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.
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:
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:
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):
Remember, 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?
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.
But better—in terms of a larger and more sustainable income flow?
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!
Catch up on all the The Greybeard’s articles on deaccumulation.
That is a really good point, Greybeard. I have never seen an analysis of the passive vs active debate related to income-focused investors. The reality is that ETFs do tend to provide a more volatile dividend profile.
Currently, I am a pure active (as opposed to active fund) investor. However, I expect that as retirement approaches my exposure to investment trusts will increase significantly. I have written before on the fact that–as retirement gets closer–I plan to build up the percentage of my investments in ITs (see http://bit.ly/1IaH2hI, if you’re interested).
Really interesting post. I will have to spend some time scouring the internet to see whether a income active vs. passive study does exist somewhere!
It’s worth remembering IUKD’s *yield* (i.e. It’s dividend payout divided by its price) was higher than most investment trusts (going on my memory) back in 2006/2007. So while the dividend payout lop was savage, the absolute reduction in income generated per £ invested in 2006 might not have been quite as dramatic as Greybeard’s graph demonstrates that it was for IKUD itself. Potentially one could have smoothed one’s income via cash buffers, as we’ve discussed before.
Personally I’ve never thought IUKD looked like a good income vehicle — even on launch — and for what it’s worth I do think some of the other income ETFs look better constructed, but that’s by-the-by from Greybeard’s perspective. As he says, who knows, we can only go on past data and backtesting. The same is true of trusts, too, of course, but the flexibility of an active manager and the ability to shimmy about with capital to keep income payments up in a pinch is something he’s prepared to pay for in seeking the smooth and rising income he desires.
The other argument is that you shouldn’t go for income per se at all, but rather you should go for total return from broad market cap index funds and sell down your holdings to generate income as required. This *should* theoretically beat an income investment trust in total return terms (because otherwise an income trust is an actively managed vehicle that beats the market, and we don’t typically believe those exist as a class) and it’s the approach you’ll see in most US literature. It’s what my co-blogger The Accumulator always argues is the better approach, too.
Personally, I am very sympathetic to the income angle that Greybeard outlines, as I’ve said many times before, even if it’s at the expense of a lower total return (which let’s face it you’ll only know when it’s too late and you’ll either have more important things on your mind, or you – um – won’t be thinking much at all).
It’s really a pays yer money takes your choice thing.
Even using active funds in *growing* your pot is a pays-yer-money thing, but really all your paying for there (when you don’t care about income) is a long shot at beating the market or potentially some other aspect of stability.
Of course some rich people seek that capital stability via, say, very expensive hedge funds, rather than, say, holding more bonds and fewer equities, which the evidence says most of them would be better of doing if they weren’t so vain. 🙂 And generally “we” decry that. So I can see why this income approach does cause debate.
However as Greybeard alludes, I’d rather it caused existential active-versus-passive debates on posts such as this one — which is specifically *about* the debate — than on other posts where he’s trying to get into the detail of his strategy. 🙂
To be honest Greybeard’s approach is pretty much what I would do if I was a passive and retired investor.
ETFs may be fine during the accumulation period where volatile dividends are simply reinvested, but if I wanted to live off the dividends I’d much prefer the stability that income trusts provide.
You could smooth the ETF income with a cash buffer, but for most people that’s just too much bother. The easy option is to accept slightly lower returns due to higher charges, in return for income stability.
Seems to be a lack of logic in this article
– No comparison of investment trust performance to index
– Random attachment to i-shares IUKD etf ignoring every other index tracker (maybe it just fits the case you want to make?)
– No comparison of total returns (capital + income)
– No mention of the fact you can just sell shares cheaply
– No mention of huge mound of research that out performing active management is as rare as a virgin in Newcastle
– No mention of importance of lowest costs for improving investment returns
Overall: C-, please try harder next time..
Ignoring for the moment that the article is already over target length, and so there’s a limit to how much extra information can be crammed in, I’ll take your points in order:
1) Irrelevant to income-centric case, and thesis of article.
2) Why don’t you suggest an alternative income-focused ETF, then? One that covers the same timescale?
3) Irrelevant to income-centric case, and thesis of article.
4) If you have this “huge mound” of *income-specific* evidence to hand, let’s see it. As the article says (you *did* read it, didn’t you?), what evidence is out there tends to focus on the capital case.
5) Irrelevant to income-centric case, and thesis of article.
