There’s not a lot to jump up and down about as a passive investor, which is why we tend to get over-excited around here whenever a new index tracker enables us to trim our costs by another 0.1%.
It’s rather like a retired detective deducing who ate all the cake at their kid’s birthday party. Our methods may seem extreme, but they help us to feel useful again.
The question is are we using a sledgehammer to crack a nut when we race to inform you that some tracker or another is now a smidgeon cheaper than last week?
Just how much do a fund’s costs need to fall before it’s worth selling out of the old and buying into the new and ever so slightly more efficient?
And should we bother to update the Slow & Steady Portfolio on account of cheaper funds? (Some readers think not).
Before we go on, investors who are new to the simple life of passive investing should avert their gaze now. You definitely do not have to go to these lengths to fine-tune your portfolio.
In fact, this piece is probably the most anal thing I’ve ever written.
It is strictly for hardcore investing life-hackers who are magnetically attracted to every infinitesimal advantage that crosses their path.
Numbers game
What we need to know is whether a new cut-price fund will make a worthwhile difference to our long-term investment prospects.
The numbers that matter:
- The cost of holding the fund – Take into account the Ongoing Charge Figure (OCF), any initial charges, capital gains tax consequences 1 and differences in dealing costs and platform fees.
- Fund worth – The bigger your holding, the more you gain from OCF clipping.
- Future contributions – See above.
- Investment time horizon – The more years you hold, the more cost reductions compound to your advantage.
- Return on investment – The bigger your pile, the more percentage fees like the OCF will cost you.
You can quickly use these factors to work out your savings with a fund cost comparison calculator. Let’s now use that calculator to rustle up a few illuminating examples of the impact of price pruning.
I’ll keep the numbers moderate so that it might represent the situation of a fairly typical small investor, rather than use a 40-year time horizon or similar to hammer home my point.
Example 1: Seeing the light
You get the biggest boost when the fee drop is pronounced, such as with a switch from active funds to passive funds.
Old fund OCF 1.5%
New fund OCF 0.5%
Fund worth £10,000
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund worth after 20 years cost savings:
Old fund = £62,676
New fund = £72,255
You gain £9,579 or 15.28%
That’s a lot of money that might as well be in your pocket rather than a fund manager’s. Especially when you scale that saving up across four or five funds in a portfolio.
Example 2: The Gillette switch
Now let’s look at a closer shave. The type you might make as a seasoned passive investor benefiting from tighter price competition in the tracker market.
Old fund OCF 0.5%
New fund OCF 0.25%
Fund worth £10,000
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund worth after 20 years cost savings:
Old fund = £72,255
New fund = £74,892
You gain £2,637 or 3.65%
I’ll take that. It’s still a fair wedge, even though it may be 20 years off.
Example 3: The salami slicer
What about the kind of 0.1% finessing that prompted the wholesale switching of our Slow & Steady passive portfolio back in 2012?
Old fund OCF 0.3%
New fund OCF 0.2%
Fund worth £10,000
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund worth after 20 years cost savings:
Old fund = £74,357
New fund = £75,432
You gain £1,075 or 1.45%
£1,000 eh? Well, I’d definitely snatch your hand off if you gave that to me now. But that’s actually the gain you’ll make in 20 years time.
Just how much is that worth now?
The present value of money
The time value of money is a concept that helps explain our natural intuition that money gained in the future is less valuable than cash in the hand right now.
We can estimate how much the future £1,075 gain from the last example is worth to us now by using a present value of money calculator.
If I assume the same 6% interest rate and 20-year stretch, then the calculator tells me the present value of £1,075 is £335.
Whether you’re prepared to get out of bed for that kind of money is a personal choice. I am.
Let’s say it takes five hours to research the new fund, take a decision, make the trades and track the changes. And let’s say I charge out my free time at £20 an hour. That means that any switch that delivers more than £100 today is worth my time.
Using a future value of money calculator it turns out that £100 today is worth £321 in 20 years time. So any switch that saves me over £321 in 20 years is worth the faff (given my assumptions above).
Sorry, I told you this was beardy. And I must repeat that none of this is compulsory!
Previously I’ve always compared funds using the fund cost comparison calculator to decide whether a switch was worth the hassle. But there’s something about blogging that forces you to don your white coat and make matters more scientific.
Just one last thing
Sadly there is another factor you need to think about before you go a-switching, which is the risk of being out of the market while the transaction takes place.
If you invest in index funds then you can be sitting in cash for a few days, after selling the old fund and while you’re waiting for your broker to stop playing on Facebook and buy your new fund.
