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Reasons to use active funds instead of passive funds for retirement income

The Greybeard is exploring post-retirement investing in modern Britain.

Now here’s a thing. Every time I launch into an explanation of how – and why – I’m transitioning my largest SIPP into an income-producing vehicle based around income-centric investment trusts, Monevator readers pop up in the comments box to tell me that I shouldn’t.

Better by far, they say, to opt for an income-focused passive ETF.

Available for a cost of just a few basis points, they argue, such ETFs are much cheaper than an open-ended fund or closed-end investment trust.

In vain does our esteemed proprietor, The Investor, try to turn the discussion back to the topic in hand – which last time round, was on the individual merits of some of the income-centric investment trusts that I’ve been considering.

But no: the relentless tide of passive ETF-huggers remorselessly advances its views, steamrollering everything – even The Investor – in its path.

Don’t take it passively

So why don’t I like income-focused passive ETFs?

It’s a fair question. So let’s start here: consider the following chart, highlighting the relative performance of two investments.

  • The blue line denotes Investment A
  • The orange line denotes Investment B.

GB-passive-index-crop

What we see is clear enough. Investment A initially outperforms Investment B from its late 2005 starting point, but then does much worse. By the time the stock market reached its nadir and started to climb back upwards, in March 2009, a significant gap had opened up between Investment A and Investment B.

And although the righthand y-axis has been excised in the interests of a cheap authorial dramatic trick, the difference in performance between the two investments at this point – as you’ll see in a moment – is equivalent to around 20 percentage points.

In fact, by March 2009 our holding in Investment A is something like 45% underwater.

Next, with a conjuror’s flourish, let’s attach the correct labels to our two investments, and also show the performance to date.

Investment A is the venerable iShares UK Dividend ETF (IUKD) – pretty much the first UK-focused passive income-centric ETF.

Investment B? The FTSE 100.

Now let’s take a look at the full chart, extended to take us up to the present:

MVT-GB-passive-index-full

IUKD is still underwater, almost ten years after its November 2005 launch, while the FTSE is up 23%.

The gap between the two is 25 percentage points – hardly a nominal tracking error.

Far from a rising income stream

From an income perspective, IUKD has also disappointed.

After a strong start, during which the ETF bought into a whole host of Icarus-emulating soon-to-be stock market dogs (think Royal Bank of Scotland, Lloyds, Northern Rock et al) income payments from IUKD plunged downwards just like the share price.

  • IUKD’s highest payout was in 2008, when it delivered 57p per share.
  • Last year, the 2014 distribution to shareholders was 41p per share.

In other words, six years later, income was still 28% below 2006’s distribution – and that was its best performance since 2008!

Here’s the full sorry tale:

IUKD-income-graph

That’s hardly the kind of steady income-generating performance that an income-seeking retiree wants.

Certainly not me.

Compare and contrast

For the sake of the uninitiated, I should stress again there are in contrast many UK equity income trusts with multiple decade histories of delivering a rising income.

For instance, here is the dividend payout record of one such fund, the City of London Investment Trust (Ticker: CTY):

city-of-london-dividendsRemember, this investment trust went through exactly the same bear market as the IUKD ETF – yet it managed to keep on raising its dividend throughout.

While that’s no guarantee it or any other income trust will always be able to perform as well – income-wise – when markets turn tricky, it seems a fairly convincing performance under fire.

Show me the proof

By now, it should be fairly clear why I prefer an actively-managed investment trust to at least one passive income-focused ETF – namely the original iShares UK Dividend ETF.

And yet, you might reasonably ask, why I am so insistent on generalising that disdain so as to include all passive income-focused ETFs?

Two reasons…

First, while there is a considerable body of (admittedly much-debated) argument and evidence as to the outperformance of passive products in terms of capital growth, I am aware of no such equivalent argument or evidence when it comes to income-focused passive products.

Let me repeat that: for income, there is no theoretical underpinning that says passive should be better.

Cheaper, yes.

But better—in terms of a larger and more sustainable income flow?

No.

Maybe you are aware of such a theoretical underpinning—and if so, please enlighten us all, via the comment box below.

In the meantime, it seems a dangerous generalisation to say that because passive products deliver the best capital performance, they will also deliver the best income performance.

They might, to be sure.

But – as far as I’m aware – there’s no a priori reason for assuming that they should. Unlike capital-focused passive products.

And that’s not all.

Computer say ‘buy’

To my mind, I find my second reason for distrusting one’s retirement to a passive product to be just as persuasive.

And it’s this: All passive products follow an index. In the case of income-focused ETFs, that index has to be constructed so as to offer a rising and sustainable dividend.

But how, exactly? The approach taken by IUKD didn’t work.

