This is guest post on spread betting tax avoidance strategies from Andy Richardson at Financial Spread Betting.

Before you find yourself packing your bags for an extended stay at Her Majesty’s pleasure, let us remind ourselves that tax avoidance (arranging your affairs so as to pay no more tax than is necessary) is legal whereas tax evasion (failing to pay tax that you actually owe) is definitely illegal.

Some people have argued that tax avoidance is a moral duty. And of course some tax avoidance schemes are state-sponsored – think about National Savings, Individual Savings Accounts (ISAs), and pensions.

If we treat tax avoidance as a legitimate pursuit (and you can make your own mind up about that) then how might spread betting be used as a vehicle for minimising tax liability – specifically avoiding capital gains tax (CGT) liability?

Let’s think about why spread betting is tax-free in the first place.

Why is spread betting tax-free?

The fact that spread betting proceeds are (usually) free from income tax and capital gains tax seems to rest on the fact that for most participants it is classed as gambling rather than investment.

(Editor’s note: How long this will last after the arrival of the potentially more mass-market Halifax Spread Trading service, we’ll have to see!)

With spread betting, you don’t invest in companies by buying shares. You merely make a bet with a bookmaker on whether you think a company’s share price will go up or down. The bookmakers (i.e. the spread betting companies) pay tax on their profits, but you don’t pay tax on your winnings.

So suppose the HMRC did make spread betting proceeds subject to tax. What do you think would happen?

It is said that HMRC would then have to let you offset your spread betting losses against other investment gains, which would be a net loser for the Exchequer because – as we all know – there are substantially more losers than winners in the spread betting game.

But measures can be taken to make spread betting safer.

The logical conclusion of this article is that it may be possible to run a tax-free spread betting portfolio as an alternative to a traditional investment portfolio. But this doesn’t help anyone facing a potential CGT bill due to crystallising a profit in their existing portfolio.

So let’s consider that first, after a quick reminder from Monevator‘s editor.

Wealth warning: While this article explains more sensible ways to spread bet, doing so is still more risky than buying traditional shares with cash – especially if you get your sums wrong! Spread betting on margin can rack up big losses quickly, and you can lose more money than you thought you were risking. This article is aimed at experienced traders and investors. We take no responsibility for your losses in any circumstances.

Hedging a potential capital gains tax liability with a spread bet

One of the features of spread betting is that it is just as easy to take a short position (i.e. bet on a falling price) as it is to take a long position.

This raises the possibility of offsetting an existing position – perhaps in a share you own in the traditional way, or even in a company Sharesave scheme – with a spread bet that neutralises any future fall in price, without you having to trigger a CGT liability by crystallising the profit in your initial portfolio.

Suppose you were lucky enough to ten-bag your shareholding in Penny Stock Corporation (not a real company!) so that your £10,000 investment has become £100,000. With the price so toppy, you want to take your money and run, without having to hand over a proportion of it to Her Majesty’s Revenue and Customs in the form of capital gains tax.

Rather than selling the shares, you might place an equivalent opposing ‘short’ spread bet on the same stock, to the effect that any subsequent fall in your traditional long position is offset exactly by the tax-free rise in the value of your short spread bet.

To help you get your head around this, let’s say Penny Stock Corporation is now priced at 1,000p-per-share (the company is no longer a ‘penny stock’ but at the time you bought it – before it ten-bagged – it was!).

1. A £100-per-point short spread bet should therefore exactly offset your ongoing £100,000 investment.

2. To effectively ‘insure’ the value of your investment in this way, the spread betting company will ask you to deposit a much smaller sum than £100,000 – but obviously you do need some spare cash with which to place the bet.

3. When the tax implications become more favourable, you can close all or part of your traditional long position and the matching short spread bet, so as to release your gains tax-free.

There are some other variations on this ‘hedging‘ theme, like closing a position in your traditional portfolio to fully utilise your annual CGT allowance at the end of the tax year, while at the same time taking out an equivalent long spread bet to ‘keep you in position’ tax-free until such time (after 30 days, according to the HMRC rules) that you can legitimately re-establish your original share holding.

You might even want to crystallise a loss in your traditional portfolio to offset another CGT gain, but to stay ‘in position’ via a spread bet in the same company, just in case the price of the loss-making share recovers.

Spread betting as an alternative to traditional investment

So much for minimising CGT events in your traditional portfolio – do you actually need a traditional portfolio?

There is little that is fundamentally different about holding equity positions in a spread betting account and holding shares in a traditional brokerage account.

• There is no limit to how long you can hold ‘rolling’ equity spread bets.

• You can collect dividends on those positions, albeit at a reduced rate.

• Just like in a traditional share dealing account, when the price of a stock goes up you make money .

• When the price goes down, you lose money.

Which begs the question: why bother with a traditional brokerage account when you could run your ‘investment’ portfolio in a spread betting account, tax-free?

For smaller accounts, this could make perfect sense, because a trader or investor with limited funds can get more bang for his trading buck due to the leveraged nature of spread betting.

You may be able to take a £10,000-equivalent position with a margin deposit of only £2,000, providing you have the balance held elsewhere (in case the spread betting company demands it) or providing you have a very tight risk-management policies using stop orders to limit your potential downside.

For larger account holders, it may not be so easy or advisable to squirrel away a substantial proportion of net worth in a spread betting account.

Still, it could provide a good home for surplus funds beyond the annual ISA and Self-Invested Personal Pension contribution limits, especially if your portfolio that you have sitting outside of these tax shelters seems likely to run up against the capital gains tax-free allowance any time soon.

There are some caveats, of course.

Whereas you pay a one-off dealing fee (plus stamp duty reserve tax) to open a traditional share holding position, a rolling spread bet incurs ongoing financing charges that are levied by the spread betting company in exchange for it ramping up your position size through leverage.

Therefore, your rolling spread bet positions are not so much owned as mortgaged.

For a long spread betting position held overnight, you will normally be charged financing at LIBOR (currently 0.5%) plus 2.5%.

i.e. At (0.5%.+ 2.5%)/365 days, you’d pay 0.008% for each day you held the position.

Of course, in the present low interest rate environment – with many companies trading at what some think are historically low valuations that could multi-bag in short order  – the financing charges could pay for themselves. It’s your call.

(Editor’s note: If you do not want to use leverage, but simply want the tax free benefits of spread betting, you can offset some or all of the financing charges by holding an equivalent cash balance in a high interest savings account. Whether it’s possible to match your costs with interest earned (after tax) will depend on prevailing interest rates at the time. Remember you’ll also need access to ready cash to meet any margins calls).

What about dividends? Well, although you receive dividend-equivalent adjustments on spread bets sooner than on traditional share holdings (i.e. at the ex-dividend date rather than a later payment date) those dividend adjustments are typically 80%-90% of the actual dividend. (For more on this, see the advantages and disadvantages article on my website).

Finally, spread bet positions in individual equities bestow no voting rights or other benefits upon the holders of those positions, unlike share holdings.

Remember: You don’t actually own the shares. You’ve simply made a bet with a bookmaker as to whether they will go up or down in price.

What about index tracking?

Many investors don’t buy individual shares at all, of course. They rely instead on index-tracking funds or exchange traded funds (ETFs) to simply follow the market up and down.

Spread betting may provide a more efficient way of doing this, because I’d argue that a spread bet on a stock index is far more transparent than the tracking errors and Total Expense Ratios (TER) associated with traditional index funds.

If the underlying index rises, your index spread bet position will rise by exactly the same amount, and likewise if it falls. There’s no obfuscated tracking error or TER to worry about –  just the simple bid-ask spread and the ongoing cost of financing your position.

In addition – and perhaps more importantly – tracking overseas markets or shares via spread betting eliminates currency risk. All your positions will be quoted in pounds sterling, as will your profits and losses.

Let’s suppose you’re trading the crude oil contract, which trades in USA dollars.

You opt to buy, staking £1 a point. If oil then rises 400 cents to $104, your profit is 400 times £1 or £400.

If you had bought a USA crude oil futures contract or an ETF, by contrast, your trade and profits would have been in USA dollars. So, if the dollar went down by 5% against the pound during your trade, your profit on oil would have transformed into a loss!

You will find a very wide range of domestic and international indices that you can spread bet, and best of all, the proceeds from this form of index tracking are currently CGT-free!

• Further reading: See my website for other ways to make intelligent spread bets.