If shares surge in the meantime then the transaction will cost you more than you bargained for, because your cash in limbo will not be invested and so will not track the gains.
How much might it set you back? Needless to say, that’s complicated, but the short answer is – if you’re very unlucky – it might actually do more damage than paying slightly higher ongoing fees.
It’s potentially worth considering ETFs over index funds from an instant trading perspective if the risk of being out of the market feels like a biggie to you.
Take it steady,
The Accumulator
- See ivanopinion’s excellent comment 41 below[↩]
Good reads from around the Web.
I have found a new website and it’s right up our street. Called Portfolio Charts, it’s dedicated to exploring asset allocation visually – and assuming all the maths is correct and the resultant graphs are accurate – it appears to be brilliant.
Now don’t get me wrong. I still think most people are best off not immersing themselves in the minutia of a dozen different asset allocations and wondering for six months whether the Coward’s Portfolio, the Merriman Ultimate, or the Golden Butterfly is the best allocation for them (or indeed whether they’re really finishing moves from Street Fighter III).
In truth, The Accumulator’s back of a blackboard graphs are about as spuriously precise as is required to overcome inertia and keep new investors focused on what matters.
But if you’ve been coming here for a while, there’s a good chance you’re not most people. And that while you know you should know better, you’ll also have plenty of fun clicking around the site looking at how adding 10% more Treasuries dampened volatility if you were power-shouldered 1980s New York executive buying stocks to fund a place in the Hamptons.
(Yes, it’s American of course. Perhaps that’s an advantage if it means we focus on the gist rather than the detail?)
Less risky but more rewarding
The latest post exploring whether an investor should go 100% equities is a good place to get started.
The author writes:
In investing, the concept of efficiency is most commonly discussed in terms of risk-adjusted returns. Basically, it’s all about trade-offs.
What are you willing to risk for your potential higher gain?
Sure you can invest in a portfolio with a higher average return, but with the trade-off that your odds of actually achieving that return with any certainty are much lower.
Portfolios that work towards good returns while minimizing downside risk tend to do quite well compared to pedal-to-the-metal portfolios.
Now that sounds great, but how is one to identify these magical portfolio unicorns with superior risk-adjusted returns to the stock market?
Surely they are quite rare, so why waste our time chasing the unattainable?
Here’s the thing — they’re not rare at all.
Then follows this graph, which goes straight into the Monevator Hall of Money Shots.
Source: PortfolioCharts.com
The square red box on the far left represents the performance of an all-stocks portfolio. The other symbols mark the same for a variety of lazy portfolios.
What this graphic shows is that over the period, adding other assets to your 100% stocks portfolio typically resulted in a less-steep worst year loss 1 while also tending to increase the minimum long-term annual compound returns your portfolio earned.
It doesn’t mean you won’t do better with 100% stocks – it doesn’t prove anything will happen in the future, because it is only a study of the past – but it does indicate very clearly that for long-term investors, diversifying assets has historically done the business on the basis of risk versus reward.
There’s plenty more where that came from over at Portfolio Charts.
- i.e. Maximum drawdown – the fall in the value of your portfolio from peak to trough.[↩]
I promised a quick update on how 2011’s demo high yield portfolio (HYP) was doing from an income perspective – having already cunningly posted the exciting capital value update on the slow news day of June 23rd.
Ahem.
Okay, so June 23rd – aka EU Referendum Day – turned out to not be so dull, after all. And we all got distracted for a few weeks.
But now I’m back to share the income picture, and to muse a bit about what it all means.
Loadsamoney
An ultra-quick recap: You’ll remember I invested £5,000 of my own real money into this demo HYP back in 2011, and that I’m benchmarking it against two alternatives – a FTSE 100 tracker and a trio of investment trusts.
Please refer back to my most recent capital update for more on the whys and wherefores, including links to a mini-FAQ all about HYPs, this demo, and the benchmarks.
Today, as I’m already ludicrously tardy with it, I just want to cut to the chase and get those income details up!
So here’s a snapshot of how the demo HYP and its benchmarks are doing, both in capital terms (updated since 23rd June, because why not?) and in terms of how they’re kicking out income.
I’ve also calculated yields for the portfolios.
| Current value | Income | Yield | Yield on purchase |
|
| Demo HYP | £5,896 | £231 | 3.9% | 4.6% |
| FTSE 100 ETF | £5,549 | £235 | 4.2% | 4.7% |
| Trio of trusts | £6,318 | £265 | 4.2% | 5.3% |
Note: ETF/Trust prices from Yahoo, dividends from iShares and the A.I.C..