I’ll abstain from awarding an overall grade to your comment, though 🙂
I have used ITs in my SIPP portfolio for many years, and have been reasonably content with the returns – obviously some have performed better than others. When I converted my SIPP to drawdown in June 2012, I maintained the portfolio of trusts and recently posted a review after the first 3 yrs.
Annualised returns were around 12% however this included the near 30% cagr for smaller companies specialist Aberforth – excluding this, the returns would have been ~10% p.a. – similar to Vanguard’s Lifestrategy 60 fund.
I don’t like the set-up for the IUKD and I am not surprised to see it came a cropper and has not really recovered too well. Therefore, I do not think it is the best example to use for a comparison.
A more robust proposition imho would be the Vanguard UK Equity Income fund – current yield 4% and a return of over 15% p.a. over the past 6 yrs (since inception).
Better still, the more globally diversified Vanguard Lifestrategy range incorporating bonds as required to reflect the degree of risk required.
There’s probably not a great deal to be given up sticking to the ‘basket’ of ITs but I would not rule out passives based on the arguments so far put forward.
I still don’t get the focus on income in a SIPP where income and capital are treated the same for tax purposes. Even in retirement, isn’t it total return what’s important?
Somewhat playing devil’s advocate here, but…
Although it’s usually (and probably fairly) stated that the best way for the vast majority of people to maximise total returns over the long term is by investing in the index at minimal cost, there is one major issue that this ignores, which is that many of the biggest market participants are unable to act in the way that would maximise their own returns due to fund restrictions or legislation. The main issues here are that (1) many funds are ‘long only’ and non-leveraged, being unable either to bet on shares falling or to borrow money to magnify equity returns, and (2) those market participants that are able to use leverage and sell short are unable to borrow enough money and/or shares cheaply enough to eliminate the very large market distortion that comes from the other crowd.
Consequently, the non-leveraged, long-only funds systematically over-weight equities that are relatively volatile and high risk (often because the companies themselves are highly indebted) but would be expected to deliver higher returns in reward for this risk. This happens to the extent that the risk-adjusted return of the ‘high beta’ shares drops. The net impact is that the entirely rational actions of every market participant subject to their own restrictions leads to the price-weighted index being more volatile than it could be if more funds had the option of using leverage to increase risk and returns (or hold cash reserves to dilute them) and the ability to short the stocks being pumped up by irrational actors. Some funds can, but they do not have access to enough capital to arbitrage away the distortions completely. [the huge capital inflows to hedge funds in recent years might have changed this]
Hedge funds do tend to get decent returns before fees, but the chance of outperformance surviving the typical 2+20 fees is slight. Investment trusts fit a nice niche in that they are able to borrow to invest or to hold fairly large amounts of cash depending on market conditions (allowing them to get good returns while reducing exposure to the most volatile/irrationally exuberant parts of the market and times in the market), while at the same time they charge fees typically lower than most active open-ended funds.
@Neverland — I think your points are fair enough, even pertinent, but I would disagree with them being criticisms of the article, per se. As Greybeard says, there’s only so much one article can cover. You’ve pretty much asked for a small Phd project there. 🙂 I take this article as saying “I have reasons for not wanting to use passives, and here’s a pointer to them”.
If somebody wants to maximize total return, then as both the article says and I said in my comment above, that’s a different debate.
@diy investor — Yes, IUKD looked an odd fish to me from day one also — as I said to The Accumulator many years ago when he was looking for a passive income fund for some reason or another, I think it’s more a value fund that uses dividend yield as a sieve than an income fund.
That said, I know for a fact (because I watched them do it!) that when it arrived on the scene some private investors did turn to it as a one-shot replacement for a HYP or as a higher-yielding replacement of an income IT or similar.
Some of the other ETFs do indeed look more coherent to me. But I think Greybeard’s point — that rigid rules can produce perverse outcomes in currently unforeseen circumstances — does stand. Sure, IT managers can’t necessarily see the future either, but — within the context of their income seeking mandate — they can make changes in the face of adversity to preserve or grow that income, albeit potentially at the loss of some capital return. (E.g. They could and many did sell banks ahead of dividend cuts in 2007/8/9 or even before that. If bank shares had suddenly bounced back more strongly than they did as it turned out, then that would have been the price they’d paid for their evasive action. As it happened, in this case they got the best of both worlds but I wouldn’t bank on that happening all the time (if it did then why aren’t income IT managers the investing top dogs that hedge fund managers strut about posing as? Etc)).
