Important: What follows is for general interest, not personal investment advice. I am a private investor, not a financial advisor. Please read my disclaimer.
Chalk up another scalp to the efficient market theory. Roughly ten months after I bought it, our demo High Yield Portfolio (HYP) that I put £5,000 of my own hard-earned into on 6 May 2011 is lagging the FTSE 100.
This isn’t exactly a shocker – we don’t run all those articles extolling passive investing for nothing!
Still, I wouldn’t be human if I wasn’t mildly miffed.
I didn’t propose the HYP as a market-beating vehicle, however. Like its Motley Fool promoter, Stephen Bland, who has been banging the drum for one-shot income portfolios for over a decade, I see a HYP’s main aspiration as delivering a superior and rising investment income.
Yet the decision to buy a HYP is hardly the only option. For that reason, I plan to track how our demo HYP does versus a couple of other equity-based investments over the years ahead.
I won’t compare it to murky structured products, pseudo-bonds, offshore tax wheezes, or anything of that sort. You’re on the wrong site for that, I’m afraid!
What about a cash or annuity comparison?
I don’t propose to closely track how £5,000 kept in cash or in gilts would have done over time.
With all income assumed to be spent each year and no prospect of a capital gain from cash, any comparison would become increasingly useless.
Suffice to say that with base rates at 0.5%, my HYP’s starting yield of 4.3% was much higher than the best instant access cash rates available. Even locking away your money in a fixed-term deposit wouldn’t have got you more than about 3%.
Where the comparison with fixed returns would be more useful is with an annuity.
I think HYP’s are best thought of as an instant way to buy income for now and the future. They are much more a (far riskier) alternative to buying an annuity, say, than a method for beating the market.
To that end, I wish I’d looked at what annuity rates were available when I bought the portfolio, although I don’t think they’re much changed today.
For the record, according to the Best Buy tables from Hargreaves Lansdown on 1 March 2012, a 65-year old male can buy:
- A level annuity of £5,937 today for £100,000
- A 3% escalation annuity of around £4,103
The first equates to a yield of 5.9%. Much higher than the HYP, but with no inflation-proofing. The escalating annuity will rise over time, as I expect the HYP income to, but its starting yield is lower at 4.1%.
If anyone has access to a snapshot of rates in May 2011 so we can get a more accurate line in the sand, please do let me know in the comments below.
Remember that annuities are very different beasts to HYPs. They are guaranteed to pay out, for starters! A very pertinent consideration once you’re income-earning days are behind you. I’m many years from retiring, but I expect to convert some portion of my funds into an annuity when I do so for this reason.
On the other hand there’s no practical age constraint to when you can buy a HYP, unlike with an annuity. An annuity isn’t really a credible alternative if you’re under 55 and looking to live off investment income, even if you’re prepared to accept a very low yield.
Comparison with the FTSE 100
Given the portfolio’s constituency of mainly blue chip British mega-caps, the most straightforward benchmark is the UK’s index of 100 biggest shares.
Passively tracking the FTSE 100 offers a simple way to get a relatively high and hopefully growing dividend yield, as well as cheap exposure to capital growth in what’s a very globally-facing stock market.
I plan to track the portfolio against the iShares FTSE 100 ETF (Ticker: ISF). Like the HYP constituents, it’s stock market-listed. Comparison with this ETF should also make calculating income due a fairly straightforward task.
There are cheaper trackers available, but ISF is good enough and a popular choice among investors.
This exercise isn’t really about scientifically proving anything, anyway. Rather it’s to give interested readers a semi-regular insight into the indolent management of a largely hands-off portfolio of income producing shares, versus a couple of alternatives.
Income investment trusts
I’m growing ever fonder of income investment trusts as the years go by. I have been impressed with how the cash reserves retained by these trusts helped them ride out the dividend cuts of recent years without cutting their payments to shareholders.
If you can get income investment trusts when they are trading at a discount to NAV, I think they offer an excellent way to buy an above-market income that will hopefully rise ahead of inflation.1
With these trusts you do pay management charges (just as you do with open-ended equity income funds, which I am not as fond of but which are a reasonable alternative). This makes them more expensive to run than a tracker fund, let alone a portfolio of directly held shares.
On the other hand, once you’re into the spending phase of your investment life-cycle, costs are slightly less of a concern, given you’ve less time for their impact to mount through reinvested compound interest.
What do you get for paying these higher costs? A portion of the trust’s revenue reserves for one thing, as well as its ability to use gearing when the manager thinks shares are cheap. (Your own bank would surely baulk at giving you a loan to buy shares in a bear market!)
You’re also paying the trust’s manager to do some managing for you. It is inevitable that any portfolio of shares – even big and supposedly ‘safe’ blue chips – will have a few blowups and other challenges along the way. Buying a trust outsources all this bother.
Enthusiasts will argue your manager can deliver extra returns through superior stock picking. I wouldn’t bet on that; any out-performance is most likely to come through the tilt towards more value-orientated dividend-paying shares, I think, rather than through specific stock picks. A few have managed it though, so you never know.
