its stake in Lloyds – ThisIsMoney
  • Look out for ‘Brexit stocks’ that could rise if the pound keeps rallying – Telegraph

Other stuff worth reading

  • Buy-to-let slump puts first time buyers in the driver’s seat – Guardian
  • How to get out of a Help to Buy home – ThisIsMoney
  • Terry Smith: The unique advantage of equity investment [Search result]FT
  • What happens when markets as we know them cease to exist? [Podcast]Bloomberg
  • HMRC is over-taxing some lump sum ‘pension freedom’ withdrawals – Telegraph
  • Put just £40 a week aside to enjoy a happy retirement – Guardian
  • A stark, bitter, and funny take on the absurdity of London for young people – Vice
  • Growth in unpaid internships raises fears over social mobility – Guardian
  • How the six-hour workday actually saves money – Bloomberg
  • Mentor people who aren’t like you – Harvard Business Review
  • First coal-free energy day in Britain since the industrial revolution – BBC
  • Time to be honest about the fears getting in your way – New York Times

Book of the week: The Book Essay feature in the Financial Times is an appropriately excellent read. It’s a wander through a topical subject via a few on-trend tomes. If you can scale the pay-wall [perhaps via this search result] then this week’s discussion on the intersection between the remorseless outsourcing of modern businesses and the dash for freedom by some of the self-employed is worth a read. The books highlighted include Down and Out in the New Economy by Ilana Gershon, The Amateur by Andy Merrifield, and Masters of Craft by Richard E. Ocejo.

Like these links? Subscribe to get them every week!

  1. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.

from Monevator

An income from ETFs in retirement (Part 2): Example portfolios

An income from ETFs in retirement (Part 2): Example portfolios post image

Here at Monevator, a frequent request is for a post on leveraging the low costs and in-built diversification of ETFs in order to generate an income in retirement.

And as the resident Monevator writer on all things retirement, it falls to me to respond.

In my previous article I explained why I thought that ETFs weren’t necessarily the proverbial answer to a maiden’s prayer when it came to generating an income in retirement.

In particular, I highlighted the lower yields from traditional total market ETFs, and the travails of the iShares’ FTSE UK Dividend Plus ETF (IUKD). To get the most out of this article, read that article first.

But I also undertook to present two example ETF portfolios.

The first portfolio would be drawn from the very biggest ETF providers. It would boast very low charges. It would aim to deliver a globally-diversified passive income, from equities and fixed income investments, of the same sort you’d expect to get from an alternative strategy such as a global investment trust or fund.

The second portfolio would shop for so-called ‘smart’ income-seeking ETFs – again with a global dimension – and deliberately aim for a diversified spread of ETFs and ETF providers. The strategy – through an element of diversification – would try to minimise the downsides of ETF algorithms blowing up, à la IUKD.

It’s a small world

In this article I’m going to focus on the first of these case studies, the passive market cap index tracking income portfolio. As a bonus, I’ve created not just one portfolio, but two.

That is, two takes on the same thing, but from two different providers. The two 800lb gorillas of the ETF world, in fact: iShares (once owned by Barclays, now part of BlackRock), and Vanguard.

Between them, these behemoths control 55% of the global ETF market. They have used their scale to drive down ETF costs.

One consequence is that while iShares and Vanguard are recording year-on-year net inflows into their funds, customers are deserting the smaller (and usually more expensive) players such as HSBC, Deutsche Bank, Lyxor, UBS, and Amundi.

Both Vanguard and iShares again cut some of their fees in December – in iShares’ case following hefty cuts to its so-called ‘Core’ range of low-cost ETFs in October. Each cut strengthens the theoretical appeal of ETFs to investors wanting a retirement income, by increasing the cost gulf between the actively-managed investment trusts I tend to favour, and passive ETFs.

There’s no reason why a private investor would need or want all their ETFs to come from one fund house, as I’ve done here. Indeed, it might even be considered a small notch up on the risk-o-meter, in that you’d have all your eggs in one basket in the very unlikely occurrence of one of these giants failing.

I’m doing it for comparative purposes. You can roll your own portfolios to suit.

A retirement income using Vanguard ETFs

Let’s start by building a passive portfolio using ETFs from Vanguard.

Owned by its customers rather than a third-party bank or other financial institution, Vanguard has – appropriately enough – been in the vanguard of the push to drive ETF costs down.

I’ve selected six low-cost vanilla ETFs, with a two-thirds equity and one-third fixed income split, as follows:

Ticker ETF OCF Yield
VUKE FTSE 100 UCITS ETF 0.09% 3.83%
VERX FTSE Developed Europe ex UK UCITS ETF 0.12% 2.81%
VAPX FTSE Developed Asia Pacific ex Japan UCITS ETF 0.22%  2.83%
VUSA S&P 500 UCITS ETF 0.07% 1.67%
VGOV U.K. Gilt UCITS ETF 0.12% 1.60%
VECP EUR Corporate Bond UCITS ETF 0.12% 0.38%

Source: Author’s search of provider data.

Clearly, one can play tunes with this.

  • As presented, Japan is missing. Vanguard does not yet appear to have an ETF embracing all of developed Asia Pacific including Japan, so investors wanting exposure to Japan could add Vanguard’s FTSE Japan UCITS ETF.
  • Emerging markets exposure? That would be Vanguard’s FTSE Emerging Markets UCITS ETF (VFEM, on an OCF of 0.25%).
  • The inclusion of Vanguard’s European-focused EUR Corporate Bond UCITS ETF? Simply because Vanguard presently has no UK-only (or even UK-mainly) corporate bond ETF offering.