Disclaimer: Due to the nature of this article it is important that we include a specific disclaimer. The author of this article is not a tax advisor or investment advisor, therefore you should treat the information given here as for educational purposes only and seek independent professional advice on matters of tax planning and investment.

Further reading:

1. Will Halifax take spread betting mainstream?
2. Shortsandlongs.com offering £300 if you switch your spread betting firm
3. Tax avoidance versus tax evasion

It’s hard to find friends of Facebook’s Initial Public Offering (IPO). Commentators are lining up to poke the social network’s prospects with a stick, and most aren’t hitting the like button.

From Reuters:

Here’s the thing about the big, honking 187-page prospectus Facebook filed late Wednesday. Once you dig past those headline numbers, the company itself ends up looking pretty unremarkable.

From Wall Street analysts:

Retired Neuberger Berman value investor and present CNBC commentator Gary Kaminsky observed that at similar multiples as Facebook, Google would be trading at $850 and Apple trading at $1250.

From CBS News:

At $5 per customer, Facebook is really bad at making money off its customer base.

And so on. Wearing my passive investor’s Helm of Much Smugness, I let the furore rage over my head. Whatever will be, will be – let the index decide.

But wait!

Facebook is going to be worth billions. It’s the pump primer for the tech bubble part II. Am I predestined to scoop up tons of the stuff as my tracker robotically swings into action, like an ASIMO sent to clean up a nuclear accident?

Most index trackers hold securities in proportion to their presence in the index that is followed by the fund. Give or take a few quirks in replication strategies it’s a financial game of Simon Says.

But what happens when an index tracker has to deal with big new IPOs?

Your exposure to Facebook

Any passive investor with a globally diversified portfolio is likely to hold an index tracker that covers the US market. How big a splashdown Facebook makes in your world will depend on:

• What index your tracker tracks.

• How the index admits new entrants.

• The size of the index.

• Your portfolio’s size and exposure to that tracker.

• Facebook’s market cap.¹

So how much Facebook action would a regular 60:40 equity/bond portfolio get, in raw moolah terms?

Here’s one possible calculation, assuming:

1. Portfolio size = $100,000
2. US equity allocation of 50% = 30% of a 60:40 portfolio
3. Facebook’s market cap = $100 billion = 0.5% of index being tracked

Then:

(Portfolio size) x (US equity exposure) x (index exposure) = Facebook held

Substituting in:

$100,000 x 0.3 x 0.005 = $150²

That’s equivalent to 0.15% of our notional $100,000 portfolio. I reckon I can stand that kind of punt on one of the planet’s best known brands.

Signing up

Facebook (Ticker: FB) won’t hit the New York Stock Exchange (NYSE) or NASDAQ for another three to four months.

Even then it’s not going to instantly pop into your index tracker in a puff of hype.

The indices will take some time to grind into action and admit Facebook into the ranks. How that affects you depends, as mentioned above, on the index you track and its rules on new members.

UK passive investors may well get their US exposure from one of the following:

Each index has its own brand method of carving up the investable US market.

Facebook’s impact upon a global index like MSCI World will be diluted by the fact that this benchmark monitors an investible universe worth $22.5 billion.

Facebook’s influence will be around twice as large in the well-known S&P 500 index that concentrates on US large cap companies worth over $11 billion.

Platinum membership: The S&P 500

If your index tracker follows the S&P 500, then you may well have to wait a while before you own a piece of Facebook. Google went public on August 25, 2004 but it didn’t gain entry to the S&P 500 until March 31, 2006.

Facebook only needs a market cap of $5 billion to get into the S&P 500, which is much less than its currently guesstimated valuation of $80-100 billion. But size alone is no passport to entry.

S&P 500 companies must also have a public float of 50%. That means half of the company’s shares must be tradable on a public exchange.

It’s thought only 5% of Facebook’s shares will be made publically available through the IPO. The rest will be controlled by management, employees, and early investors. Most are subject to various lock-ups.

Even when enough Facebook paper millionaires/billionaires cash out and start building rocket ships to Alpha Centauri, the final decision on entry is made by the S&P index selection committee. Its members stuff their pipe with a company’s financials, liquidity, and trading volume numbers, smoke it, and then make an announcement if the company gets in.

And even if a company has all the right chops, its industry sector mustn’t be over-subscribed and an existing member must be fit for elimination.

It all reminds me of the time I tried to get into the Gentleman’s Beefsteak Club.

Tufty Club membership: The S&P TMIX

In contrast, Facebook’s entry into the Vanguard US Equity Index fund is likely to be far swifter, because getting into its S&P Total Market Index (S&P TMIX) is about as tough as getting through the doors at McDonald’s.

The S&P TMIX offers exposure to large, mid, small, and micro cap companies that trade on the NYSE and NASDAQ.

In this case there is no:

• Minimum market cap
• Worries about the public float
• Bother with financial viability nonsense

The index is rebalanced quarterly, so it will only be a matter of weeks after Facebook’s IPO before it will be ushered into the S&P TMIX.

Facebook could be a relative lightweight

The weighting of Facebook in the indices may not match the heady $100 billion valuation being put on the company by the media, however.

Most indices – including the S&P 500 and S&P TMIX – calculate a company’s market cap using what is known as a ‘free-float methodology’.

The company’s share price is multiplied by the number of shares freely available in the market to determine its free-float market cap. It excludes shares sat on by company insiders, other public companies, and governments.

If only 5% of Facebook’s outstanding shares are made publicly available, then the impact on index trackers governed by the free-float methodology will be a fraction of the valuations hitting the headlines now.

Market impact costs

The mechanical responses of trackers to index changes make them easy pickings for hedge fund sharps and arbitrage bandits.

They lie in wait knowing exactly when a fat caravan of index trackers is coming down the road to buy and sell.

The arbitrageurs nip in first, driving up the prices of securities that the trackers must buy.

Worse, the tracker funds will have to sell the securities kicked out of the index (which the arbitrageurs have been furiously selling) and so they earn depressed prices on exit and pay inflated prices on entry.

When Berkshire Hathaway entered the S&P 500 in 2010, the price of its shares jumped almost 12% between the S&P’s announcement and the couple of weeks it took for the index trackers to make their move.

This index turnover cost is calculated by New York University Professor Antti Petajisto to equate to a drag on performance of 0.21-0.28% a year, between 1990 and 2005.

This isn’t a cost that would show up on any fee schedule, but would stealthily chip away at returns through tracking error. (Of course, a great many active funds are closet trackers enrobed in high fees, and so they suffer the same malaise).

You can avoid this problem with a synthetic ETF – mostly because it’s unlikely to hold any shares in the companies it notionally tracks – but then it may well be stuffed with Japanese small-caps, so you really need to know what you’re jumping into bed with.

Poke me, I must be dreaming

Of course, we’ll all be smiling if Facebook turns into the next Google.

And even if it doesn’t, the ponderous reflexes of index trackers will at least help passive investors avoid a Day One bloody nose if the internet giant, like so many IPOs, dives like a paper dart.

Take it steady,

The Accumulator

1. Most indices are weighted by market cap so that individual companies impact the index in proportion to their size. So a company that makes up 10% of the index will move the value of the index by 1% if its own share price moves by 10%.
2. Approximately £95.

Further reading:

1. How index trackers work
2. Index trackers: The good, the bad, and the ugly
3. Exchange Traded Notes and Certificates: The scary face of index trackers

Important: This article is not a recommendation to buy or sell shares in Aberforth Smaller Companies Trust. I am a private investor, storing and sharing my notes. Please read my disclaimer.

Name: Aberforth Smaller Companies Trust
Ticker: ASL
Business: Investment trust
More: Trustnet / Google Finance
Official site: Aberforth Smaller Companies

Many active stock pickers spend their days trawling in the lower reaches of the index, searching for small cap bargains to boost their returns.

As we’ve written many times on Monevator, most of these would-be Mini Buffetts will fail to beat the index. Stock picking is immensely hard (although that doesn’t stop me trying it). Most readers will be better off with index funds.

However UK investors looking to hang up their small cap Geiger counters face a stiffer challenge than mere self-awareness.

Whereas lucky US investors can choose from small cap index funds and value-based ETFs galore, here in Britain it’s like shopping for bread in Soviet Moscow during a farmer’s strike. Blindfolded.