@John — I think I’d use a mix of vehicles (and lots of other stuff too!) And I’d definitely use a cash buffer. But then I am my father’s son, and he once tested an aquarium stand he made for me for an 18″ fish tank by getting three blokes to stand on it at once! 😉
“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.”
My understanding is that most passive vs active research focuses on total return, not capital growth as stated here.
As The Investor said in his comment, if you consider total return then you’re back in well-researched territory where chances of an active fund beating the index over the long term are not in your favour.
“It will do this irrespective of future income prospects, because it only knows about past income performance.”
If future income prospects can be quantified then they can be included in the index rules. Or are you implying that active managers can predict the future?
I don’t think that “income” is a magic loophole that escapes the passive vs active evidence. But I agree that City of London Investment Trust is a solid investment trust with reasonable fees. In return for ~.3% above an index tracker you get smooth income. That can be worth the cost and that’s is a logical argument for active management in retirement.
Just a little proof
You could compare your chosen investment trust (City of London Inv. Trust) with a very typical UK passive fund a FTSE All Share Tracker. So that we are comparing like with like there is an Inv. Trust that tracks the FTSE all share called the Aberdeen UK Tracker.
As of today 25/06/2015 the following figures were taken from the AIC site (www.theaic.co.uk).
Yield on City of London 3.7%
Yield on Aberdeen UK Tracker 4.1%
Dividend growth per year on City of London 3.5%
Dividend growth per year on Aberdeen UK Tracker 10.9%
Good article Greybeard.
Have been banging on about this for years!!!
As Greybeard states :-
“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.”
When seeking a tilt to yield such ETF funds seem to use incredibly naive methods. Human input IMHO can aid greatly in evaluating the many issues involved when seeking sustainable yield, and far more subtly than a computer.
e.g. SWOT analysis.
@ The Investor
“The other argument is that you shouldn’t go for income per se at all, but rather you should go for total return from broad market cap index funds and sell down your holdings to generate income as required.”
Nothing new to add here, but to remind others that dividends come along almost regularly, but the other half of total return, the capital gains do not arrive on a regular calendar basis. This is unfortunate in retirement.
The worst case scenario for the retiree is to be forced to sell stocks at distressed prices merely to generate needed income.
Have no particular axe to grind one way or the other, so in retirement we run a mix of whole market trackers and income ITs, sufficient to meet income needs. Interesting to compare how the two perform over the years, and to watch out for the rebalancing opportunities which arise from time to time.
We do not hold however hold, and will never hold again, Income ETFs having been sadly disappointed in this area.
“Yield on Aberdeen UK Tracker 4.1%”
Something odd here. All Share Yield was 3.39% at the weekend.
How can a tracker outyield the index?
“Dividend growth per year on Aberdeen UK Tracker 10.9%”
Also seems suspect. Was this a one off?
Alternatively, select a diversified group of 30-40 stocks including USA dividend aristocrats. These have been increasing dividends for more than 25+ years like Colgate, coke, Johnson Johnson, proctor gamble, 3m etc this is my strategy. Reg, jon
Your AUKT numbers don’t sound correct. Their factsheet says 3.1% yield, and that seems to match the last year’s dividend of 10.2p. Prior year dividend was 10.3p, so its actually gone down. HL website says yield over the last 5 years between 3% – 3.6% pa. HL shows an odd current yield, too. No idea how its being calculated.
@magneto @steve A tracker can outyield the FTSE All Share when its on a discount. The figures I have quoted are from The Association of Investment companies which is the trade body for Investment Trusts, The quote daily prices, yields etc for most listed Investment trusts. As of today the figures I have quoted are from their website have a look http://www.theaic.co.uk. I apologize for not stating the yearly dividend growth figures are for the last 5 years.
very interesting and a lot of thoughts for me ponder.
Ive been dubious of div paying ETF,s so I just hold vanilla trackers .
still in accumulation stage so don’t have to make this discission as yet
but thanks Grey Beard for this article.
If you are going to pursue a ‘take the dividends’ strategy for your retirement income, then I largely agree that the passive vehicles may not be up to the job. However I think the main argument/debate is whether the reach for yield, in order to (somewhat artificially) limit your withdrawals to dividends, exposes you to unnecessary risk. Though, I can also see that it would be comforting to be able to meet income needs without ‘destroying’ capital.