Readers might also wonder why individual regional ETFs have been chosen, rather than Vanguard’s all-in-one solution, the company’s FTSE Developed World UCITS ETF. (This is denominated in dollars under the ticker VDEV, on a yield of 1.97%, and in pounds on a ticker of VEVE.)

The answer: cost. With an OCF of 0.18%, it’s a pricier option than Vanguard’s FTSE 100 UCITS ETF (0.09% OCF), FTSE Developed Europe ex UK UCITS ETF (0.12% OCF), and S&P 500 UCITS ETF (0.07%) products.

Remember that as with any other unhedged investments you make overseas, you face currency risk with foreign market tracking ETFs.

Currency risk simply describes how the fluctuating level of the pound versus other currencies will in turn cause both income and capital values to vary. This occurs irrespective of what currency your fund is denominated in (and to be clear it’s a factor with most investment trusts and other funds, too).

In general, the ETFs cited in this article and most commonly offered to UK investors are Irish-domiciled or UK-domiciled, rather than hailing from the United States.

Irish-domiciled or UK-domiciled ETFs will be most familiar to UK-based investors, but readers should note that there are circumstances where (according to what I’ve read—I’m no tax specialist) United States-domiciled ETFs are subject to a lower overall tax take.

A retirement income using iShares ETFs

Now, let’s now look at building a similar portfolio using ETFs from iShares. Here’s a similar table to the Vanguard table, in identical order, following the same logic of a regional equity focus, and a one-third allocation to fixed income.

Ticker ETF OCF Yield
ISF iShares Core FTSE 100 UCITS ETF 0.07% 3.86%
EUE iShares EURO STOXX 50 UCITS ETF 0.35% 3.36%
IPXJ iShares MSCI Pacific ex‑Japan UCITS ETF 0.60% 3.19%
IUSA iShares S&P 500 UCITS ETF 0.40% 1.35%
IGLT iShares Core UK Gilts UCITS ETF 0.20% 1.85%
SLXX iShares Core £ Corporate Bond UCITS ETF 0.20% 2.91%

Source: Author’s search of provider data.

As with the Vanguard portfolio, there are a few points to note, in addition to the broad principles laid out above.

Chief among these is that iShares’ touted low costs aren’t necessarily all that much use to income investors wanting an easy life, especially when ill or inform in old age. That’s because some of iShares’ lowest-cost ETF products—from its ‘Core’ range—aren’t available on an income-paying basis.

Instead, with the low-cost ‘Core’ range, the income is often (but not always) rolled up into the price – effectively turning them into what the investment fund world calls accumulation units, rather than income units.

iShares’ attractive-looking Core S&P 500 tracker, for instance, is available with an eye-catching OCF of just 0.07%, but if you want an actual income, you’ll have to either periodically sell some of your capital, or buy an iShares ETF under a different ticker that does offer income – in this case, iShares’ IUSA iShares S&P 500 UCITS ETF (not iShares Core S&P 500 UCITS ETF), which comes with a much heftier OCF of 0.40%.

So, in each case above – bearing in mind that this is an article focusing on an ETF-derived natural income in retirement – I’ve listed ETFs that actually do pay out an income.

Diehard ETF proponents of passive investing, of the persuasion that regularly appear in the comment sections on these articles, may not see periodic selling of ETF capital (at the market’s lows, as well as its highs, as required) in order to generate an income to be a problem.

Each to their own, but that strategy is obviously outside the scope of this article – and would render the table above incompatible with the Vanguard one I listed earlier for comparison purposes.

That said, should investors be interested in the ‘sell to create an income’ strategy, here are the ETFs in question:

Ticker ETF OCF
CSSX iShares Core EURO STOXX 50 UCITS ETF 0.10%
CPXJ iShares Core MSCI Pacific ex‑Japan UCITS ETF 0.20%
CPXJ iShares Core MSCI Pacific ex‑Japan UCITS ETF 0.07%

Source: Author’s search of provider data.

Passive ETFs in retirement: the bottom line

So what conclusions can we draw from this discussion?

To my mind, there are four:

  • The income to be expected from such a portfolio of passive ETFs is lower than that offered by leading income-centric investment trusts – but so too are the fees.
  • In the case of individual ETFs, it is possible to draw a more favourable comparison between ETFs and investment trusts: Vanguard’s FTSE 100 VUKE ETF, for instance, offers an almost identical yield to that of City of London Investment Trust (one of the lowest-priced on the market), but at a cost that is just one-fifth of City of London’s 0.43% OCF. That said, while their investment universes overlap, they are not identical.
  • ETFs aren’t as simple as is sometimes made out. Which geography or index to track, currency risk, and tax regime – even getting the right ticker – all serve to complicate life. (Investment trusts present some of these challenges too, and they usually won’t insulate you from say currency risk on your underlying holdings. But trust managers can do some of the work for you, and they can use their trust’s income reserves to smooth some of the ups and downs when it comes to the income you receive.)
  • Vanguard’s ETFs are more ‘income-friendly’ than iShares’ ETFs: for investors wanting income and low costs, Vanguard looks like the place to go.

In my next post I’ll see what a basket of Smart Beta-style ETFs might deliver for income seekers.

Note: Data variously sourced from Vanguard, iShares, Morningstar, the Financial Times, and Hargreaves Lansdown. Do catch up on all Greybeard’s previous posts about deaccumulation and retirement.

from Monevator

The Lifetime ISA

The Lifetime ISA post image

The ISA has long been an incredibly attractive way for UK investors to shield their investment income and capital gains from all taxes.