Recent developments haven’t really helped matters. My co-blogger The Accumulator rejected Credit Suisse’s CUKS ETF as an expensive-ish mid cap tracker disguised as a small company affair, and the RBS Hoare Govett Smaller Company tracker got the thumbs down for being a synthetic exchange traded note (ETN) that suffers from a lack of transparency.

So whether you’re a small cap sniffer-outer tired of the game or a passive investor looking to bolt-on value via the little companies, what are you to do?

Enter the Aberforth Smaller Companies Trust

I’ve several times suggested that readers, friends – and The Accumulator for that matter – do some research into the Aberforth Smaller Companies Trust (ASCoT), to see if it can plug this gap in their portfolios.

As Aberforth reported its full-year results to December 31 this week, I thought I’d offer a quick summary here, too.

Now let me be very clear – this is no index fund. It’s a managed investment trust, and while the TER of 0.85% isn’t too bad compared to the worst of those beasts, this is no low cost vehicle scooping off market returns like an elegant crane dipping its beak into an unruffled lake to skim a sliver of water.

But it’s no hippo executing a belly flop, either.

Investing in smaller companies is always more expensive than buying liquid large caps, so you’d expect the TER to be larger than, say, the blue chip buying income investment trusts.

A TER of 0.85% is much less too than what the average small stock picker pays in dealing fees and spreads to execute their own trades – though buying either the trust or the companies it buys on your behalf will cost you the same initial 0.5% in stamp duty.

That TER doesn’t include the cost of interest. ASCoT’s portfolio was on average geared to the tune of 10% throughout 2011, and it’s currently running at 13%.¹.

It also doesn’t include the underlying transaction costs paid by the fund manager in turning over the portfolio as it dives in and out of positions.

While the manager talks a good long-term game, the trust turned over 29% of its portfolio in 2011, so these costs will not be inconsequential.

They will ultimately be paid from out of your returns, either by reducing the underlying NAV, or through shareholders being paid a lower annual dividend yield if the costs are met out of income.

Enter the Hoare-Govett Smaller Companies Index

Costs are a drag on a trust’s performance, which means managers need to offset them through some winning picks if they’re not to fall behind their benchmark.

ASCoT’s chosen benchmark is that already-mentioned RBS Hoare Govett Smaller Companies Index (HGSC) (excluding investment companies).

Encouragingly (unless you’re a conspiracy theorist) the trust’s chairman Paul Marsh is one of the two professors who spend much of their working days monitoring this index. He should certainly know his small caps, as well as his benchmark!

Indeed, Marsh and his colleague Elroy Dimson spend a lot of time delving into past returns from Britain’s little companies. They tracked returns from the HGSC index back to 1955 and found that:

… if you’d put £1,000 into the HGSC index in 1955 and then reinvested your dividends thereafter, by the end of 2010 you’d have a pot worth £3.25 million.

That smashed the returns from the wider FTSE All-Share by 3.4% a year; playing safe and investing £1,000 then reinvesting dividends into the All-Share instead would have delivered just £620,000.

Nice returns if you can get them, although past performance isn’t a guarantee of future returns. And given the paucity of small trackers in the UK, unless you fancy that synthetic ETN mentioned I cited earlier there’s no way to easily capture them anyway.

In some ways then, we’re not even asking for ASCoT to beat the index in return for gobbling up some of our return as fees, like you’d normally demand (/hope!) for from a managed fund. Just matching the HGSC index would be nice.

So how’s it done?

On a total return² basis:

Note: C.A.G.R. is Compound Annual Growth Rate.

For my money, Aberforth has made a pretty good fist of at least tracking the index over the long-term.

In recent years though it’s clearly struggled, which is reflected in growing investor disenchantment with the trust.

Absolute performance relative to HGSC Index; rebased to 100 at 31 December 2001

The discount to NAV has widened to nearly 17%, and on a share price return basis, that’s meant an investment made at the start of 2011 had fallen even more than NAV in cash terms by year-end – you’d have been down some 18.5% on your initial stake.

Value shares out of favour

The managers claim their recent run of under-performance is due to the trust’s value investing style.

Over the long-term, they say, analysis by Paul Marsh’s London Business School points to value shares in the HGSC beating its growth shares by a thumping 5% per year since 1955.

Sometimes value stops working, however – one reason why people find it hard to stick with for the long-term.

During the dotcom boom, ASCoT did poorly as investors bought companies that weren’t even making profits, but then rebounded when those companies failed, for example. The managers claim that for whatever reason, the past five years have been similar, with their research showing HGSC growth shares have beaten value shares by 10% per annum.

Clearly that’s a big headwind to performance. But if you believe in mean reversion in markets then the trust should turnaround when the wind changes.

Cheap small cap value shares

We won’t run through all 89 companies that Aberforth Smaller Companies had invested in at the last count, but I will state I like its style.

The trust is currently particularly weighted towards the smallest small companies, where I agree valuations look most compelling.

What’s more these shares don’t look particularly imperiled. Some 43% of the companies ASCoT has bought have net cash, meaning that at the very least they’re unlikely to go bust any time soon.

You may think it’s bizarre that lowly-rated cash-rich companies are among the cheapest you can buy currently, given all the dire headlines about the economy.

The managers agree, stating in their annual report:

…during the bear market of the second half of the year, the correlation between balance sheet strength and share price performance within the benchmark was remarkably low – the relationship between the two was effectively random. This frustrating lack of discernment can probably be attributed to the prevailing climate of extreme risk aversion, which has, so far, out-weighed other considerations.

I concur, having seen various small cap shares pummeled in late 2011, and liquidity so constrained that I’ve had to buy or sell some investments in blocks of £1,000 or less to avoid moving the price. Bearishness still reigns in this stock market.

ASCoT’s holdings also look cheap on other measures. As of December 31st:

• Their average P/E rating was just 9.0, compared to 11.8 a year ago and 10.5 for the HGSC index.

• The companies’ dividend yield was 3.4%, compared to 3.2% for the index. This yield was 3.3x covered by profits.

• On an EV/EBIDTA basis, the trust’s portfolio is valued at 6.9x, compared to 8.9x for the HGSC as a whole.

The trust was yielding 4% in December (thanks to the amplifying affect of the discount), and it’s still yielding 3.6% after a strong run in the share price in January.

Equally, the discount remains elevated at 15.3%.

The managers believe that the trust’s fortunes will reverse in time (and I agree) stating:

The present gulf between the valuations of value and growth stocks is exaggerated. History suggests that the relationship between the two groups will not stay at such stretched levels. The process of normalisation will be advantageous to the value investment style.

Investors who are prepared to wait can enjoy a decent dividend income, which in recent years has grown much faster than inflation:

Dividends versus RPI growth; Figures rebased to 100 at 31 December 2001

Why I hold Aberforth Smaller Companies Trust

I’ve almost always held Aberforth Smaller Companies Trust shares in the past 4-5 years, although residing in my active portfolio the position is liable to be trimmed and expanded as I see fit.

My current holding is the largest I’ve ever had, representing around 5% of my total net worth.

As with Caledonia Investments, I like the underlying companies, and the long-term record and approach of the managers. I think they’ll do well eventually. Both trusts are on large discounts, and I think in time they’ll close, which will amplify returns.

Passive investors looking for a straight proxy for the HGSC index shouldn’t be interested in such speculation, of course, and will rightly be wary of investing in ASCoT given its relatively high costs.

But I think one shouldn’t let perfect be the enemy of the good.

In the absence of a cheap small cap value tracker, I think a small deviation from the righteous passive way to invest say 5% of your portfolio in this small cap trust is likely to prove more rewarding than skipping past the small cap segment of the market altogether.

Note: As with all our specific share write-ups, I can take no responsibility for the accuracy of this post. Please do your own research on Aberforth Smaller Companies Trust and read my disclaimer.

1. Using debt to buy shares will boost returns when the markets do well, but exacerbate losses in a downturn
2. Total return is underlying net asset value growth plus dividends paid.

Further reading:

1. Buying small caps to gear up for the recovery
2. Buying an investment trust on a discount versus a premium
3. Six small cap property companies

If you find the range of index funds aimed at UK investors about as appealing as snacks on a train’s buffet trolley, then take a look at the BlackRock family of trackers known as the BlackRock Collective Investment Funds (CIF).

Nestling within this series of index-hugging Unit Trusts is:

• A highly competitive emerging markets fund.

• The first property index fund for UK passive investors.

• Some dirt cheap total expense ratios (TERs) that are not all they seem.