Just to add further to the confusion, over the last three years, share prices :-
AUKT +32.5% now @ 5.7% discount
CTY +40.0% now @ 1.9% premium
Getting wildly different yields for AUKT dependent on source.
AUKT isn’t a member of the aitc: I have no idea whether that is relevant.
It is not clear if the comparioson is between capital value of the two investments of income value. What happened to the income generated by the iShares UK Dividend ETF (IUKD) compared to other ETFs? Would the graph be quite so dramatic? If income is the goal then capital value (growth) should not be a major focus but is certainly a worry. I do agree that if income is the focus then a level of management would seem to be required to respond to dividend changes etc.
Re: The Aberdeen tracker, one of the nice things about investment trusts is as limited companies, you can get lots of information from their filings rather than having to rely on online data sources. Looking at the last annual report is illustrative — the dividend actually declined very slightly in the last financial year (graph, page 2).
In all AUKT paid 10.2p in dividends in 2014, which makes the historic dividend yield on last year’s payout 3.1%, based on today’s price of 326.5p.
The forecast yield will doubtless be higher (though not sure who is doing estimates of this trust’s payout?) but even if it were to leap to around 12p, that’s still going to be only a little over 3.5%.
I suspect the data confusion mystery may be answered by this comment on the company’s website:
@Vanguardfan — Yes, it essentially comes down to what you’re comfortable with. The reason people obsess over the 4% withdrawal rate, for instance, is because they are looking for a ‘safe’ path for selling their capital whatever the market conditions in order to use up their ‘pot’ over the remainder of their life. Various strategies such as the one I linked to in Weekend Reading last Saturday might be employed to try and take the edge of the nerve-racking task of selling shares in a bear market when your portfolio has already halved, but that’s about the gist.
As my slightly sardonic tone indicates (sorry, it’s late) I have never really been taken with that strategy, despite it’s popularity in the US gurus. But of course the opposite tack — the ‘only spend the income’ tack — means (a) you’ll need a lot more capital because you’re only spending the income* and (b) you’re likely to have a lot left over when you pop your clogs.
*Incidentally, I do think getting too worked up about how income trusts are possibly achieving their higher income at the expense of some capital gains are a bit moot when the alternative ‘sell your capital’ strategy is explictly doing the same thing. 🙂
The reality is most of us are going to have a set of different choices, and I believe the optimal decision is going to be largely down to how one is wired, emotionally, and of course one’s circumstances.
Another interestig article.
I am interested in the statement that:
Is there much evidence from disinterested researchers about non Cap weighted passive products? I know Research Affiliates pumps out plenty of arguments to support it’s products but have the academic community studied the differences between all these ersatz products and low cost active alternatives?
Comparison with cap weighted indices and active managers have a huge evidence base but as far as I can see the overwhelming majority of alternative indices and their funds have barely had their mettle tested under a variety of market conditions.
About the chart: FTSE 100 outperformed the iShares UK Dividend ETF is a good example that value (dividend is a value) premium sometimes doesn’t work. It has worked in the long run http://www.schroders.com/globalassets/static/images/tvp-why-graph.gif. Of course there is no guarantee for the future. If You need concrete income You can use a total return approach with simple passive funds as The Investor suggests and if You are rich enough You can use only the unstable dividends as an income and You never touch the capital.
I’ve been following a “live off our dividend strategy” for 4 years now and the psychological and motivational advantages of seeing actual dividends hit your brokerage account is notto be underestimated. View these as “dividend paychecks” and this June for eg I will have 17 companies paying me. Over the years you see the dividends compounding and slowly catching up to meet your monthly expenses, and bingo you are finally free ! Of course the crucial factor is too select companies that will still be around in 20-30 years time. I don’t have any ITs and sold all my dividends ETFs but do hold significant cash buffers. So stocks & cash and fingers crossed it is for me. Regards, Jon
By the way the iShares UK Dividend ETF aims to track the performance of the FTSE UK Dividend+ Index. And the FTSE UK Dividend+ Index is a yield weighted index designed to select and measure the performance of higher yielding stocks within the universe of the FTSE 350 Index, excluding investment trusts. From 2010 he FTSE UK Dividend+ Index has outperformed the FTSE 350 Index.http://www.docdroid.net/14qpg/fudp-20150529.pdf.html
I agree its rather similar to the argument of: paying off your mortgage does not make sense from a purely financial perspective; but the physiological benefit of feeling you are not beholden to some 3rd party is great it creates a sense of freedom. I would say a goal of retirement is to feel free in general and get on with other things. So thinking about when to sell shares and fretting about capital values is not something I personally want to be concerned with. Just let the dividends roll into the cash buffer and make sure they are spent every year is my plan. Great article these always create a lot of interesting debate Greybeard
@investor, I hadn’t really thought of ITs doing the job of capital destruction when necessary – I guess I’d sort of conceptualised income ITs as massive HYPs, but of course there’s no need for them to be.