The annual contribution limit has risen over the years, too. From 6 April 2017 you’ve been able to sock away £20,000 a year.

Some or all of that allowance can now go into an Innovative Finance ISA. Similar to a cash ISA, this enables you to shelter the higher income you can get from peer-to-peer platforms from tax (although big boys Ratesetter and Zopa have yet to win approval for theirs).

The ISA has also become a weapon of redistribution, albeit one with a distinctly Tory slant.

First came the Help to Buy ISA, which tops-up the savings of first-time buyers. Help to Buy ISAs became available in late 2015.

And then 6 April 2017 saw the launch of the Lifetime ISA – also known as a ‘Lisa’.

The Lifetime ISA / Lisa enables young (and young-ish) people to save up to £4,000 every year into a special new ISA wrapper. This money is then boosted by the Government by 25%.

  • For example save the maximum £4,000 and they’ll give you £1,000. That would mean £5,000 went into your Lifetime ISA that year.

The money in your Lifetime ISA grows tax-free, as with normal ISAs. It can later be used to buy your first home or else be put towards retirement.

Here it is illustrated in one official government graphic:

(Click to enlarge your Lifetime ISA options!)

This graphic is actually a bit misleading. It implies the bonus is static, whereas the Treasury’s own documents make clear the bonus becomes part of your total Lifetime ISA pot that compounds over the years. Also, from April 2018 the bonus will be added monthly.

Anyway, free money growing safe from taxes sounds great, right?

Well, it might be, but complications abound with the deceptively simple Lifetime ISA and there are harsh penalties if you stray off-piste.

In this article we’ll dive into the detail of the Lifetime ISA. In a follow-up later this week I’ll look at who should make the Lifetime ISA a big part of their savings strategy, and who should probably not.

(Spoiler alert: I think everyone who can open a Lisa should do so, but in many cases with just the minimum contribution allowed. For example Hargreaves Lansdown will let you open one with just £100. This way you have it should your circumstances change, even after you’re too old to be allowed to open a new one).

The Lifetime ISA explained

Let’s run through the key points.

Opening a Lifetime ISA:

  • You must be aged between 18 and 39.
  • You must be a UK resident.1
  • You can only open one Lifetime ISA per person, per tax year.2

You can open a Lisa if you’re just one day shy of your 40th birthday (and as mentioned I think you should).

After that, computer says no.

How much can you put in?

  • You can save up to £4,000 a year into your Lifetime ISA(s).
  • Any cash you put in it before your 50th birthday will receive an added 25% bonus from the government.
  • The first government bonuses will be paid into your Lifetime ISA account in April 2018.
  • From then on bonuses will be paid monthly.
  • Once in your Lisa, the bonus earns interest (or can be invested) just like the money you contribute yourself. This nicely increases the total pot you’re compounding.
  • For the 2017-18 tax year only, you can transfer savings you’ve built up in a Help to Buy: ISA into a Lifetime ISA in that year and still save up to £4,000 into your Lifetime ISA and get the government bonus.3 See MoneySavingExpert for some ideas on timing.
  • You can save into a Lisa until the day before your 50th birthday. After that it can remain invested, but you can’t put new money in (and you’ll get no more bonuses).

The showstopper attraction then is you get an added £1 for every £4 you put into the Lifetime ISA per year, up to the £4,000 limit.

That’s much better than with a normal ISA, where you pay in taxed money and get no extra top-ups.

Indeed it’s free money – always the safest return.4 For the youngest Lifetime ISA savers, it could add up to tens of thousands of pounds of bonus payments over the decades (presuming the scheme survives.)

If you begin at age 18 and you save the full £4,000 a year, then at 50 you’d have saved £128,000 and enjoyed £32,000 of top-ups. (And that’s just the money that’s gone in, before any growth…)

There are no minimum or maximum monthly contributions to the Lifetime ISA. You should be able to save whatever you want each month, up to the £4,000 a year limit.

What about my other ISAs?

The larger £20,000 annual ISA limit applies across all your ISAs – Lifetime ISA, Help to Buy ISA, Innovative ISAs, and, um, Bog Standard ISAs.

For example, if you put the full £4,000 in a Lifetime ISA, you have £16,000 of your allowance leftover for the rest of the ISA gang that year.

How can I invest my Lifetime ISA money?

Qualifying investments for a Lifetime ISA are the same as for a normal ISA. Cash, shares, bonds, investment trusts, ETFs, funds – all should be fair game.

This means that unlike with a Help to Buy ISA (which is limited to cash) as a Lifetime ISA owner you can take your government-sourced money and pump prudently invest it into shares.

However there’s a snag. In theory, all those assets I listed can be held in a Lifetime ISA – but currently there are no cash Lifetime ISAs available.

This is a pretty strange state of affairs, and it won’t last if the Lifetime ISA survives.

In the meantime, if you are risk averse (perhaps because you think you’ll need the money in a few years for a house and you don’t want to risk the ups and downs of the stock market) you could perhaps open a Lifetime ISA that’s meant for shares, and invest your money and the bonus in a short-term bond ETF.

Or you could just wait for cash Lisas to become available.