The best picks from this Blackrock range offer a useful alternative to the tasty TER troika of Vanguard, HSBC, and L&G. They also offer the prospect of fee-dodging salvation for some Hargreaves Lansdown investors.

Until their adoption by the major fund platforms, coherent information on the BlackRock CIF index funds was shrouded in financial fog.

And there are still plenty of wisps obscuring the view even now.

Glimpses of ludicrously cheap TERs on MorningStar dissolve into the ether on the discount broker sites, while BlackRock’s homepage reveals nary a trace of these fabled funds… Just what exactly is going on?

The family BlackRock

Here’s the full rundown of index funds available from the BlackRock CIF range:

Note: Stated TERs for the Class A funds can vary by platform.

The funds appear in two guises: Class A and D.

Obviously – given the lower TERs – Class D is the good stuff, but sadly it’s reserved for institutional investors. i.e. Pension fund type financial behemoths. However, it’s possible to join in the party, if you know where to look. More below.

Financial fleas like you and me are normally offered Class A. As ever in the world of finance, the less you can afford something, the more you have to pay for it.

Other points of intrigue:

• Published TERs are all over the place for the Class A funds. I’ve never seen such swings – anything up to 0.28% – and almost every platform plus MorningStar and BlackRock seems to have its own ‘exclusive’ number. The funds are relatively new and the TERs are still settling down, so ask for the latest information before you invest.

• You can shave 0.2% off the Class A TERs – see the Cavendish Online trick below.

• There’s an initial charge of 5%. But there’s no need to pay it as any decent online platform will discount it to zero.

• Only the UK gilts fund distributes income. The other funds offer accumulation units only.

• As the funds are newish, the performance data is short-term and fund sizes are pretty small. That’s hardly an issue that’s unique to BlackRock but it’s worth checking during your research.

• There’s a spread to pay every time you trade. BlackRock have published spread estimates on page 10 of the simplified prospectus.

• ISA eligibility is patchy – it depends on the platform.

Let’s make this interesting… the Cavendish Online trick

Yes, sorry. Where this does really get interesting (and you have to take your thrills where you can in this game) is:

Discount brokers Cavendish Online will rebate 100% of their trail commission on all BlackRock funds!

I’ve not seen any platform rebate trail commission on index funds before, and it means you can knock 0.2% off the TER of every Class A BlackRock fund you buy through Cavendish.

If you react to trading fees like Dracula to sunlight, then the rebate makes the Class A emerging market fund and the corporate bond funds well worth a second look.

The other funds are either unavailable through Cavendish, or else can all be beaten by Britain’s cheapest tracker alternatives – at least for now.

It’s also worth checking if your preferred platform is refunding any BlackRock commission along the Cavendish model.

Let’s make this interesting… emerging markets

The BlackRock Emerging Market Equity Tracker Fund is a good option for investors who can’t afford Vanguard or ETF trading fees.

Its published TER of 0.6% trounces its nearest competitor – the 0.99% of the L&G Global Emerging Markets Index Fund – even when you take into account the spread.

It can even beat the Vanguard Emerging Markets Stock Index Fund, if you buy through Cavendish Online and pay an effective TER of 0.4%.

Research is crucial with this fund, however. Its benchmark is the FTSE All World Emerging index (same as the L&G fund) but BlackRock’s interim report shows that the fund has a 20% allocation to North America.

What gives?

As it turns out, the North American allocation is chock full of emerging market companies that are listed in the US. It also turns out that the BlackRock Emerging Equity Tracker is not an index fund in the strictest sense.

Performance-wise it’s not wildly out of sync with its L&G equivalent, but you need to be comfortable with what you’re getting into.

Let’s make this interesting… global property

The BlackRock Global Property Securities Equity Tracker is the only property index fund available in the UK.

It invests in developed world commercial property, with a massive bias towards the US.

The TER of 0.61% plus spread compares well with the equivalent iShares ETF – IWDP – (on which you’ll incur trading fees) although HSBC have recently launched a global property ETF – HPRD – with a TER of 0.4%.

Cavendish doesn’t list the property tracker online (a fair few brokers seem to skip this one) but it’s worth a phone call. The fund is new enough that websites may well still be playing catch up with the latest developments.

Class D – out there somewhere?

The holy grail when it comes to BlackRock index funds would be to somehow masquerade as a pension fund and access those juicy Class D TERs.

Many platforms do list the Class D funds but the £250,000 minimum investment is a hurdle I personally find hard to clear.

However, as reader Gadgetmind reveals in the comments below, most Class D BlackRock funds can be bought by mere mortals, if you’re prepared to use the Skandia fund supermarket.

Skandia normally requires investors to use an IFA go-between, but a few discount brokers such as Clubfinance enable you to  go it alone.

Here’s the SP:

• Initial charge: 0
• Annual charge: £68.50
• Minimum investment: £2500 lump sum or £99 monthly contribution.

Clubfinance take trail commission from BlackRock but so does every other platform, so don’t worry about that.

Using the Skandia/discount broker combo, the Class D TERs become super-competitive, but only if your portfolio and contributions are large enough to reduce the annual charge and bid-offer spreads to atoms.

Even then the differences are marginal in comparison to the equivalent HSBC and Vanguard funds. Again, it’s the property and emerging market funds where the gain is most impressive.

Want to know more?

BlackRock jealously guards its CIF Investment Fund secrets on its intermediaries’ site. Admit to being an enthusiastic amateur and you’ll never find what ye seek:

• Factsheets

• Prices and performance

• The simplified prospectus

One day the financial services industry will work out how to make things easy for UK investors and empower more people to take charge of their finances. In the meantime, I’m hanging up my deerstalker for another week but hopefully I’ve clued you in to some useful index tracker ideas.

Take it steady,

The Accumulator

Further reading:

1. Are BlackRock index trackers cheap?
2. Low cost index trackers that will save you money
3. Hargreaves Lansdown slaps new fees on index funds

I see Halifax, the bank that brought us Howard the singing clerk – and brought to its shotgun suitor Lloyds a load of duff Irish property loans – is now offering spread betting.

Previously, spread betting has been the preserve of companies like IG Index and City Index. Large firms, sure, but hardly household names.

As I write, Halifax is devoting a key spot in its share dealing home page to promoting its spread betting product. I don’t know how many share dealing customers Halifax has, but its service – which I use and like – has regularly won awards, and given the size of the parent I’d imagine it’s significant.

Halifax's spread betting promotion, yesterday. (The bank calls it 'spread trading').

I think we can therefore say that spread betting has hit the mainstream.

What is spread betting?

When you spread bet on a company’s shares, you speculate that their price will go up or down.

The more the price rises or falls in line with your bet, the more money you make – and vice versa.

Invariably spread betting firms enable you to ‘gear up’ your position if you want, so the same amount of money can go further than if you had bought (or sold) shares in the firm the traditional way.

• This increases the potential reward you make from a correct bet, without the need for more money.

• But it also greatly increases the risk, since you can easily lose more than your initial deposit if your bet goes wrong.

You don’t explicitly pay commission when you spread bet, but to cover its costs and make a profit, a spread betting firm defines a price ‘spread’ that the share price must move above or below before your bet begins to pay out.

The chief benefit of spread betting – besides the ability to borrow to bet on shares, for those who want that – is that spread betting gains in the UK are currently free of capital gains tax.

What then is ‘spread trading’?

You won’t find the words ‘spread betting’ featured prominently on Halifax’s site.

Instead, the company calls its new service ‘spread trading’, rather than ‘spread betting’.

The bank might argue that it’s a more understandable term for its customers. But I’d cough and suggest ‘trading’ is probably also a rather more respectable-sounding term for a bank to be associated with than ‘betting’.

The Inland Revenue isn’t confused, though. Spread betting is exempt from Capital Gains Tax precisely because it’s judged to be gambling, not investing.

Presumably Halifax ran the term ‘spread trading’ by the authorities before launching its service. But it will still be interesting to see what name it uses in the long-term.

There may even be existing spread betters who would be drawn to opening an account with a financial giant like Halifax.

It’s important to note, though, that Halifax’s spread betting service is provided by City Index – and I presume it runs a version of that company’s own platform.

More importantly, the bank also states that: “Halifax Spread Trading is provided by City Index Ltd and therefore your contractual relationship is with City Index.”

Risky business

Halifax is also offering the same encouragement you see in most adverts for spread betting in the media: free credit to get new customers started.

It’s widely quoted that something like 80% of spread betters lose money, so I’ve always presumed the credit offers were there to hook people into the habit.