And while products tracking the FTSE UK Equity Income Index, the FTSE UK Dividend+ Index, or the S&P UK High Yield Dividend Aristocrats Index might be able to point to a different selection regime, it’s still all down to a computer rigidly following a laid-down formula based on what has worked in the past.

Rules that can be remarkably restrictive.

Follow the rules

Here’s the description of the FTSE UK Dividend+ Index, for instance:

“The FTSE UK Dividend+ Index selects the top 50 stocks by one‑year forecast dividend yield, and the constituents’ weightings within the index are determined by their dividend yield as opposed to market capitalisation.”

The S&P UK High Yield Dividend Aristocrats Index, meanwhile, measures:

“the performance of the 30 highest dividend‑yielding UK companies within the S&P Europe Broad Market Index, as determined in accordance with the Index methodology, that have followed a managed dividends policy of increasing or stable dividends for at least 10 consecutive years.”

Granted, there can be safety nets put in place, so as to avoid an over-concentration in a particular sector, for instance.

But that isn’t really the point.

The past is no guide to the future

The point is that a computer that is slavishly following an index will blindly buy and sell stocks in accordance with those index rules.

It will do this irrespective of future income prospects, because it only knows about past income performance.

So in theory, there’s nothing to repeat a re-occurrence of what happened with IUKD.

The individual circumstances might be different, but the computer will follow the rules just as precisely.

And as someone who wants to enjoy a comfortable retirement, I prefer forward-looking active income-focused management, to backwards-looking passive income optimism!

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{ 61 comments… add one }
  • 51 david m June 30, 2015, 4:28 pm

    EDIN 0.68% OC 0.09% PTC
    MRCH 0.62% 0.19%
    MYI 0.73% 0.02%
    CTY 0.44% 0.08%

    I have calculated annual Portfolio Turnover costs as Sales costs plus Purchase costs divided by opening net assets, e.g. from pages 46 and 38 of EDIN latest report.

    I find the overall historic record, e.g. EDIN page 3, more compelling.

  • 52 Passive Investor June 30, 2015, 4:38 pm

    @david m – that’s great news, I am happy to be corrected. Thanks!

  • 53 vanguardfan July 1, 2015, 9:09 am

    @Naeclue and returning to the question of whether it is desirable to have a steady income stream in retirement. For those of us used to a regular monthly income pre-retirement, I can say that many or most of my spending is arranged on a monthly basis. For the irregular bills, I put aside a regular amount each month so that there is a buffer.
    When living off drawdown, the key questions is ‘what IS my income for this year?’ and I would be interested to know how you (and others) make that decision. Do you take a fixed % of your portfolio? Do you take the same as last year’s spending plus some? How do you know how much you can spend? What does living within your means actually mean when you are living off accumulated wealth rather than earned income?
    I guess this is why the 4% rule and SWR in general attract so much angst. If you’ve got a large six figure sum sitting there, you have no idea how long it has to last you, just how to you reduce fear of running out, or even fear of missing out on spending you could afford?
    I can see that having a regular monthly pension would be far more relaxing than having to decide what you can afford to spend all the time.
    I can see how the world divides into those so fearful of spending they die with enormous almost accidental savings, and those who spend whatever money they have available to them (who I presume are fearful of missing out or of planning for a future which is inherently uncertain)

  • 54 david m July 2, 2015, 10:19 pm

    @vanguardfan

    I think those who have been careful with their spending in order to save and invest are more likely to continue to be careful and will not spend all their money.

    Points to consider:

    How do you currently decide what to spend from your employment income? Can you carry that forward to decide what to spend from your investment income/gains?

    What do your lifestyle preferences indicate: up, down or the same? Are there some exceptional one-offs to cover?

    You could use a safe withdrawal percentage (3.5% to 4.0%) uprated for inflation. I suggest this is not “set and forget” but is reviewed each year.

    Consider how you would increase or decrease spending in reaction to portfolio gains or losses in advance of them happening.

    You could use your portfolio’s natural yield, e.g. if it has a yield at or above the market (about 3.2%).

    Holding a cash reserve of two years spending would give extra comfort for when your portfolio suffers a market fall.

  • 55 Naeclue July 2, 2015, 11:45 pm

    @vanguardfan, in drawdown you can do exactly as you do now. The only difference is that the income stream is irregular. On a practical basis I like the Santander 123 account at present. It pays 3% interest on the first £20k, so I have no hesitation in keeping that well filled.

    The great thing about drawdown is you get to choose what your income is each year. The downside is that you have to be sensible. My income for this year is going to be very high because I need a new car and my wife has told me we need a new bathroom and some double glazed sash windows made from wood that supposedly lasts 50 years. Oh and expensive shutters because they are more fashionable than curtains. Next year is also going to be expensive as a new kitchen is required. In my accumulation years I would save up/budget for such things, but that makes no sense now as I already have the capital. Instead I have to consider the repercussions of spending and this is undoubtedly hard for people not used to having to think that way.