How you can use your Lifetime ISA

At last the good bit! You can use the money in your Lifetime ISA in two different ways:

To buy your first home

  • Your savings and interest and the government bonus – all compounded together over the years – can be put towards a deposit on your first home. This property can cost up to £450,000, anywhere in the country.5
  • If you’re in a couple you can both receive the Lifetime ISA bonuses before buying together, as ISAs and top-ups are limited per person rather than per home. The maximum house price remains £450,000 for a couple, though.
  • If you have a Help to Buy ISA you can transfer those savings into your Lifetime ISA in 2017-18, or else continue with both. However you will only be able to use the bonus from ONE of these two kinds of special ISAs to buy a house, which could lead to fiddly complications or decisions down the line.

This last point begs the question of what else to do with your Lifetime ISA money if you don’t buy a house?

Aha! That brings us to the second permitted use…

Put it towards your retirement / later fund

  • After your 60th birthday you can take out any or all the savings in your Lifetime ISA, tax-free.

The official line is you will be able to leave the money invested if you want to after you’re 60. You should also be able to transfer your money to another type of ISA.

For example, perhaps Innovative Finance ISAs will be providing would-be retirees with a steady tax-free income and various safeguards in two decades time?

Frankly, who knows what the landscape will look like in 20 years. (Just one reason why constant government tinkering is unhelpful. It adds more uncertainty.)

Assuming the ISA regime survives until 2037 and beyond, I expect that when the first Lisa owners hit 60 there will be lots of options.

What if I don’t buy a house and I want the money before I’m 60?

Now we come to the big sting in the tail – the potential penalty charges.

You can withdraw your Lisa money without a charge if:

  • It’s to go towards your first home costing up to £450,000, and it’s been 12 months since you first started saving into the Lifetime ISA.
  • Or you’re over 60.
  • Or you’re terminally ill.

Otherwise, you face a penalty.

  • You will have to pay a withdrawal charge of 25% if you take out money at any time before you turn 60 (unless it’s to buy a qualifying house).

This charge is tougher than you might first think.

Some will see a 25% charge as simply clawing back the 25% Government bonus.

But this is not right. Here’s the maths:

Put in £4,000
Get £1,000 bonus (that is, a 25% boost).
You now have £5,000
Withdraw early, for non-permitted reasons
Take a 25% charge = 25% of £5,000 = £1,250
£5,000 – £1,250
= £3,750

You are left with less money than you put in! (6.25% less to be precise, which is the true penalty for withdrawing after taking into account the bonus).

This is a simplified example. There’s a 30-day cooling off period when you open a Lisa, and there will be no exit penalties charged in this first year. Over sensible time periods there’d hopefully be some growth in your money.

But the principle holds. You might find you have to withdraw money early – and the freedom to do so, even with a charge, is attractively flexible compared to a locked-up pension – but you really don’t want to if you can help it.

If you start a Lifetime ISA, you need to be as confident as possible that you will abide by the rules: Buy a first home with the money, or no withdrawals until 60.

Where can I get a Lifetime ISA?

Only a few providers are offering them so far. Right now Hargreaves Lansdown, Nutmeg, and The Share Centre. That’s your lot.

Seems odd, doesn’t it? Former chancellor George Osborne announced the Lifetime ISA back in the 2016 Budget. Plenty of time for platforms to get on-board – especially when they can dangle carrots of free cash from the government in front of savers.

Theories for the tardiness abound:

  • Perhaps the new HMRC reporting regime for Lifetime ISAs is proving onerous?
  • The first lump sum top-up from the government won’t be paid until the end of the year, so what’s the rush?

Then there’s my theory, which is that the Lifetime ISA is such a muddle that firms presumed it would be scrapped before launch. (A tad naive when it comes to finance, perhaps. When has confusion ever stayed the industry’s hand?)

Don’t get me wrong. The Lisa has its attractions. The initial pros and cons aren’t going to be hard for a typical Monevator reader to figure out.

However extrapolating them over an uncertain 10-30 year time horizon is harder.

Meanwhile the average young person is likely to be bamboozled from the outset.

Should you open a Lifetime ISA?

At first glance, the Lifetime ISA sounds like a Help to Buy ISA with a personality disorder, but that doesn’t mean it’s not worthy of close attention.

As it can only opened by those aged 18-to-under-40, it seems to be aimed at helping the finances (and winning the votes) of a younger generation that has seen job security, affordable housing, and generous final salary pensions disappear over the horizon.

Whether the Lifetime ISA is the best way to address wealth inequality across the generations is a topic for another day.

But if you’re young enough to qualify and you have money that you’re committed to locking away either to buy a home or for your retirement, you should give serious thought to opening a Lifetime ISA.

As I say I would definitely open one if I were under 40, even if it was only to put £100 into it. Once it’s opened, you have the option of using it once you’re over 40, and who knows how your circumstances might change? Don’t open it, and the door closes on your 40th birthday.

All that said, weighing up whether you should be directing money towards a pension (particularly a workplace pension with super valuable employer contributions), a Lifetime ISA, a Help to Buy ISA, a normal ISA, or some other form of savings will be complicated for many people.

Not least because the two uses permitted – buying a home when young, and saving for when you’re old – entail very different investing decisions.

And also because of that exit penalty, of course.

In the next post we’ll see exactly who the Lifetime ISA might be good for, and who should say “no thanks”, and back away slowly.

Note: I’ve updated this post with all the latest on the Lifetime ISA. Older comments below this post may date back to its launch. Many are still relevant, but keep that in mind.