A few things to note:
- The 12-month period being studied is from 11 May 2015 to 12 May 2016. 1
- All income rounded to nearest pound.
- For the demo HYP, I’ve simply totted up all the real-money dividends received.
- For the FTSE 100 ETF and the trio of investment trusts, I’ve sourced and totaled dividend data from relevant information providers, and then multiplied it by the number of shares in the notional benchmark portfolios.
- Capital values are up-to-date as of 28 July 2016. (Remember, these are NOT reinvesting portfolios – all income is presumed to be withdrawn each year).
- Yield is the income over the 12-month period expressed as a percentage of the current capital value.
- Yield on purchase tells us what we’re getting as a percentage of the initial £5,000 investments.
Here’s how the income has grown for each vehicle in the four years since my one-year update.
| Income: 2011-12 |
Income: 2015-16 |
Growth | |
| Demo HYP | £182 | £231 | 27% |
| FTSE 100 ETF | £155 | £235 | 52% |
| Trio of trusts | £184 | £265 | 44% |
Thoughts (or bonfire of the vanities)
The first thing to say is that all three portfolios have been doing the business, growing the income they pay out compared to the first full year of coverage.
That’s not surprising – we’ve seen several years of generally rising dividends – but it’s still heartening.
If you had invested in any of these options for investment income – whether for financial freedom or to help fund your retirement – I think you’d be pretty happy so far.
Of course, if you’d invested in the demo HYP and your next door neighbor had invested in the trio of investment trusts, then you might be somewhat less happy as you chat over the garden fence about shares, as we all do on those balmy summer evenings…
I’m a long time fan of UK equity income trusts. But I must admit that even I’m knocked back on my heels by just how well they’re doing here.
Both in capital terms and in the income they’re chucking out, our notional trio of trusts are soundly beating the two alternatives.
Now, like everything to do with this little side project we shouldn’t start claiming to be learning anything incredibly definitive here.
For one thing, five years is a short time.
For another, the trio of trusts is influenced by luck and any sliver of skill I brought to their selection.
There are dozens of trusts out there, and picking three different ones would have given you a different result.
For instance, the worst performing component of my basket of three trusts, Merchants Trust, is pretty much flat both in capital and income terms over the past five years, whereas the best, Edinburgh, is up over 50% in capital terms.
But it’s in the selection of 20 shares for the demo HYP that idiosyncratic risk looms largest.
And here I’m desperate to cry about bad luck – rather than blame my blundering incompetence – for the fact that no fewer than a fifth of the portfolio cut or even cancelled their dividends entirely at some point over the period.
BHP Billiton, Balfour Beatty, Centrica, and Tesco: Your names are mud to me now!
A fifth of the portfolio cutting their dividends is a terrible hit rate. You’d expect it to hurt the total income and it has, as the demo HYP doesn’t have any cash reserves to smooth payments like the income trusts do. (Cash buffers I’d suggest you implement for yourself if planning to live off investment income).
In fact, the dividend cuts mean the demo HYP last year paid out only £2 more than at the second anniversary point.
So what do I plan to do about it?
Nothing. This is a no-trading portfolio, remember, as explained in the links below.
Hopefully the income from the dividend dunces will be rebuilt. (Although I don’t doubt something else in the portfolio will be hacking and slashing at their payouts over time, too.)
Finally – and curiously – despite lagging in capital growth terms, the iShares FTSE 100 ETF has delivered the strongest income growth. Its annual payout now matches the demo HYP.
This is a surprising result, and perhaps indicative of the times we live in.
But with earnings no longer covering dividends at the 350 largest UK companies 2, it will be interesting to see how it and the other vehicles fare over the next few years.
Whatever the academic theory says, it’s hard for me not to imagine the trusts will continue to have the edge in an environment of further dividend cuts.
Demo HYP: Frequently Asked Questions
Here’s that pseudo-FAQ (it’s really a bunch of links to previous demo HYP articles) for those too engrossed to click away earlier, or who I’ve now confused into having more questions:
- What’s the trading strategy? (There’s no trading!)
Right – that’s enough HYP updates for this year!
I am sure we’ve all (at least around these rarefied parts) at some time asked ourselves: “Am I saving enough for retirement?”
For years, it’s been a boringly predictable question that has been used to frighten people into upping the amount that they put into their pensions.
Towards the end of every tax year, for instance, the usual scare-story projections are trotted out by lazy journalists looking to file a feature on SIPPs or Additional Voluntary Contributions.