But perhaps the bank will be spinning its £100 of free credit as more of an introductory bonus type affair.

To give Halifax its due, the bank does state very clearly and multiple times that spread betting is not for everyone.

The website frequently states it is “for the more experienced trader”.

The bank also states prominently on its “What is spread trading?” page beneath ‘Understand the risks’ that:

Spread Trading is a high risk product. Please remember that it’s possible to quickly lose substantially more than your initial deposit and you may be required to make further deposits at short notice to maintain open positions. Spread Trading is not for everyone so please ensure you understand the risks.

The follow-up page on those risks is pretty clear, too:

Halifax Spread Trading is a product which you can use to speculate on the price movement of an investment, whether it’s rising or falling. It is important to remember that Spread Trading is designed for experienced traders and carries a high level of risk to your capital. You should only trade with money you can afford to lose. It is possible to quickly lose substantially more money than your initial deposit.

There then follows a long list of the various things that can go wrong with this type of service.

I haven’t signed up for this service, so don’t know if any vetting is applied to ensure only “experienced traders” are given accounts.

When I opened a spread betting account with a different firm in the past, the chief requirement appeared to be a credit card.

What would you bet on?

I am not adamantly anti-spread betting, unlike many old school investors.

Back in the good old days when making big capital gains was still a problem (little joke), experienced investors with fairly large portfolios could use spread betting accounts to avoid accruing taxable gains, even while running fairly traditional portfolios – as opposed to the typical day trader betting on the value of the FTSE.

Properly explaining how they do this would require an article in itself!

But to simplify, you take small, leveraged positions of the companies you want to hold in your portfolio in your spread betting account, and keep the bulk of your money in cash to offset the ongoing costs of leveraging up your positions.

You must also have cash available to meet margin calls.

Like this, you can theoretically replicate how a ‘normal’ portfolio of shares would rise and fall, without incurring a tax gain (or loss) – although at today’s low cash deposit rates I think it would be difficult to offset all the costs of borrowing.

But I don’t think this is how most spread betters behave.

Rather, they make short-term bets on anything from the gold price to the Dow Jones Industrial Average to the price of Shell to how many runs England will make in their next Test Match.

And they leverage up those positions without a cash reserve, which means they are wiped out by small moves against them.

It is therefore probably only a matter of time before a tabloid paper finds someone made into a pauper by spread betting and publishes a “Should our taxpayer-owned bank be supporting this gambling?” type story.

That might be unfair, like most tabloid sensationalism.

Yet I would question whether this is really a sensible product for a mainstream bank to be getting into.

Average investor: Not a hedge fund genius

Another thing to consider is what the evident appetite for spread betting tells us about the psychology of investors today.

It seems you can hardly open an investing magazine or newspaper without finding an ad or pullout supplement for one of the big spread betting firms.

The ability to go short (i.e. bet against) companies and the indices seems to be very appealing to the many who are sick of losing money as the markets bounce around.

But remember, the average investor is very poor at timing the market.

Therefore, as with so much else since 2008/2009, I see this evident desire to short the market as probably a pretty bullish contrarian indicator, suggesting that markets are more likely to go up than down from here.

Further reading:

1. Spread betting tax avoidance strategies
2. Shortsandlongs.com offering £300 if you switch your spread betting firm
3. Think you’ve spread your risk? Think again

When money is rarer than rocking horse dung, DIY investing can seem like the sport of kings – as beyond the reach of the average punter as international polo, yacht racing, and panda wrestling.

So if you’re wondering how to invest on a budget, what is the minimum amount of money you need to invest while remaining true to the principles of passive investing?

I think saving and investing about £50 a month should do it.

For the price of 17 pints of lager, two N-Strike Raider Rapid Fire CS-35 nerf guns, or one doggy pedicure (including pad massage) you can construct a diversified portfolio that can be expected to earn reasonable returns over the long term.

Fee’s a crowd

At £50 a month your biggest enemy is costs. You can’t afford them! Upfront fees, flat-rate transaction charges, tax, admin costs – you need to duck ‘em all like Indiana Jones in a sword fight.

To ensure bargain diversification, forget about:

• Shares
• ETFs
• Active funds
• Investment trusts

The associated charges of these investments will take too high a toll on a paltry budget. But while the room for manoeuvre is limited, you can beat costs by choosing:

Low cost index funds: Look for TERs under 0.5%, no trading fees, no initial fees.

Small-investor-friendly online brokers: Look for no annual admin fees, no trading fees on your chosen funds, no inactivity fees.

A tax-free account: Look for a Fund ISA with no management fees. (SIPPs are too expensive).

The budget investor’s solution

The essential components of this Pound Stretcher portfolio are a pair of broad market equity and bond funds that could sit at the heart of any portfolio:

Fund 1: 60% UK equity

• HSBC FTSE All Share Index Fund¹, TER 0.27%
• A diversified, large-cap fund that represents a broad slice of the UK equity market and can be expected to provide growth over the long term.
• £30 a month

Fund 2: 40% UK Gilts

•  HSBC UK Gilt Index Fund², TER 0.26%
•  A diversified, UK government bond fund that should reduce volatility in the portfolio and offer performance that’s negatively correlated to the equity fund.
•  £20 a month

This pair of bargain basement beauties cuts your costs to the bone:

• Total investment = £50 a month
• Total weighted TER = 0.266
• Total trading fees = £0
• Total initial fees = £0
• Total annual administration fees = £0
• Total tax liability = 0

To make the Pound Stretcher portfolio work on a small investing budget:

1. Use discount broker Interactive Investor (iii) for zero admin fees (select the Fund ISA account).
2. iii beats the likes of Fidelity because iii’s minimum investment is £20 per fund.
3. Use the accumulation versions of the funds to automatically reinvest dividends at no charge.
4. No trading fee funds mean you can rebalance without cost, too.
5. I’ve chosen the classic 60:40 asset allocation mix for illustration purposes only.

Got anything cheaper?

If that’s a bit rich for your blood then there are still a couple of ways to lower your monthly investing budget:

£40 a month: Choose a 50/50 bond/equity portfolio – it did the trick for the Nobel-prize winning economist Harry Markowitz.

£20 a month: You’ll have to be either very adventurous or super cautious, with a 100% asset allocation to either the equity or the bond fund.

£50 a quarter: You can drip-feed in money over less frequent periods and still benefit from pound-cost averaging.

£50 a year: You’re either a paperboy with vision or you’re not really trying.

From small acorns…

The power of compound interest makes it worth your while to start investing sooner rather than later, even when cash is tight.

Plus, you’ll bed in good habits and your portfolio will be easy to manage with just two funds.

Once you’ve built up a solid base using your core funds, you can think about switching to an international fund and slowly diversifying your holdings.

While it’s good to know how to invest on a budget, it’s better to invest more. If you’re able to increase your investing contributions over time then you could diversify the Pound Stretcher more along the lines of our Slow & Steady passive investing portfolio.

Take it steady,

The Accumulator

1. Fund identifier: GB0000438233
2. Fund identifier: GB00B4581C50

Further reading:

1. Battle of the UK Budget 2009 calculators
2. Pre-budget report 2009 review
3. By George I think he’s done us proud with this emergency budget

Before you can decide whether you think house prices will fall, you need to have some notion of where they’ve come from.

Below is a graph showing roughly the past 30 years of UK house prices, which I’ve compiled using data provided by Lloyds/Halifax.

Since the Halifax began tracking historical UK house prices in 1983:

• House prices have risen nationally by 428%.

• London house prices are up by 559%.

If you’re interested in a specific UK region (as I am with London) then download Halifax’s data and create your own house price graph. Admirers will swoon, and strangers will stand you rounds at the pub.

The graph shows UK house prices in blue, and London prices in red:

A pretty impressive looking slope – enough to make a minor Alp self-conscious. But note that this is a graph of nominal house prices. In other words, the prices are not adjusted for inflation.

We can use the Bank of England’s cute inflation calculator to work out roughly¹ what the price rises cited by Halifax represent in real terms.

In approximate real terms, according to Halifax, since 1983:

• UK house prices have risen by 101%.

• London prices have risen by 124%.

That’s obviously a lot less vertigo-inducing than a 400-500% rise in nominal terms, although as we’ll see later on it’s still a lot faster than wages have risen – which is probably why we keep hearing about a housing crisis. (It’s also a reminder of how property has generally tended to protect against inflation).