another issue that is relevant, and that hasn’t been touched on yet, is the effect on income generating strategy of the various tax wrappers (ISA and pension). I have about half my invested assets in taxable accounts, and I’d sort of assumed that I would sell these down first, in preference to removing income from either ISA or SIPP wrapper (indeed I envisage continuing to transfer assets as far as possible into these wrappers). I find it hard to analyse whether this is logical though – obviously ISA and SIPP income are taxed vary differently so that needs to come into the mix.
It would be really interesting to see some articles considering this.
On the topic of the psychological aspects of deaccumulation. I think these are hugely underestimated and the reason why, on balance, I am against the pension freedoms. When you have earned income it’s easy enough to work out if you are living within your means. When all you have is an enormous (relatively speaking, I’m aware many pension pots are actually very modest) savings account to eke out for the rest of your days, it really becomes a very stressful set of decisions trying to work out how much one can take out. I find it hard enough at the age of 50, being educated and numerate. Who want to spend old age fretting about money, as your energies and decision making abilities fade? So, I’m a big fan of guaranteed income streams, and I fully intend to annuitise enough for my basic living expenses when I reach a sensible age (no later than 70).
Earlier, you wrote: “Though, I can also see that it would be comforting to be able to meet income needs without ‘destroying’ capital.”
Now, you say: “I fully intend to annuitise enough for my basic living expenses when I reach a sensible age (no later than 70).”
I think this shows how the word “capital” is so laden with emotional overtones that it can cloud our thinking. In the former case, capital isn’t being “destroyed”, as we both (I’m sure) recognise, hence the quote marks you put around the word. It’s being spent, and consumed as a quasi-income.
Done adroitly, it’s possible to consume capital this way over long periods — if the market’s long-term capital appreciation rate is (say) 3%, then a 3% capital consumption rate simply maintains the status quo, albeit from a capital perspective, not necessarily from an income-producing one.
But take the annuity route that you also mention. Effectively, taking out an annuity wipes out the capital you invest in it — you have used it to purchase an income, and it cannot be bequeathed, etc. The capital hasn’t been “destroyed” (it’s earning gilt coupon inside an insurance firm), but it is effectively no longer yours.
I tend to agree with The Investor on this: there isn’t one “right” approach for everyone, and it’s about what suits your circumstances, and your emotional makeup.
At the end of the day, capital is a means of producing income. The irony of the present debate is that at a micro level, we all believe that our investments benefit from our active stewardship — and yet at a macro level argue the opposite, and go passive and buy trackers.
I am as conflicted as everybody else — despite what I’m doing with the SIPP, the bulk of my wealth is still at present in passive investments, including AUKT and Vanguard’s UK, S&P 500, and FTSE Developed World trackers. Gradually, though, that is changing.
Therein lies the rub. Even after three years of living off savings with a large investment component to fight my spending I have no real idea if I am living within my means, though I will easily bridge the gap to getting pension savings. It is one of the toughest aspects to get one’s head round, and the volatility of equity investments makes it harder. I am wealthier in inflation-deflated terms now that I was when I left work three years ago. How much of that is real, how much is irrational exuberance – there’s no way of telling. Even the vaunted 4% SWR is from a numerical analysis of past performance, which we are always told is not a guide to future returns.
I’m with Greybeard in that I’d like to spend only income for a long while, and I thank this article for the insight that ITs are a way of selling down some of your capital to smooth the income ride.. I’m prepared to pay for that – indeed as time goes by I’d be prepared to go even further pay for an annuity once the yield outclasses what I can get from equities, since I can’t take the capital with me 😉
@greybeard – ha! Well done for spotting the apparent inconsistency (I’m capable of thinking at least three mutually incompatible things before breakfast!) Actually, my first sentence was musing that I can understand why people adopt ‘take the income’ strategies, rather than a statement of my own intentions…just acknowledging that it’s pyschologically comforting, even if that’s an illusory comfort.