  1. Or a member of the armed forces serving overseas, or their spouse or civil partner
  2. Each time you apply for a new Lifetime ISA you’ll need to meet those first two criteria. After your 40th birthday, no more new Lifetime ISAs for you! However you can continue to contribute to your existing ones until you’re 50.
  3. Alternatively you can keep saving into both schemes. However note you will only be able to use the bonus from one of the ISA types to buy a house!
  4. Okay, it’s not totally free as the government must get the money to top-up from somewhere, via taxes. But if you’re young it will probably be coming from taxing someone older.
  5. Unlike the Help to Buy ISA, which has different limits inside and outside of London.

from Monevator

Weekend reading: Invest every month, come what may, once more with feeling

Weekend reading: Invest every month, come what may, once more with feeling post image

Good reads from around the Web.

Often it feels like the best thing to do as a writer about investing is to repeat what you said last week.

In a Bloomberg podcast I link to below, the entertaining hosts bemoan how boring the markets are right now. That’s understandable – they’re both journalists, and they want to write about drama.

Nobody becomes a journalist to say “nothing doing here, as you were”. But that’s actually pretty good advice to live by when it comes to investing.

While The Accumulator continues to labour away on his book, I’ve republished some of his old articles to remind people what we’re missing. Frustratingly, TA has a habit of putting in useful contemporaneous snippets of data when he writes (whereas I try to wax eternal, like a Poundshop Marcus Aurelius). Many of his older pieces can’t just be dusted down and passed off as new. But more than a few can, because the best financial principles are timeless.

The alternative is to just keep saying the same thing, but to try and say it better each time. This is hard. Shakespeare’s 150-odd sonnets go over the same ground as doggedly as a Roomba, but they don’t really get better as you go on. And I’m no Shakespeare.

The third approach (and the motivation for these weekly roundups) is to see how other people approach the same topics, and to applaud them when they knock it out of the park.

Which brings me to Just Keep Buying, a piece this week from the Of Dollars and Data blog. It sees the anonymous author (hey, I already feel a kinship) approach the age-old topic of dollar-cost averaging with a mix of succinct prose and revealing graphics.

This is the best bit:

If I still haven’t convinced you [to just keep buying each month] let me tell you a story.

The story is about a man with possibly the worst luck in investing history. He made a total of 4 large stock purchases between 1973 and 2007. He bought in 1973 before a 48% decline in stocks, bought in 1987 before a 34% decline, bought in 2000 before the dot com crash, and bought in 2007 before the Great Recession.

Despite these 4 individual purchases that totaled a little less than $200,000, how did he do? He ended up with a $980,000 profit for a 9% annualized return.

What was his secret? He never sold.

I’d go and read the whole article if I were you.

Happy Easter! How I wish I could still eat all my chocolate eggs in one morning. Thank goodness they used marshmallows in that famous test, not Cadbury’s Caramels.

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Product of the week: The Telegraph reports that Atom Bank is back with more table-topping – and likely loss-leading – products. Last time Atom crashed its own App with the popularity of its market-beating savings bond. Now it’s offering five-year fixed rate mortgages at as little as 1.29% (with a £900 fee and a 40% deposit). Get ’em while they’re hungry! Outliers like this don’t stick around for long.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

  • The maths behind the futility of active investing – Bloomberg
  • FCA prepares for the march of the robo advisors [Search result]FT
  • Have US inflation-linked bonds (TIPS) delivered? [Deep dive]Morningstar
  • Simplicity is an under-rated virtue for older investors [Search result]FT

Active investing

A word from a broker

Other stuff worth reading

  • The elderly now paying tax on dividends [Why I long urged ‘pointless’ ISAs]Telegraph
  • Will London fall? [Superb layout]New York Times
  • Credit cards: Flexible friend or implacable foe? [Search result]FT
  • Student loan interest rate set to rise to 6.1% – BBC
  • You’ll wait a long time for a mammoth return from premium bonds [Search result]FT
  • Tax burden gap rises between higher and lower earners [Search result]FT
  • The ‘fix-perts’ explain how to repair seven common household items – Guardian
  • Could Brexit really affect Britain’s property market? – ThisIsMoney
  • Millennials forced to choose between a child and a career – Guardian
  • The utter uselessness of job interviews – New York Times
  • John Hamm would like to buy a time machine – Wealth Simple

Book of the week: According to wealth manager turned author Jonathan DeYoe: “Our relentless obsession with money and investing is ruining our happiness and causing bad financial outcomes.” If that resonates with you (and it might if you’re reading the small print of a financial blog, though it’s not really in my own interest to point that out!) then you could try his new book, Mindful Money. It’s only £6-something on Kindle, so not too much deep thought required.

Like these links? Subscribe to get them every week!

  1. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.

from Monevator

What’s wrong with dividends?

Photo of Todd Wenning

Skepticism is a valuable trait in an investor. This doesn’t mean you should always be pessimistic, but you should question the status quo. Skepticism helps you step outside trends of the day and take a more objective view.

I’m not, therefore, surprised that some thoughtful minds have criticized the surging popularity of dividend investing in recent years.

A fresh round of dividend criticism is a good thing. It is important for us to challenge our assumptions.

Dividend doubters

Some vocal dividend skeptics include Larry Swedroe of The BAM Alliance, who has called investor preference for dividends “irrational,” and financial journalist Matt Yglesias, who bluntly called dividends “evil.”

Ouch! As much as we might want to disregard such positions, these commentators and others in their camp make some fair points.

Here are my thoughts on the more popular criticisms of dividends.

1. Shareholders should applaud share buybacks

One argument voiced by the dividend doubters runs as follows: If you’ve invested in a company, you should not mind if it is buying back its shares instead of paying dividends.