The Nationwide produces a house price index too, and it helpfully offers inflation-adjusted prices from the get-go.

Here is its graph of UK real house prices, which tells much the same story as the Halifax data:

(Click to enlarge this graph of UK real house prices)

The red trend line is the Nationwide’s, not mine.

Are real house prices beginning to bottom out like they did in the 1990s? Looks like they might be, albeit with a jerkier graph that hints at market dislocations such as emergency interest rates and the restricted supply of mortgages.

How have shares done compared to house prices?

We might also compare house price inflation to the historical return from other assets, such as shares.

The FTSE 100 was introduced on the January 3rd 1984 at a base level of 1,000 – very close to when Halifax began tracking house prices.

• Since then the FTSE 100 has risen 440%.

• If you’d invested £10,000, your real return would be 105%.

On a 1984-ish to 2011 snapshot, then, it looks like a draw between residential property and shares.

But remember that those houses would have required money to be spent on their upkeep, and many home owners would also have splashed out on price-boosting enhancements like loft conversions and extensions. None of those costs are factored into the house price index.

In contrast, the equivalent costs to companies should be reflected in their share prices in the long term.

Are you also thinking that shares pay a dividend, which isn’t caught by the index’s return? Good spot – and true – but remember that houses also deliver an equivalent, in the form of giving someone somewhere to live (or imputed rent, in economic terms).

Finally, the day-to-day level of the stock market is much more volatile than house prices, making point-to-point comparisons with housing a little dangerous. What if we’d done the comparison in 1999? Or 2009?

I’ll be coming back to look at this more deeply in a later post.

UK house prices down, a bit

In historical terms, UK houses have clearly been a decent long-term investment for the past 40 years. Over shorter spans, though, the data shows that the property market undergoes booms and busts just like any other asset class.

As we’ve seen in the graphs, in recent years boom has most definitely invited cousin bust around to stay, and he’s totally trashed the living room. Prices have accordingly come down a fair bit in the past few years, especially in real terms, though less so in London.².

Arguably, the falls are not as much as we might have expected, given how unemployment has risen, and how difficult it is to get a mortgage. And recently house prices have stabilised, despite neither of those conditions reversing.

It’s also worth noting the Halifax and Nationwide data is likely skewed because it’s based on those who need a mortgage – and we’re in a credit crunch.

Cash buyers (oligarchs, bankers, wealthy Greek and Italian refuges, and football stars) can bid up prices without any such piffling restrictions, as we’ve seen in Mayfair and Knightsbridge.

So the building society data probably over-estimates the price falls.

Many economists would have predicted a much bigger house price crash, if they were told a few years ago that the UK would undergo its deepest recession since before World War 2, or that so few first-time buyers would be able to get a mortgage.

Maybe things are different this time?

I think it’s too soon to say whether house prices having finished falling, given the economic uncertainty. The declines may well resume when interest rates rise, or if unemployment heads higher.

For now though, the failure of house prices to drop as much as many predicted before the crash (including me) makes me wonder if I underestimated a structural shift to higher UK house prices in real terms.

It’s claimed that Albert Einstein said the definition of insanity is doing the same thing over and over again, and expecting a different result.

I agree. I’d like to own a house someday, and I don’t want to keep sitting out the property market if it’s for no purpose, only to watch prices take off once more.

“When the facts change, I change my mind,” said the economist Lord Keynes.

So did I miss some changed fact in my previous analysis of house prices? As the old socialists used to chant: What about the workers?

Next: The house price to earnings ratio. (Subscribe to get it via email).

1. Inflation data for 2011 is not yet available, so I have approximated by using 2010 as my base year. These figures will likely be slightly a few per cent lower when the 2011 data comes in.
2. Prime London prices are at all time highs, which is I’d put down to the weaker pound and the influx of foreign buyers.

Further reading:

1. Are UK house prices too high?
2. Playing chicken with house prices
3. Low rental yields suggest house prices will fall

Last quarter I had the unfortunate duty of reporting the Slow and Steady portfolio’s first plunge into the red.

We were down 9.32%, as the sovereign debt crisis waded into our holdings like Godzilla chewing up Tokyo.

Since then I’ve filled an entire notepad with the near endless dirge of economic misery reported by the media:

• The Bank of England announced QE2.

• Global growth forecasts have been cut.

• Many analysts think we’re already in recession.

• The break up of the Eurozone is widely predicted.

• The ECB is providing €500bn in life support to the European banks that no-one else will lend to.

And where does all this doom and gloom leave our passive portfolio? Down 1.70% on the year, but up 6.83% on last quarter.

Significantly, our benchmark – the FTSE All-Share index – is down 5.51% on the year, so we’ve at least beaten that, thanks to our diversification into gilts.

Reminder: The Slow and Steady portfolio is Monevator’s model passive investing portfolio. It was set up at the start of 2011 with £3,000. An extra £750 is invested every quarter into a diversified set of index funds, heavily tilted towards equities.

You can read the original story and catch up on all the previous passive portfolio posts here.

What 2011 has done to our portfolio

• The US fund is the single equity bright spot over the year, gaining 3.11% as US economic indicators continue to defy the general expectation that we’re all going to hell in a shopping trolley. Happily, at 27.5% the portfolio allocates more to the US than any other fund.

• Of course, Europe has been a basket case and we’ve lost 12.47% on that fund over the year. And it doesn’t look like things are going to improve any time soon.

• Plainly the UK is in pretty poor shape too and our FTSE All-Share fund has lost 3.17% in 2011. The All-Share is dominated by multi-nationals, however, and their ability to scour the globe for opportunities has mitigated the impact of bad news on the home front.

• Japan is still struggling to come to terms with the aftermath of the tsunami, not to mention the strong yen, so unsurprisingly we’re down 10.39% there.

• Similarly the Pacific ex Japan fund has lost 10.36% as their major trading partners struggle in the economic headwinds.

• The portfolio’s biggest percentage loss was the 14.64% vaporised from the Emerging Markets fund. Chinese equities fell as the government tightened lending while India’s markets and currency also plunged.

• Our main bulwark against the negativity has been the UK gilt fund. It’s continued to appreciate throughout the year, gaining 14.65%. The movement of our gilt fund against the grain of our equity holdings has been a textbook illustration of the value of non-correlated assets. And a textbook dumbfounding of the forecasts that the only way for bonds was down.

So despite the abrupt end of the bull market and a year where I continually expected to find the Four Horsemen of the Apocalypse drinking in my local, we’ve ended up £89.65 down on our 2011 contribution of £5,250.

I think I can handle that, but if you can’t then increase the percentage allocated to bonds in your portfolio.

New purchases

Every quarter we add another £750 to the portfolio.

This time we’re also going to up our bond allocation by 2% to 22%, as we’re a year older.

The portfolio initially had a 20-year time horizon (now 19) and the slow shift from volatile to non-volatile assets acknowledges the fact that we’ve got less time to bounce back from major stock market declines as we edge towards retirement.

To keep things simple we’ll just knock 1% off each of our two biggest holdings: UK equity and US equity.

UK equity

HSBC FTSE All Share Index – TER 0.27%
Fund identifier: GB0000438233

New purchase: £77.50
Buy 23.5279 units @ 329.4p

Target allocation: 19%

Developed World ex UK equities

Split between four funds covering North America, Europe, the developed Pacific and Japan.

Target allocation (across the following four funds): 49%

North American equities

HSBC American Index – TER 0.28%
Fund identifier: GB0000470418

New purchase: £80.96
Buy 42.1253 units @ 192.2p

Target allocation: 26.5%

(Note: TER up from 0.25% to 0.28%)

European equities excluding UK

HSBC European Index – TER 0.31%
Fund identifier: GB0000469071

New purchase: £116.19
Buy 28.4989 units @ 407.7

Target allocation: 12.5%

Japanese equities

HSBC Japan Index – TER 0.29%
Fund identifier: GB0000150374

New purchase: £63.36
Buy 109.178 units @ 58.03p

Target allocation: 5%

Pacific equities excluding Japan

HSBC Pacific Index – TER 0.37%
Fund identifier: GB0000150713

New purchase: £40.44
Buy 19.182 units @ 210.8p

Target allocation: 5%

Emerging market equities

Legal & General Global Emerging Markets Index Fund – TER 0.99%
Fund identifier: GB00B4MBFN60

New purchase: £88.38
Buy 206.3554 units @ 42.83p

Target allocation: 10%

(Note: TER up from 0.98% to 0.99%).