Age is also a factor too I think. I would be pretty reluctant to start selling capital at age 50, but at age 70, I’ll probably think differently. I also know that at 60 I have a real actual pension coming, which barring any really drastic events, should be enough to keep me from eating cat food…
Thanks to Greybeard for an interesting article and for some of the comments which were very illuminating too.
My take is that the psychological advantages of the income IT approach are extremely important and probably its main advantage. But I worry about costs. With total market index trackers it is now straightforward to get total investment charges down to 0.2%. The total costs of an IT once all the non-explicit charges are considered will, I would guess, be at around 1.2%. Taking a rather optimistic estimate of a 4% real return on a portfolio this means that the IT manager will take around a quarter of my portfolio returns (1% divided by 4%) going forward. This feels like very expensive psychological management and is too much for me!
A less important but significant issue is portfolio risk. Income IT’s by definition only invest in a sector of the market (higher yielding shares in countries with higher yielding stock markets). There are periods where this approach will yield better portfolio returns than the total market but long periods where it won’t. Factor in the additional risks of discounts / premiums and the risk that leveraging brings to IT investment and over-all I am planning to stick to vanilla index fund investing.
There is always the possibility that I will see things differently in 10 years or so when I expect to start drawing down!
You’d have to be nuts to choose IUKD for income. It proves nothing in isolation. @ The Investor – I mentioned I was using it as a proxy value fund (there was no other choice at the time) – not for passive income. I don’t use it now.
The reassuring thing about ITs is how long they’ve been reliably doing their thing. You won’t find passive vehicles with comparable records of smooth dividend delivery. And who wants to bank their retirement on products untested by time?
@ Greybeard – when was the last time CTY didn’t maintain its payout? Are there examples of ITs out there that promised and didn’t deliver?
I suspect if I intended to live off the income, I would do much the same as you.
But my plan is to take a total return approach because I think it will likely perform better over the decades. Whether it performs better over my decades is in the lap of the Great Ones.
My approach means I’ll have to accept a greater chance of volatility unless I’m rich enough to have it mostly in gilts by then. I think I’ll be fine with the swings but that’s easy to say now.
If anyone wants to look into managing their own income smoothing then look up the bucket strategy.
@ Uncertain – yes, lots of evidence out there about the performance of fundamental approaches. If you accept they are a proxy for the value factor. Look up Larry Swedroe. Theoretically it works but in the States there are cheaper ways of accessing the same juice than RA.
@ Ermine – the 4% safe withdrawal rate is more like the 3% SWR in the UK. Even then it’s such an artificial construct it’s not worth basing a retirement on. It was only relevant for 30-year retirements with a specific US equities/bonds asset allocation (60:40 or 50:50, can’t quite remember which) that didn’t take into account drags like costs and taxes.
All that tends to get lost in the media mangle. Dynamic withdrawal rate strategies are where it’s at. I’ll get round to writing about them one of these days.
> the 4% safe withdrawal rate is more like the 3% SWR in the UK
Oy vey, and with a single stroke of your pen us Brits have gotten 33% poorer 🙁 (needing 33 times annual spend rather than 25 times). We need that dynamic withdrawal rate strategy article, which seems the obvious way to go. After all, in a market crash the working folk around our retired future self will also be going through the wringer, and it would perhaps be gauch not to share some of the pain cutting back a bit!
Oops, my mistake. Incidentally, regarding there being no other choices at the time, isn’t it extraordinary how far we’ve come with all these options in just the past few years? Somebody should write a blog about it. 😉
This is an excellent post, and a useful discussion afterwards. It has jolted me out of my IUKD reverie; I have had a chunky holding of IUKD for years, despite misgivings based on its methodology and various @monevator comments over the years (notably about trading costs). Its performance has underwhelmed but not by enough to trigger a rethink; thanks to the rethink this blog has triggered, I shall now switch in favour of Vanguard Equity Income unless somebody has a better idea.
The other ETF I have found to be thoroughly disappointing is SPDR’s International Dividend ETF DWX. 5 year returns of ~4.5% (cf. Vanguard Total International, ~4.9%). Any better suggestions for an income-orientated global / non-US ETF would be appreciated.
I prefer the active IT income approach.