IFAs – those fine, upstanding members of the community – are also keen advocates of the ‘are you saving enough for retirement’ question.
(You’re not? Well, they have just the product for you.)
Most Monevator readers, I’d guess, will have long since learned to switch off when they see the words. Broadly speaking, we will have decided years ago what level of saving was appropriate for our circumstances, and proceeded accordingly.
The savings vehicle of choice might have differed – one man’s SIPP is another woman’s ISA, and all that – but there would be no denying the commitment to serious saving and investing.
Miserly returns
Up until recently, I’d have put myself very firmly in that camp, too.
Now, I’m not so sure.
Take a look at the UK’s latest historic equity returns, as published in the prestigious Barclays Equity Gilt Study 2016, released in March.
Continuously published since 1956, the Barclays study tracks the real (after inflation) returns on cash, equities, and bonds, all the way back to 1899.
Here are the real returns (% per annum) for UK equities, gilts, and cash:
| 2015 | 10 years | 20 years | 50 years | 116 years | |
| Equities (shares) | -0.1 | 2.3 | 3.7 | 5.6 | 5.0 |
| Government bonds (gilts) | -0.6 | 3.0 | 4.3 | 2.9 | 1.3 |
| Cash | -0.7 | -1.1 | 0.9 | 1.4 | 0.8 |
Source: Barclays Capital Equity Gilt Study 2016.
No surprises there, perhaps. 2015 was a dud, and real returns from equities over the past ten years were just 2.3% a year. Only over the past 20 and 50 years do we see serious returns being achieved.
The only consolation is that cash and bonds didn’t do much better, either, although gilts have fractionally outperformed equities over ten and 20 years.
So much for the risk premium, Mr Ross Goobey 1.
Rear view vision
Now let’s turn the clock back ten years, and look at the 2006 edition of the Barclays Equity Gilt Study.
UK equity real returns (% per annum) as per a decade ago:
| 2005 | 10 years | 20 years | 50 years | 106 years | |
| Equities | 18.9 | 5.0 | 7.4 | 6.6 | 5.2 |
Source: Barclays Capital Equity Gilt Study 2005.
You don’t need to have made a recent visit to Specsavers to see the difference.
Ten years ago, the expectations of equity returns, based on past returns, were very different from those of today – and much, much, higher.
And that, what’s more, was in 2006 – in other words, a time when the UK’s stock markets were well into the post-dotcom ‘lost decade’.
Take the equity returns you’d have been looking at in 2005 as having been accrued over the previous 20 years, for instance: 7.4% a year. Incredibly, that’s twice the return of 3.7% seen in our latest figures.
The past ten years? 5.0% a year in 2005 – just over twice the return seen in the latest figures.
Flawed assumption?
All of which matters – at least to many Monevator readers – because the mid-2000s was when many of us were formulating our retirement plans.
Looking back at my own spreadsheets, for instance, I see that I was pumping £530 a month into various retirement-related investment vehicles, by way of regular monthly savings.
That’s net of any tax relief, and also excludes any end-of-year lump sum investments made for tax purposes.
Small beer to some, perhaps. But, totaling it all up, I was probably putting aside £9,000-£10,000 a year.
Again, small beer to some. But significant enough at the time, and especially so given my own circumstances, with one child still in primary school, and one just started in secondary school.
Save more! Save more!
The point is this: doing those same sort of calculations today, and looking at today’s expected investing returns, those Barclays Equity Gilt Study figures suggest that I would need to be putting aside considerably more.
And I’m not at all sure that would be possible, for someone at a similar stage of life, and with similar financial circumstances.
Heck, even though I’m in the fortunate position of being able to invest considerably more these days, it’s still a pinch at times – even though one child has left home, and the other is at university.
What to make of it all?
For me, the bottom line is that even though I was aware – on an intellectual level – that returns over the past few years had been lower, I was unprepared for how much lower they appear to have been.
Or that even though 2015 saw the FTSE 100 finally surpass its dotcom peak – some 15 years afterwards – the intervening years were so dismal as to still halve the long-term returns compared to 2006.
Am I saving enough for retirement? Possibly so. Just.
But I bet many others aren’t, even though they thought that they were.
Note: You might want read all Greybeard’s previous posts about deaccumulation and retirement.
- George Ross Goobey was the fund manager who in the late 1940s and 1950s famously persuaded pension funds to invest in equities, not just gilts.[↩]
Good reads from around the Web.