Frankly, this is the anti-dividend crowd’s best argument.

In principle, by holding a stock you are implicitly saying you would buy the stock again today. Otherwise, you should sell the stock if you think the price is too high.

As such, you should not be upset with the company also repurchasing the stock at the current price.

To see why this is not a knockout punch to dividends, we need to recognize a few things:

  • Investors and capital allocators (managers) typically have different motivations
  • Investors are working with only public information; managers possess non-public information
  • Investors may reasonably decide to hold on to a slightly overvalued stock
  • A buyback made at a discount to a stock’s intrinsic value is a wealth transfer from selling shareholders to ongoing shareholders; the opposite is true if the stock is overvalued
  • A dividend has the same wealth transfer effect as a buyback made at fair value – it treats ongoing and selling shareholders equally

Ideally, management teams would follow a fair value discipline with buybacks, but they often have other, less attractive motivations.

These can include supporting earnings per share growth to meet broker estimates, to offset dilution (stock options and so on), or to manage firm leverage. A buyback, then, doesn’t necessarily signal anything about the company’s underlying value.

To be fair, if you suspect the management team is buying back stock primarily for these reasons, you might question why you own the stock in the first place.

Even so, a dividend investor should be perfectly content holding onto what he or she perceives to be a slightly overvalued share in a great company. This is because the odds that you’re right about the share’s fair value are much lower than the odds that you’ve correctly assessed the company’s quality.

I’d wager all of us – and this is certainly true for me – have sold a great dividend-paying company on short-term valuation concerns only to watch the stock (and its dividend) march onto higher gains in the years ahead.

In a perfect situation, we’d sell at a high price, the stock price would quickly correct, and we’d be more than willing to buy it back at a lower price. In practice, we know this isn’t typical. Either our valuation work was wrong, the stock continued to rise anyway, or we failed to seize on the opportunity to buy it back later.

Does this mean that management should follow the same logic and knowingly transfer wealth from ongoing to selling shareholders?

Absolutely not! If they have excess capital on the back of a good year and they feel their stock doesn’t present good value, they could retain the capital or pay a special dividend.

2. Dividends are depriving companies of value-enhancing capital

This statement is only true if you believe management could reinvest the ‘lost’ capital at high-rates of return.

First, it requires the company to have an abundance of high return projects. But mature companies that generate a lot of cash flow may not have enough high return projects available. I believe whatever capital the company can’t reinvest at attractive rates should be returned to shareholders.

Second, this statement requires a belief in management’s capital allocation skill. Fact is if all management teams were strong capital allocators, we wouldn’t see as many restructuring and impairment charges as we do.

Simple statistics would also suggest outstanding capital allocation skill is quite limited:

Standard Deviation chart

Statistically, almost nobody is Warren Buffett.

If we think about capital allocation skill of management teams across the market as a normal distribution (see the illustration above), we can conclude that only 5% of them are exceptionally skilled (two standard deviations above the mean). Another 27% are good allocators (between one and two deviations above the mean), 18% are fair-to-good, and the remaining 50% are sub-par.

The top 5% of management teams should be able to retain all of the company’s free cash flow to reinvest as they see fit. The odds are pretty good that this cohort could do more with the capital than we could.

For example, I’d put Berkshire Hathaway’s Warren Buffett and Charlie Munger in this camp – and as a Berkshire Hathaway shareholder myself, I presently have no issue with the company not paying a dividend for this very reason.

The other 95% of companies should pay varying levels of dividends to shareholders, either because they don’t have enough good reinvestment opportunities or they don’t have a strong investment mentality.

Many management teams rise through the ranks based on qualities (marketing, sales, operations, and so on) that may be of great value to the business, but this doesn’t necessarily mean they are great investors or capital allocators.

The presence of a progressive dividend policy (a stated goal of increasing or keeping the same level of dividends each year) can serve as a check on empire building by management. Capital rationing may actually be a net positive for some management teams who, being forced to work with less capital, allocate the remaining capital more efficiently than they would have with 100% cash flow retention.

In fact, I once heard it brilliantly argued (regrettably I forget by whom) that companies should distribute all free cash flow as dividends and then convince shareholders to give them the money back when they have an attractive investment opportunity.

It’s not practical, of course, but I agree with the logic.

3. You can create your own dividend by selling shares

It’s true that if you want to generate 4% cash from your investment, you can sell 4% of your shares and create a ‘dividend’. Shareholders are making the quasi-dividend decisions in this scenario, the thinking goes, and so companies are relieved of forming dividend policies.

The first problem with this philosophy is that it doesn’t adequately address the downside of the previous point.

You’re still entrusting management to reinvest all of its capital in value-enhancing projects or buying back its stock at good-to-fair prices. This is far from a sure thing.

Second, this DIY selling route may not be cost-effective for smaller investors.

Let’s say you have £10,000 invested in a share and you want to create a 4% dividend by selling £400 worth of the position each year. Unless your broker fees are less than £4 per trade, this trade would cost more than 1%.

Whilst broker fees are trending lower, there are not many brokers with share trading costs that low.

Finally, one of the attractive features of dividends is that you don’t need to make regular sell decisions (and rack up fresh trading costs with each sale) if you want an income.

The distribution of regular dividends frees investors from having to make unnecessary decisions in the first place.

An investor with a 20 share portfolio who wanted to create semiannual dividends would need to make 40 sale decisions each year. With quarterly dividends, the trades double to 80.