UK Gilts

L&G All Stocks Gilt Index Trust: TER 0.25%
Fund identifier: GB0002051406

New purchase: £283.17
Buy 156.0167 units @ 181.5p

Target allocation: 22%

Total cost = £750

Total cash = 5p

Trading cost = £0

A reminder on rebalancing: This portfolio is rebalanced to target allocations every quarter, mostly using new contributions. It’s no problem to do as our vanilla index funds don’t incur trading costs.

Take it steady,

The Accumulator

Further reading:

1. The Slow and Steady passive portfolio update: Q1 2011
2. The Slow and Steady passive portfolio update: Q2 2011
3. The Slow and Steady passive portfolio update: Q3 2011

A common reaction among my peers to the slow-motion car-crash that is the pensions crisis is: “We’re gonna have to work ’til we’re dead anyway.”

It’s a fatalistic, short-sighted, shoulder-shrugging attitude that translates as: “I’m not saving enough for my pension and I’m going to put off doing anything about it by pretending I can’t do anything about it.”

But of course there’s plenty we can do about it, and it only takes a quick play with a compound interest calculator to see that delay does nothing but make the problem worse.

Compound interest and time are the nitro and glycerin of personal finance. Except it’s a friendly explosion.

It’s well known that compound interest can turbo-boost your fortune. Initially the effect of earning interest on interest is small – almost invisible – but over time it accelerates dramatically.

Compound interest's most spectacular effects occur in later years.

To maximize the miracle grow power of compound interest, it’s important to understand the major components that influence the effect:

• Time: The longer you can wait before you spend the money, the bigger the snowball effect of compounding.

• Interest rate: A small difference in the amount you earn makes a big difference over the long term.

• Tax and other costs: The less tax is clipped off your interest (or the longer you can defer the day of reckoning with the taxman) the more your returns will have had a chance to compound.

• Frequency of compounding: The more often interest is paid (such as quarterly or monthly), the quicker the compounding effect can get to work.

Time is the critical factor

Compound interest can do much of the heavy lifting towards your financial goals, if given enough time.

The Monevator millionaire calculator illustrates the point by showing how much you need to save every year to earn a million by age 65.¹

• If you harness the power of compound interest from age 20 then you only need to save £2581 per year to hit the target, assuming an annual average interest rate of 8%.

• A 30-year old who starts saving at the same rate ends up with less than half the amount by 65: £480,329.

• A 40-year old is left wondering where all the time went, getting only a fifth of the way to a million by 65: £203,781.

Here’s how much our 20-, 30- and 40-somethings would have to put away every year to earn a million at 65:

The differences are horrendous. Delay for 10 years and you must save at over twice the rate. Wait 20 years and you’re looking at saving more than five times the amount of a 20-year old.

Make your child a millionaire: If you’re expecting kids any time soon, then you could make your child a millionaire by age 65 by unleashing the power of compound interest from day one. If you earn an average annual interest rate of 8% then an investment of £1.48 a day will do the trick. Not a bad present in these days of pension insecurity. Just make sure they can’t get their mitts on the moolah a day earlier.

The interest rate matters

Seemingly small changes in the interest rate can have a profound impact on your final result. See how much less our protagonists need to save if we up the average annual interest rate to 10%.

Our 20-year old would-be-millionaire can save nearly 50% less per year by earning 2% more than in our previous example.

Stretching for yield works less well (and is considerably more dangerous) for the 40-year old, who can only reduce his annual saving amounts by around 25%, given the shorter time he has left.

Don’t sell yourself short

In contrast, things look considerably less sunny if we drop the average annual interest rate to 6%.

A 20-something investor earning 6% must save 81% more than a 20-something who earns 8%. With less interest to compound over the decades our young investor must increase their annual commitment, if they want to achieve the same financial goal in the same amount of time on the lower interest rate.

Meanwhile, our tardy 40-year old must find an extra 33% at 6%, in comparison to 8%.

The message is that it can pay to invest aggressively if you’re young and you can handle the risk. Sitting in low-yielding assets like cash or bonds is likely to cost you over the long run.

The historical return rate of the UK stock market is around 5% before inflation (add on about another 3% for that) while cash and gilts have brought in about 1%.

If you’re young then you have the time to hopefully take advantage of the peaks and ride out the troughs that come with an aggressive asset allocation tilted towards equities.

The table above also shows why you must guard against other assailants trying to mug your returns, such as the taxman and the expensive fund manager.

Make sure your money is tax-shielded in ISAs and pensions, and that you use low-cost index trackers so that the power of compounding has as much interest, dividends and capital gain to work with as possible.

The takeaways

• Don’t think that investing for the future can wait until later. The early years count. Start saving something now and do it regularly. The longer your investments have time to grow, the greater the power of compound interest to make you money.

• Be patient and think long term. Leave the money alone. Reinvest all your gains. The effect of compounding is miniscule at first and may seem agonisingly pointless. The most dramatic effects occur in the later years, but you’ll be grateful for them and will thank your younger self for your foresight.

• It’s never too late. You may have lost years to procrastination, financial naivety or whatever else – I know I did. But here’s a brilliant quote about letting go of the past:

The best time to plant a tree is 20 years ago. The second best time is now.

Forget about yesterday, and do something about tomorrow.

Take it steady,

The Accumulator

1. I’m not saying you need a pension of a million pounds. I’m simply using the figure to illustrate that compound interest can make the seemingly unachievable achievable.

Further reading:

1. Why I wish they’d taught me about compound interest at school
2. Compound interest turbo-charges your salary, too
3. Compound interest calculator

Whether you choose to buy a house or rent is one of the biggest financial decisions you’ll ever make.

The sheer cost of houses compared to crisps, cars, and fancy shoes means this was true even 50 years ago.

Nowadays you could pay five or six times average earnings to get onto the property ladder. At today’s high house prices – even in the midst of a slump – the risks of making the wrong decision look greater than ever before.

Is there reason to believe today’s levels are justified, or will UK house prices fall?

In the next few posts I’ll explain how we got to today’s high house prices, and consider if there’s any justification for them.

I can’t tell you for sure if or when UK house prices will fall further, but hopefully you’ll feel in a better position to make your own mind up.

Why house prices matter

Most older people (say 50 or over) will tell you that you can’t go wrong in buying your own house.

Few of the older generation invested much money outside their home. The capital gains they saw from rising house prices – even as inflation reduced the burden of their once-daunting mortgage – was beyond their wildest dreams!

A few gnarly veterans do however warn that prices can go down as well as up.

I see both sides.

I know that house prices can go down. But I also think that NOT buying my own home a decade ago was my biggest financial mistake.

True, saving hard for my aspirational loft apartment (hey, I was young!) got me interest in investing, which is my passion now.

Would that be true if I’d bought a flat and spent my surplus income on broken boilers and Banksy prints?

I doubt it. Buying a house would have been a far easier path to wealth, however.

A little knowledge is a dangerous thing, and my knowledge that London property looked expensive compared to incomes and renting kept me from buying. Yet prices still kept rising.

• Friends who bought naively thinking “London house prices never go down” made a killing.

• Those of us who knew prices had fallen before and so could again have paid for it.

Should you care about house prices?

You might ask what does it matter? Why are the British obsessed with property?

After all, you could choose never to buy a house, and to rent all your life. Some people do exactly that.

The huge advantage of buying your own home is that you lock in the cost of living in it when you buy. Once you’ve paid off your mortgage, you only need to pay the cost of maintenance to keep living there. No more rent!

In contrast, someone who rents will need to pay ever rising rents throughout the next 25 years, when they could have been paying off a mortgage – and beyond that into retirement, too.

They’ll also miss out on any capital gains from rising prices, which are especially attractive because price gains on your own home are tax free.

On the other hand, it’s much easier to move if you rent. You don’t have to pay for decoration and upkeep, either, which you can estimate will cost you about 1% of your house’s value over the long-term, unless you fancy living with the equivalent of an avocado bathroom suite for your whole life.

It’s worth noting that the house price indices completely ignore these extra costs of ownership, and also the cost of adding value through loft extensions and other improvements.

Even so, most people have made a good profit by buying a home in the UK over the past 40 years.

Are UK house prices too high?

This is a financial blog, and I am not going to consider the lifestyle benefits of living in your own home in any great detail.