    I could smooth out the expenditure by taking out loans, just as people can do when they have insufficient capital for expenditure, but this is an expensive way of funding, aside from house purchase/mortgage. So effectively what I do is lend the money to myself to fund the expenditure, although I don’t really think of it like that.

    There are lots of different ways of managing personal finances and people have to find what is best for them. For some people that may involved smoothed out income from ITs to simulate/replace previously regular pay cheques and “saving up”, or even the continued use of loan finance if they really must do it that way.

    If you have been inefficient in handling personal finance whilst working, I suspect this will carry on into retirement. I have witnessed that financial efficiency is completely unrelated to income or academic achievement.

  • 56 PC July 3, 2015, 6:59 am

    @naeclue I’m with you. I see the chance to choose how much income to take in any year as a freedom.

    I’ve been self employed for the past 5 years and have got used to managing my finances that way. I’m intending to do much the same in retirement.

    I admit I’m lucky in that my irregular income more than covers our basic expenses, but still it’s not that hard to figure out how much you can afford to take as income.

  • 57 ivanopinion July 3, 2015, 6:41 pm

    At least part of the steady-dividend “magic” of ITs (perhaps all of it) is that, unlike most other collective investment funds, they are permitted to retain 15% of their income each year, which allows them to build buffers to smooth their dividends.

    It certainly seems to work well. Many of the UK equity income ITs have now had many decades of not just maintaining, but increasing, their dividend EVERY year. The best have managed this every year since 1967.
    http://www.theaic.co.uk/aic/news/press-releases/the-dividend-heroes-of-the-investment-company-sector

    I did look into this a while back and the dividends seem to increase at faster than the rate of inflation. So, these ITs are close to an index-linked annuity. Whilst they are without the same guarantee as an actual annuity, you get a higher yield, you get to keep your capital and you also get some capital growth (on average, over the long term).

  • 58 ivanopinion July 4, 2015, 10:35 am

    Someone raised an interesting point above, regarding whether investment trusts are looking good only because of survivorship bias. I guess we would need to know how many of them that have aimed for a steadily increasing dividend have failed.

    The AIC’s figures only seem to go back to 2012: http://www.theaic.co.uk/aic/news/press-releases/investment-company-dividend-heroes-0
    So, what we can tell is that of the 17 ITs originally highlighted, one of them, Albany, has fallen off the list in 4 years. However, AFAICT this is not because its dividend fell; it was taken over by Troy Income & Growth.

    (Interestingly, several of the others seem to have gained some extra years of their record. Murray Income was credited with 28 years in 2012, but this has increased to 41, only 4 years later. Scottish American up from 24 to 35. So, the AIC cocked up their 2012 figures.)

  • 59 Topman July 5, 2015, 8:02 pm

    @The Greybeard

    I can’t see where this Blog Post had been archived; I can find it via “Search” when I’m minded to look at it but I don’t see it under any of the headings e.g. “Investing”. Is it me at fault I wonder, or is it you?

  • 60 The Compounder May 20, 2016, 11:59 am

    I know I have come late to the party in this discussion, but I have far fewer income investment trusts in my portfolio due to the fact that the managers are financial illusionists. Firstly, the reason that many of these trusts have a long history of increasing dividend pay outs is because they’ll pay from capital. The other argument is that they can pay from income reserves accumulated during the goods times to “smooth income”. Fair enough, but it only smooths the income for the manager because they usually include cash in their NAV calculations, and thus they make you pay a management fee on the cash that they have decided, on your behalf, to keep tucked away under THEIR mattress.

    Think about it – it’s outrageous. The manager holds your cash, usually with pitiful interest being paid, when it should have been paid out to you years ago to do with it as you please, and to compound the interest. Not only do they impose an opportunity cost of not giving you your cash, they make you pay interest on it in the form of a management charge. It really sucks and I am getting so fed up with it.

    The only manager I can readily remember who excludes cash from their management fees are Aberforth, but I haven’t looked around for a while because I would prefer to just go with funds and ETFs. Yes, the income will fluctuate, but at least you can trust a computer not to treat you like an idiot!!

  • 61 ivanopinion May 20, 2016, 1:59 pm

    In reply to: “Firstly, the reason that many of these trusts have a long history of increasing dividend pay outs is because they’ll pay from capital.”

    As long as they do this sustainably, what’s the problem? If they were doing this at an unsustainable level over several decades, the chickens would, by now, be coming home to roost. In fact, most of the “dividend heroes” have also delivered good levels of capital growth.

    I agree it is a bit much to charge management fees on cash holdings, but there’s a limit on how much cash an IT can hold, so this is never going to be a big distortion in the fee.

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