Given the heavy biases and emotions tied to sale decisions, there’s a good chance that you’d mishandle at least a few of those 40 to 80 sales.

4. Investor preference for dividends is illogical

Dividend critics often point to some behavioral biases that can occur with dividend investing.

These include mental accounting (treating income and capital returns differently), regret avoidance, and an inability to defer gratification.

For starters, I cannot think of a single investment strategy that wouldn’t come with a unique set of biases. To be human is to be biased. It is just a fact that we need to recognize and appreciate. The better we acknowledge these biases and consider them before taking actions, the better our outcomes will be over extended periods of time.

Moreover, while mental accounting has its downsides, anything that takes investors’ minds off short-term market price moves and instead focuses them on the prospects of the underlying businesses they own is a net positive.

Let’s say your stock portfolio was down 20% in a given year due mainly to a broader market sell-off rather than any big change in business fundamentals. To an investor focused solely on ‘total return’, this might easily result in panic and poor investment decisions.

If instead that same investor noticed their portfolio was now producing higher dividends than in the prior year – and that the dividend yield on their diminished capital was effectively higher, too – they could reasonably conclude that the underlying businesses are doing just fine. As a result, this investor could have better odds of staying calm in a challenging environment.

Regret avoidance speaks to an investor’s aversion to selling shares to create a dividend because they fear what would happen to the stock after they sold. If they sold 3% or 4% of their shares and the stock subsequently rallied, they would be upset with their decision. On the other hand, if they received a 3% or 4% dividend, they would consider the rally outside of their control.

I have no doubt this is true. As previously discussed though, I think investors likely benefit from not having to make too many decisions. Fewer and better decisions should be the mantra of all long-term investors.

Finally, in my experience speaking with and learning from other dividend investors, I can confidently say that an inability to delay gratification is not a common trait of the group. On the contrary, the hallmark of dividend investing is patience.

5. Dividends are not tax efficient

This depends on in which country you’re investing and where the company you own is based.

Much is written about dividends and taxation from a US perspective, but it’s important to realize that different countries around the world treat both income and capital gains in varying fashions.

The U.S., for example, has a ‘double taxation’ issue when it comes to dividends, whereby profits are taxed at the corporate level and then again at the individual level.

Some other countries, however, provide some tax credits to individuals receiving dividends that reduce or eliminate double taxation.

Further, the investor can mitigate the tax impact of dividends by holding dividend-paying shares in tax-efficient wrappers like ISAs and SIPPs in the UK, or IRAs in the US.

Dividend investors looking across the globe for investment ideas should take note of any tax withholding required by foreign governments. They should consider their country’s tax laws and treaties to determine the right type of account (tax-deferred or not) for their foreign dividend stocks.

I would agree with critics that it’s important to be mindful of any tax drag dividends might have on your returns. Many of the studies that show dividends accounting for the majority of long-term shareholder returns assume full dividend reinvestment and don’t take taxes or trading costs.

The smaller the percentage of the dividend you invest back into the share that paid it due to taxes, the less you realize of the share’s ‘total shareholder return’.

Wrapping it up

You’d be hard-pressed to find a successful investor who doesn’t appreciate the value of dividends. There’s also plenty of academic research supporting the role dividends play in long-term returns.

For example, the following graph indicates that higher-yielding shares have outperformed lower-yielders over the long-term:

Over the long-term, higher-yielding shares have delivered higher returns.

Source: Credit Suisse Equity Yearbook 2017

We dividend-minded investors shouldn’t rest easy. Markets, investor preferences, and corporate finance regularly change, and dividend investors must be prepared to address these changes anew with clear eyes.

With time, dividends will fall in and out of favour, but there’s nothing wrong with them in themselves. I believe they remain a long-term investor’s best friend.

Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.

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Weekend reading: The perversity of the Lifetime Allowance for pensions

Weekend reading: The perversity of the Lifetime Allowance for pensions post image

Good reads from around the Web.

Pensioners often seem as cosseted and fussed over by the government these days as pandas on the verge of getting it on in a panda sanctuary.

They’re a protected species, guarded by the pension triple-lock against the austerity that has hit other potentially vulnerable groups, and shielded from radical policies to, say, address the housing shortage that might turf sensitively coax 70-somethings and their cats from four-bedroom family homes that they can’t really afford.

That’s not to say many pensioners (perhaps including you 🙂 ) aren’t relatively poor despite a life of hard work, or that they haven’t done their bit, or that we should punish them for giving us Brexit.1

I just mean that when it comes to fueling the great engine of State – which most of us agree needs to be paid for – pensioners’ pennies have been kept away from the furnace. (Don’t get me started on the new Inheritance Tax rules that came in this week, although to be fair as I see it that as more of a perk for the beneficiaries).

We’ve even had the pension freedoms, which have given richer pensioners a sense of control akin to when they got their first Austin Allegros.

The 55% tax strikes back

Standing against this smorgasbord of delight for pensioners (and arguably would-be pensioners) is the ludicrous Lifetime Allowance, which former Pensions Minister Ros Altman lambasts in The Telegraph this week.

For those too young, impoverished, Ostrich-like, foreign, or accidentally reading this website to know, the Lifetime Allowance for pensions basically sees the Treasury taking your projected annual pension at the time you begin receiving it and multiplying it by 20. If the resultant sum is over the Lifetime Allowance – once £1.8 million, but reduced again this week to just £1 million today – you could see an effective tax charge as high as 55% on the excess. There are protections against this, but they’re a mind-bender.