Because trusts go in and out of fashion – and to reduce management risk – rather than just pick one trust, I’m going to compare the HYP against a blended trio of income trusts I like and that at times I’ve invested in:
- City of London Investment Trust (Ticker: CTY)
- The Edinburgh Investment Trust (Ticker: EDIN)
- Merchants Trust PLC (Ticker: MRCH)
Snapshot comparison to date
I bought the High Yield Portfolio on the 6th May 2011 using Halifax’s cheap ShareBuilder service.
Here’s where capital values stand to-date, with a caveat:
- Demonstration HYP: Down 5%
- iShares FTSE 100 ETF: Down 2.5%
- Basket of trusts: Down 0.8%
One thing to note is that the Demo HYP is a real-money portfolio – so it includes all dealing costs and stamp duty – whereas for now I’ve simply calculated the benchmark returns on their prevailing prices. This is probably worth about 0.75% to 1% of the differential with the trusts, though much less with the ETF, where there’s no stamp duty to pay.
Still, the portfolio is clearly lagging both the ETF and the trusts to-date. Not surprising, given I don’t see any reason why a one-shot portfolio of shares should beat the market, especially over eight months, but I am disappointed by the magnitude versus the FTSE 100, even allowing for the HYP’s higher yield.
The good news is income is holding up fine for our portfolio (as well as for the comparison investments, for that matter).2 That’s the main point. Long-term I want to see annual income rising steadily ahead of inflation, with minimal tampering from me, and with all income spent, not reinvested.
We’ll return to the HYP in May with a more detailed look at how the portfolio stands after one year, a recap of its first year of income versus the benchmarks’ payouts (and perhaps their return on a real-money basis) and even some fancy graphs.
Note: At the time of writing I own shares in all those you’ll find in the demonstration High Yield Portfolio.
Comments on this entry are closed.
There is another big difference between HYP dividends and annuity income: while the latter is taxed at 20% once over your personal allowance, the HYP dividends have no further tax to pay for a basic rate tax payer.
The HYP can also be moved to an ISA in stages (starting with REITs) to make use of capital gains allowances and to simplify paperwork.
@gadgetmind — Agreed, and there’s plenty more differences than that, too. I need to do a full post on that at some point, I think. This was just a nod to an alternative way of buying income, rather than full take on the pros and cons. (In fact, I need to revisit pensions at some point, since they’ve become much more attractive since I started this blog in 2007, mainly by becoming less restrictive — for now at least!).
Cheers as ever for stopping by. 🙂
Commiserations on the timing of the HYP purchase 😉 Though as you say, you’re taking the hit on dealing costs and SD, and it’s not that bad compared to what it looked like in August, I’ve been tracking your HYP in a model portfolio too.
One thing that I might query is the effect of charges. If I look at my family history I could expect to live a lot longer than I’ve been working for. And my stake is maximised at the moment, and I don’t aim to run the capital down. Somewhere in my gut I feel the effect of charges compounding on a larger stake and over a longer time will actually make more difference, in terms of the income lost added up over the years?
Interesting… looking at http://www.sharingpensions.co.uk there is a table showing a 65 year old single life level pension annuity at £6112 (not that far off your £5937) but in May 2011 the same annuity produced £6806 – that’s about 11% more !!
If you have the cash (as opposed to a pension fund) then you could instead buy a Purchased life Annuity producing £5826 which doesn’t sound great until you realise most of this is treated as return of capital so it gets effectively taxed at about 6% and is worth about £5476. The Pension annuity gets taxed at 20% (or higher!) so is only worth £4889.
These figures are just indications for the same 65 year old but show that the PLA (if you really have to buy an annuity) is worth thinking about.
Personally I have the 3 Investment Trusts you mentioned plus a few others and some income producing funds in a SIPP which I hope is going to produce about 5% with hopefully no erosion of capital.
Interested to hear what others think !
Kudos for putting it all up there for people to look at! My own income-oriented portfolio (which includes a big slug of HYP shares) is up significantly since April 2011 (around 15%). Why the difference? Maybe my yield threshold was a bit higher (over 5%)? Also I have a fair chunk of fixed interest investments, including gilts (which I have been able to sell for a gain), which helps to smooth out the stock market gyrations.
On annuities, sometimes you don’t have a choice (and paying any higher-taxed income into a pension is a ‘no-brainer’). But if you have a defined contribution pension, it might be worth taking the maximum cash-free lump sum and investing that in a ISA. As gadgetmind has pointed out, tax is an important consideration. For that reason, I will take the lower but rising annuity and hope that the tax threshold rises over time to maximise my after-tax income.
Haha – so sorry: that should read 5% gain since May.
@Moneyman – Glad you found it interesting. And yes, I’m sure it’s the gilts that made the difference. This is a pure equity portfolio for demonstration purposes, and gilts were about the best performing asset classes of 2011. Also we’ll see in May (assuming no big reversal by then!) a couple of shares have really thumped performance, as sometimes happens in an active portfolio: Tesco and Admiral.
I should point out in case it’s not obvious to new readers that why I own this HYP, it’s only a tiny fraction of my net worth, run as a demo. What’s more, most investors will want to be properly diversified across asset classes for just the reasons @Moneyman states. Here’s a few ideas for cheap diversification.