I’m also not going to go into the morality of high house prices, and the fact that young people are disadvantaged compared to the old by endless house price appreciation.

What you want to know is are house prices too high, or will they come down? The rest is personal opinion.

Coming up: Historical UK house prices. (Subscribe to get it emailed!)

Further reading:

1. Low rental yields suggest house prices will fall
2. Playing chicken with house prices
3. Historical UK house prices

Were I able to go back in time to impart one piece of wisdom to my teenage self – one nugget that would have made all the difference to my financial future – I would somehow engineer the absence of my maths teacher for a single lesson.

Then, heavily disguised as fresh supply teacher meat, I would instruct the class in the power of compound interest.

It wouldn’t take long, needn’t tear a hole in the fabric of space-time, and it would have made a far deeper impression on me than another drone-a-thon about quadratic equations.

Because everyone likes the idea of money for nothing.

Alas in reality what little money I did lay my hands on at that time went on instant gratification. You know how it goes.

If only I had understood what a mighty money tree I could grow by saving even a pitiful amount early on and watering it with time and compound interest!

How compound interest works

Compound interest is the astonishing multiplier effect¹ of interest earned on interest, over time.

It works like this for a saver who sticks away £1 and earns interest of 10%:

In Year Two, you don’t add a bean to your savings, yet you still rack up more interest than the previous year (11p instead of 10p), because you also earned 10% interest on your interest.

Big wow. It doesn’t sound so life-changing – until you scale up the amounts and timescale involved.

Once that self-feeding, compound interest mechanism gathers momentum it creates a runaway money snowball that can transform your financial position.

But time is needed to generate that momentum. The sooner you start saving and investing, the more dramatically compound interest can work for you.

Compound interest unleashed

Let’s consider two investors: Captain Sensible and Captain Blithe.

From the age of 25, Captain Sensible invests £2,000 per year in an ISA for 10 years until he is 35. At 35 he stops and never puts another penny into his fund again.

Captain Sensible then leaves his nest egg untouched to grow until he hits age 65. He earns an average annual return of 8%² and when he looks at his account 30 years later, he has £314,870 to play with.

Captain Blithe, meanwhile, spends the lot between the ages of 25 to 35. Only when he hits 35 does he sober up and start tucking away £2,000 per year in his ISA. He keeps this up for the next 30 years until he reaches 65.

Captain Blithe earns an average annual return of 8%, too. He ends up with £244,691.

To recap:

• Captain Sensible has invested a total of £20,000.
• Captain Blithe has invested a total of £60,000.

Yet Captain Sensible’s pile is worth over 28% more than the late-starting Captain Blithe’s – even though Sensible only invested a third of the amount.

Do it. Do it now!

Remember our ho-hum interest table above? Let’s dial up the years setting to 30 to see how she performs:

After 30 years at 10%, you’re earning almost twice your entire initial investment as annual interest. That’s the power of compound interest.

Of course, the only place you can hope to get a 10% return these days is the stock market, and stocks go down as well as up. Real-life returns are more volatile, but the principle is rock solid.

Compound interest is an offer you’d be mad to refuse. Have a play with our compound interest calculator to see how much you can achieve.

When you’re young, time is on your side. Make the most of the once-in-a-lifetime opportunity by sticking some money away (anything is better than nothing) and let compound interest get to work securing your future.

You’ll be laughing later. (At me, as I snivel and regret my youthful folly).

Take it steady,

The Accumulator

P.S. – Even if you’re not so young, now is still the best time to start.

1. At this point most compound interest articles like to quote Albert Einstein as saying: “The most powerful force in the universe is compound interest.” It seems more likely that this is an internet meme than an Einstein quote, but it lives on because it would be fantastic if true.
2. That is, an 8% annual average return over the entire 40-year investment period.

Further reading:

1. How compound interest can save our pensions
2. Compound interest turbo-charges your salary, too
3. Compound interest calculator

Important: This is not a recommendation for you personally to buy or sell any small cap property companies. I’m just a private investor, storing and sharing notes for wider interest. Read my disclaimer.

We’ve seen how most of the UK’s big commercial property companies are trading at discounts. If you believe the pessimism about Europe and the global economy is overdone, then some offer good yields as well as seemingly undervalued assets for you to snap up.

There is also a plethora of small cap property companies and developers in the FTSE All-Share – although fewer than before the 2008/9 downturn, which inflicted several fatalities in the sector.

In many cases the surviving small cap property companies appear to be even more attractively valued than their larger brethren. But with the greater potential of small caps comes more risk, too.

Of the various elements I suggested you dig into when we looked at the large REITs, I’d say you should pay extra attention to management, insider ownership, and any funding commitments or requirements.

For example many private investors follow London developer Quintain Estates, which has residential sites in Greenwich and Wembley, and other assets and operations besides. On a net assets basis, it seems hugely undervalued. It has also attracted the interest of the well-regarded active investor Laxey Partners, which is now the major shareholder.

However I’ve not been able to reconcile myself to the seemingly large amount of money Quintain will need to complete work at its sites (at least when I last looked at them a year or so ago). I did hold the shares briefly, but I sold them for a small loss as I decided I wasn’t very comfortable.

Similarly, while I’ve owned shares in the first three of the following six firms at some point or another, I don’t currently hold any of them, as I’ve reshuffled the active portion of my portfolio to try to take advantage of the ongoing volatility (remember: don’t do this at home!)

Small cap property companies I like

I think all these companies have some attractive qualities and good potential, but obviously also risks. Please remember to do a lot more research before even considering investing – these are just jumping off points for further research.

Mountview Estates: This interesting company buys residential property that is blighted by legacy rent controls. (Blighted from our perspective, not the tenants’!) These rights eventually lapse with the death of tenants, and the property can be refurbished and/or resold. Mountview is potentially a very undervalued play on residential property paying a reasonable 4% yield, but you’ll have to think long-term.

Daejan: A family dominated FTSE 250 firm with residential and commercial property interests in UK and the US, especially London. Very steep discount to NAV (it’s priced at 0.5x book value) but the dominant family aspect and the more second tier assets it holds (in my personal opinion) means it very rarely trades at a premium. Perhaps also worth considering for the great long-term dividend record, though the starting yield is only 2.8%. Suffered recently in the fall out from the collapse from Southern Cross care homes.

Mucklow: Sort of a mini-Segro at £180 million but mainly focused in the Midlands region, Mucklow is another conservatively run family affair with a superb dividend record. The yield is currently 6.2%. I held until a few months ago, when I swapped it for something more volatile that has since fallen. The sort of company I should try to tuck away for the long term.

Panther Securities: A £52 million small cap run by wily veteran Andrew Perloff, who is noted for his hilarious and strident annual reports as much as his good long-term results. Almost like investing in a private company run by your clever uncle. Horrible spread, so try a limit order or a ‘real’ broker.

McKay Securities: Another £52 million outfit, this time focused on commercial property in the south east and around London. It’s priced at 0.6x book value but there’s around £120 million of debt, secured against just under £220 million of assets. That looks a bit precarious, but the managers do inspire some confidence. They didn’t raise cash in the downturn, and they recently spent £2.7 million on a new modern office in Bracknell that is being let for a yield of over 12%, even though it’s not yet fully occupied. Risky but could be very rewarding.

J Smart: An even smaller cap property developer with plain speaking management. It recently issued a mild profit warning as occupancy levels fell and construction remains subdued. Looks cheap, but under the cosh and will need a turnaround in UK PLC to get going.

Finally, a reader asked about commercial property investment trusts. The only big one I’ve ever invested in is £700 million F&C Commercial Property. It’s on a small 6% discount and pays a 5.8% yield. I suspect it’s becoming popular with income seekers at present, though that’s just a hunch. About four-fifths of the portfolio is in London, with the rest spread about the UK. As with nearly all property companies there’s a fair bit of debt, with gearing near 30%.

Of course, mainstream investment trusts might also invest in commercial property. The currently much-hated Caledonia trust has money in London & Stamford and the aforementioned Quintain, for example. Beware, Caledonia’s shares languish on a 25% discount, so while I continue to hold myself, the market clearly doesn’t think much of its manager’s judgement!

Final warning: All small cap property firms are likely to suffer badly if there’s a renewed and prolonged UK recession. I still don’t expect that myself, but the odds have undoubtedly risen sharply in the past six months.

Further reading:

1. UK commercial property trading at a discount
2. Commercial property is an attractive asset to own
3. Five reasons to buy commercial property