Using 4 trusts from Greybeards list the 10 year total return on £100 to 29/05/15 is:
This compares to FTSE All Share £217
M&G Index tracker UT £210
Current NDY on the 4 trusts is about 4.1%. All have long records of maintaining or increasing their dividends over 40 years so one could look to live off the natural yield, although keeping a cash reserve of two years spending would provide extra comfort.
That’s certainly impressive performance from the four investment trusts. But I don’t think it proves that the IT strategy is best for a number of reasons.
– the total return includes the effects of gearing (Dangerous in bear market)
– at least one of the trusts is mainly international (FTSE All share not fair comparison)
– one retrospective 10 year return comparison is not representative of all possible 10 year return periods (recency bias)
– the M & G tracker has an OCF of 0.48% which was probably even higher for some of the 10 year period. Vanguard and others are cheaper than this.
I know I am probably labouring my point but while I think Grey Beards article was thought provoking, the idea that the active IT income investment approach is better than total return passive investment is empirically wrong and quite dangerous for inexperienced investors looking to optimise their investment stratagem. I agree that the psychological benefit of drawing a regular probably increasing income managed by a financial services professional is significant but it comes at considerable cost (approx 20% of income)
Two asides – first an interesting comment on Neil Woodfords investment skill (he has been managing Edinburgh IT since 2008)
At least two of the Trusts are trading in a premium ie It would be particularly expensive to convert from passive vehicles to these investment trusts at the moment
Basing a retirement income stream on a set of funds (predominantly equity) that have delivered regular rising payments in the past rings all sorts of alarm bells to me. It smacks of massive survivor bias for one thing. If a payment track record becomes sacrosanct, another problem I can see is that fund managers may be tempted into playing silly games in order to generate income, such as buying cum-dividend stocks and selling ex-div, or taking on excessive risk by buying bombed out high yielding stocks.
I would question the need for striving for a regular income stream in retirement. Are outgoings regular? Mine certainly are not and never have been. I guess if someone is used to paying for everything on credit then outgoings could be regular, but I have always had a PAYG approach where big bills get paid as they turn up (holidays, cars, kitchens, bathrooms, etc.). If we did not have the money for a new kitchen, we saved up (budgeted) until we did.
At present my wife and I have no regular pension payments at all and live off income from our SIPPs, ISAs and other investments. It really is not all that difficult and I see no good reason to pay a substantial amount of my investment returns to a fund manager in order to pointlessly smooth out dividend payments.
Just keep running your 60/40 fund or whatever and take extra income and/or reinvest once per year on rebalancing.
@FirevLondon: see the list of income-centric ITs in my previous Monevator post.
@Passive Investor — ditto, taking note of the charges. With a TER of .5% or so, your “non-explicit charges” would need to be quite steep to take things up to your cited 1.2%.
@Greybeard. One of the difficulties here is the opaque way charges are reported. I have even gone to the annual accounts of one IT and it is impossible to tell. I would be pleasantly surprised if portfolio turnover costs, performance charges (not all ITs, I know) and bid-ask spreads didn’t exceed 0.7%. Perhaps this is overly cynical but the fact that the full charges are never disclosed indicates to me that they are likely to be high. Somewhere I have seen some data on portfolio turnover costs and I’ll try to find it. This paper is relevant but doesn’t give full figures on costs.
PS @Greybeard. The IMA link I sent in my previous does include some useful real data in appendix 4 (around p 41 onwards). There clearly is wide variability in portfolio turnover costs between funds, between sectors and over time. But overall 0.5% seems like a reasonable ball- park estimate
The crux of this article is that the FTSE100 has outperformed IUKD over 10 years.
Going to the FT’s charting tool, I compared IUKD with the FTSE and I have a choice of 12 timeframes to pick from, 1 day to 10 years, IUKD loses out on 10 years but wins on the other 11 time frames, rather selective data mining to “prove” a point….
When IUKD came out I rejected it in favour of the UK equity income trusts I held at that time. I did not like the look of the contents but I bought in after it fell 25% and over time I made further purchases as it fell an additional 50%, ultimately it made me a fair bit of money.
The method chosen is less than ideal as an income producing vehicle, more of a recovery play, value proxy. The Vanguard Uk Equity Income Index has performed pretty well since launch, the portfolio looks like many active income funds/trusts, you pays your money and takes your pick.
I no longer hold IUKD but do hold the Vanguard Index fund mentioned plus three investment trusts fishing in the same water.