A big congratulations to fellow UK personal finance blogger and sometime Monevator contributor, Retirement Investing Today.
After years of saving hard and investing wisely, RIT – as he is known to his friends and to those with carpal tunnel syndrome – has achieved his goal of financial independence.
The recent stock market rally has pushed his portfolio to the £1,014,000. According to his sums, that makes work optional for the foreseeable future.
Somewhat ironically though, the weak pound that has helped lift his assets has arrived in concert with a host of other post-Brexit imponderables that have made that “foreseeable future” rather less foreseeable.
RIT writes:
You’d think we’d be out celebrating. But in the RIT household this week (and in the run up in recent weeks) there has been calm as I’ve actually been umming and ahing about whether I can actually call myself Financial Independent.
The main reason for this is that over the years I’ve diligently planned for just about every financial situation that I can think of.
However what in hindsight I’ve actually glossed over is the risk of politicians just blatantly changing the rules.
In the past few weeks we’ve seen some of this appear via the Brexit vote, which for somebody who intends to emigrate to an EU country as soon as they FIRE has brought real risk.
One impact is that in UK pound terms, the European-based property that RIT plans to sip fancy foreign beverages in until senility comes knocking is now more expensive.
The pounds thrown off by his investment portfolio won’t stretch as far when buying that booze on the continent, either. Nor his bread, his olives, nor his live-in maid and butler.
(Okay, they’re not in his plan. But if they were…)
RIT is also having to think again about his pension and healthcare entitlements in life after Brexit.
It’s yet another reminder that everything can turn on a dime, which for me makes micro-debates about whether 2.73% or 2.74% is a safe withdrawal rate in retirement rather moot.
Still, it’s great to have such options.
Tribal uncertainties
Brexit will sort itself out in time. Being free at 43-years old, RIT has plenty of that on his side.
And that’s the really inspiring part of his journey, for the likes of you and me.
If he can do it, can we?
Like me, RIT began blogging many years ago when there were barely any UK personal finance blogs around. If I recall correctly he started blind, before discovering how others had blazed a trail to financial independence before him.
When I began Monevator in 2007 I’d read some nascent US blogs – and a few influential financial forum posters – but my own journey to financial freedom was otherwise motivated by a personal epiphany.
You probably always need such a ‘lightbulb moment’ to get started.
But once you have begun, there are nowadays all sorts of sites to help and inspire you. I feature many in the links here every week.
Indeed, the Internet is abundant with role models.
- Will you do what a 25-year old friend of mine does, and follow a slew of fashion fanatics on Instagram, spend all your money (literally) on shoes and handbags, and then beg others for a pint so you can cry over your penurious plight?
- Will you work your fingers off and save nearly everything that’s left after food and rent or mortgage payments, in the style of RIT and my co-blogger The Accumulator? (Their patron saint and blogger Jacob also described his methods on Monevator).
- Will you be a bit slacker like yours truly – saving more than almost anyone you know, but still splashing out strategically on nice clothes, the odd overseas holiday, and making more effort to grow your income than to cut back on every last frothy coffee?
- Or will you (and the correct answer is “yes, this one!”) roll-your-own plan?
Your choice – but choose carefully.
US financial advisor Tony Isola wrote this week about the downsides of similar minds flocking together on the Internet, before asking:
[What] if we are genetically predisposed to join a tribe?
The answer is: find the right one!
I know I have.
Your tribe, like mine, should consist of people of high character.
Data and evidence should take precedence over emotion. The focus should be on what the tribe can control. Things beyond the tribe’s influence are rightly ignored.
Investment friction, like taxes and high-fee products, along with global diversification, are prime examples of the former; short-term market returns, the latter.
Finally, your tribe should think in probabilities and not certainties, which are non-existent in the markets.
Unfortunately most investors end up in tribes that spend their time throwing coconuts at each other, like our ancestral primates. They worship false investment gods and create cults of personality.
Deal with it; tribes are a major influence upon the choices we make. Joining the right one to manage your investments is a decision you should not take lightly.
With his blog – and the completion of his first goal – RIT has surely inspired many people climbing towards financial independence.
Not a bad tribe to belong to.
Still crazy after all of these years
RIT tends to update his blog on Saturdays – and often after I’ve done my Weekend Reading links.
This means he actually achieved financial independence a week ago. By now he might have spent it all on fast cars and even faster women!
It’s okay, stand down – I just checked and everything’s good. Rather than withdrawing his cash to head to a casino, RIT is predictably blogging about safe withdrawal rates.
Old habits die hard.