Now, £1 million might seem a fortune to some of the frugalistas among you. But keep in mind it would currently buy an index-linked annuity paying merely £20,000 a year. It’s also easily breached by those on generous final salary schemes, such as those in the public sector.

Equally, the Lifetime Allowance is very hard to plan for if you’re younger and contributing to say a SIPP that’s invested in a bunch of index funds. If the market does well, you could end up being penalised for your years of extra cautious saving and diligent investing. Holidays you could have taken, restaurants you might have tried – all gone up in tax smoke.

The counterargument is that the State isn’t in the business of given people a richer retirement. That may be true, but surely Lifetime Contribution allowance – akin to the ISA allowances, and adjusted to take into account defined benefit schemes in the public sector – would be a fairer and less random system?

Because as things stand, as Altman points out, people are retiring early merely to avoid it – including some super-valuable workers that we might prefer to see carrying on into their 70s.

Altman writes:

If you are on course for a £50,000-a-year pension by the time you’re 60, you will know in advance that you will come in over the limit.

In these circumstances, it makes sense to retire before you reach that point, which you can do at any age from 55, and take a reduced pension (the earlier you retire, the lower the pension).

This lets you avoid hitting the Lifetime Allowance, because the new rules don’t take into account that this lower pension would be paid for more years. They ignore the fact that you would probably receive the same amount – or even more – over your lifetime. By taking the lower pension, you can avoid the draconian pension tax, and still get the same expected pension payments in the end.

This encourages GPs and senior workers to retire much younger than they otherwise might.

This was a new perspective for me. Indeed Altman makes a pretty convincing case that the Lifetime Allowance is doing few favours for anyone, including society at large.

Worth a read.

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

  • Young ‘savvy’ men trade the most, and see lower returns [Research]Science Direct
  • What we said when the world changed forever [PDF]Morgan Housel
  • 10-year index linked gilt yields at all-time low [Graph]Bond Vigilantes/Twitter
  • The difference between price and value – Todd Wenning
  • Global stock market valuation ratios [Interactive map]Star Capital
  • Active outperforming legend Joel Greenblatt does a talk for Google [Video]YouTube
  • The key to gauging the value of everything – The Value Perspective
  • Charlie Munger on handling mistakes – Novel Investor
  • Thinking about risk when you’re a seed investor – Medium

Other articles

  • The best hot spots for London commuters [Interactive tool]Totally Money
  • What I’ve learned about life – What I Learned On Wall Street
  • The point of money is to magnify you – Jane Hwangbo
  • Age makes you happier. And poorer – The Psy-Fi blog
  • The basics of basic (aka universal) income – John Kay
  • Kurzweil claims the singularity will happen by 2045 – Futurism
  • 23 things AIs can do better/faster/cheaper than you can – Seth Godin
  • Is [X] really the “new Internet”? – Stefano Bernadi
  • Diversification, adaptation, and stock market valuation [Long, says higher valuations might be justified in the era of easy passive investing]Philosophical Economics

Product of the week: The Lifetime ISA has made it to launch – much to the surprise of many who have pondered the thing. That’s not to say it has no attractive features for young savers. It’s more that it’s a complicated product that may well confound them. Get up to speed with ThisIsMoney and a Q&A from the FT [Search result]. I’m hoping to chip in (/away) on Tuesday, too.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.3

Passive investing

  • Swedroe: Benefits of alternative lending [Peer-to-peer etc. US but relevant]
  • Even the best stock pickers can’t beat the Smart Beta bots – Bloomberg

Active investing

  • Tesla’s story is even more attractive to investors than its cars – New York Times
  • Trading places: How DIY hedge funds became a thing – Wired
  • Larry Fink walks back talk of Blackrock’s shift to robot investing – CNBC

A word from a broker

  • The Lifetime ISA: A £1,000 a year gift from the government – Hargreaves Lansdown
  • The case for investing in UK small caps right now – TD Direct

Other stuff worth reading

  • How to identify bubbles [Podcast]Bloomberg
  • London faces a glut of new luxury homes [Search result]FT
  • New buy-to-let tax: How it works and how to beat it – Telegraph
  • How can I stop my boyfriend hoarding his lose change? – Guardian
  • £849k now, or £24k for life? Cashing in a gold-plated pension – ThisIsMoney
  • Deprived of the £155 state pension because of ‘contracting out’ – ThisIsMoney
  • Ritholz: Your brain wasn’t built to handle reality – Bloomberg
  • Brexiteer philosopher kings latest: War talk, the death penalty, political disintegration
  • Mark Carney urges The City to plan for no Brexit trade deal – BBC
  • Automation makes things cheaper so why does it hurt? – Harvard Business Review
  • The ungrateful refugee – Guardian

Book of the week: The low volatility or ‘low vol’ factor has been pretty popular in recent years, which made it expensive last time I looked. However this too will pass. To learn the underpinnings of the low volatility anomaly, try High Returns from Low Risk. Written by one of the pioneers of low volatility, it explains how lower risk stocks have contrarily beaten the riskiest ones by a claimed 18 times over the past 80 years. You’ll thus be ready to swoop for low vol when it comes off the boil! Although I guess by definition there won’t be any rush…

Like these links? Subscribe to get them every week!

  1. I fully know not all old people voted for Brexit by any means, and saw and met many wonderful and wrinkly Remainers on the march the other week. Just as not all Leavers are xenophobes. Etc etc.
  2. Remember you need to be FSCS protected with these so-called bonds for their safety to compare with UK government bonds.
  3. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.

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