@ Passive Investor
I think we have different preferences and outlooks on this. As an experienced investor I prefer the active IT income approach and don’t believe it is empirically wrong. I believe it can offer higher and more consistent income and better returns overall (net of charges), and I gave an example of that happening over the last 10 years.
On your specific points:
1. It is not necessarily dangerous to hold geared IT’s in a bear market if you can commit to hold them through such a period. If in de-accumulation you could spend your cash reserve, and/or dividends in order to minimise any sales.
2. I agree MYI is international. It is included partly as a diversifier.
3. I think the 10 year period is not necessarily unrepresentative and I would expect to see similar results over other 5 or 10+ year time periods. Index trackers are usually compared favourably to UT’s and not IT’s.
4. The M&G tracker was chosen because it was about the best with a 10 year record. One with lower fees may have increased the return to nearly match the index.
5. EDIN (£214) has beaten the Vanguard income index tracker (£191) over 5 years (I don’t have 6 year figures).
6. Average premium/discount across the 4 trusts is close to zero so I would regard it as reasonable at a portfolio level where you are buying for the longer term.
@david m. You are right I think in that we are probably going to have to agree to disagree. Just to be clear I don’t think the income IT approach is completely without merit I just think it is quite an expensive way of getting a smoother income and peace of mind (ie not worrying about portfolio valuation provided income is steady). The two points I do feel strongly about are:
1. Investment is all about costs and though ITs have a better charging structure than UTs they are significantly more expensive than a modern tracker. The correct basis for comparison is not the OCF of the tracker and the IT but the tracking error of the tracker and the total cost of investment if the IT. The management charge of an IT excludes portfolio turnover and other costs. We can only estimate these but a reasonable estimate (in my opinion at least)is 0.5%-0.7%
2. It seems completely implausible to me to think that IT managers have above average skill compared with UT managers and the rest of the market participants. Because of that I am not convinced by the data you quote about returns over a few selected periods.
Incidentally I am not in draw down so perhaps not as experienced as you but I have been investing for 25 years and have had an (? Unhealthy) interest in the theory of trackers since the mid 1990s.
Thanks anyway for your interesting comments and for taking the time to respond to mine. All the best
You state: “It seems completely implausible to me to think that IT managers have above average skill compared with UT managers and the rest of the market participants. Because of that I am not convinced by the data you quote about returns over a few selected periods.”
And you’re right: it is implausible. But don’t forget that IT managers have one advantage not possessed by UT managers etc: they don’t have to sell, in order to cope with redemptions. They can be as LTBH as they like, because redemptions aren’t an issue. So there are no awkward decisions to make about what to sell, etc etc.
@ Greybeard. That’s a fair point about IT vs UT redemptions in a falling market. I also think their long termism (compared with UTs) is attractive. As a group though like any other group of investors the average performance of ITs can only really be the market average minus costs (with extra volatility from gearing). I will be genuinely interested in a year or two when hopefully turnover costs are made explicit. If they are lower than I think and there are any large ITs with liquidity available at a discount I might even be tempted! Look forward to your next article. 🙂
@ Passive Investor
Thanks for your latest reply, and for prompting me to do more research:
On charges the current average OCF on the four trusts is 0.62% (AIC website; latest annual reports). Portfolio turnover costs would add to this. From the latest reports these appear to average only 0.09% on these four. This is because of low turnover (below 30%pa) and is helped by little or no stamp duty being paid by MYI.
On IT performance helpful factors can include cheaper fees (than UT’s), gains from gearing if markets mostly rising, gains from discounts mostly narrowing, no selling holdings or holding cash to meet redemptions, a culture of manager stability, and Directors can act to change under-performing managers. Some of these could change in future.
John Baron’s book on Investment Trusts, his website and his IC monthly columns are worth a read for anyone considering an IT income approach.
Thanks for that. The 0.09% turnover cost is much lower than I thought and sounds a bit low even for only 30% turnover to me. If it is correct then I am happy to have been wrong and may even go down the IT income route in due course. (The bid-ask spread, gearing and discount/premium issue still concern me but I agree that ITs certainly have some structural advantages over UTs)
PS That is 0.09% per year not per quarter?
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.
@david m – that’s great news, I am happy to be corrected. Thanks!
@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)
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.
@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.
@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.
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.
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).
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.)
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?
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!!
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.