@oldtimer47 — Thanks for the rate information. On reflection annuity rates probably were higher in May 2011, given their sensitivity to long-term government bond rates. As just discussed with @Moneyman and alluded to by @Ermine, May was about the time the stock markets turned down and gilts started rallying, pulling down yields.
It really is a bit ridiculous that people can save for 30 years and then face buying such a volatile one-shot investment (although I appreciate the rules have been much modified recently). There ought to be some sort of smooth glide path in and out to annuities, as well as to the end stage of the pension investment cycle, if people are going to continue buying annuities en masse. Then again, perhaps financial theory would say that any attempt to second guess rates to provide such smoothing would hurt as many as it helped over time.
I’m many years from understanding or needing to understand how to turn my investment fund into a retirement income in the most specifically efficient manner, so your comments are all news but still interesting to me. My working assumption is I’ll annuitize about 1/4 of my fund, and probably run a large chunk of the rest with as a very well diversified income orientated portfolio.
But that’s at least 30 years, a lot of legislative changes, and a lot of returns away! 🙂
Dear TI
Annuity rates for a 65 year-old male are never going to be a useful benchmark for me, because I’m female! How about also giving rates for the other half of your readership? (Or at least, the proportion of your readership this post neglects?)
PS: you’ll have to imagine for yourself the smiley face that saves comments like this from sounding curmudgeonly – I don’t know how to do the emoticon!
@Tyro — Okay, by request I’ll bring in a female annuity rate into the comparison too, in May. (Please remind me if I don’t! 🙂 ).
That said, I don’t want to go overboard on the specific annuity comparison. I am just trying to set up a couple of comparators for the portfolio, rather than suggesting too heavily this was a specific choice an investor might have made in May 2011.
Longevity risk is clearly what drives lower female annuity rates. Equally, because you’ll probably live longer than a man, investing a portion of retirement funds into equities for income may make *more* sense. (I am actively exploring this possibility for my mother). It’s a very big topic, which I don’t want to treat too lightly in this context.
But anyway, as I say I’ll pop in the two rates next time. Cheers! 🙂
Once upon a time I used to price commercial annuities based on swap rates. I have to query your comparison of your HYP yield and the annuity rate. The yield of the annuity depends on the mortality assumptions, but even on a generous 25 year assumption for a male aged 65 (ie predicting a life expectancy of about 90), then your £6,000 annuity is only equivalent to a “flat” yield of about 3.25%. More detailed information about the yield curve might tweak the figure but the lack of principal repayment will always make the yield figure look small. Increasing life expectancy makes annuities increasingly expensive, even if we aren’t in an insanely low yield environment. (There’s another interesting conversation to be had about to what extent that low-yield environment is due to increasing life expectancy and the impact on demographics…)
Thanks for the update on your hyp. I run a similar strategy which is a combination of individual shares (25) and higher yielding ITs. I have been putting it together for the past 18 months but it is more or less completed now.
Interesting to compare the dividend growth rate between shares and ITs over the past year – shares average 10% whilst ITs are only 6% (global and UK growth & income sectors). I guess the ITs must be rebuilding reserves. It will be interesting to see how this pans out between the two over time.
I saw a recent article from Capita Registars which said dividends paid in 2011 had increased by 19% overall. The forecast for 2012 is 10%.
Including dividends, my portfolio just about broke even last year. I was a bit reassured to see Buffetts return was only around 4%!
Look forward to the next instalment.
(btw, are the returns including reinvested dividends?)
JH
@NumberMuncher — We may be at cross-purposes here. I am saying that if I have £100,000, I can spend it to buy the HYP on a yield of 4.3%, or the flat annuity yield of just under 6%. The maths seems very simple (£6,000/£100,000), so I think either I’m misunderstanding how annuities work (I can’t see how) or you’re talking about trying to calculate the fair value of the annuity based on the loss of capital to heirs on death or similar?
I am not interested in the latter for the purposes of this article — I am just looking at what income your money can buy.
Starting to wish I hadn’t raised the subject of annuities (not for the first time!) 🙂 It’s not that this commentary isn’t interesting (or appreciated) but I in NO WAY want to suggest that a short paragraph in an article about a different investment vehicle is going to cover off the subject of whether you should buy an annuity or not. It’s a huge subject, and well beyond the scope of this piece (and my knowledge of post-retirement investing, though I may need to learn more).
@John — Yes, you’d have to compare IT returns over several years — as I say in the article, they held dividends despite the cuts in the downturn, so now to an extent shareholders are having to take the other side of that. Also, much of the recent dividend hikes are outside of the typical HYP fare (e.g. resources)
I’ve seen the Capita report too (in fact I mention it above).
Also as mentioned above, the income is all going to be spent.
I suspect I am going to have to reiterate this every time I do an update, but this isn’t a capital building vehicle demo, it’s a demo of buying income via high yield shares. 🙂 I know some do use HYPs as capital builders, but while not actively bad I wouldn’t expect that to be ideal, either, personally, as you’ll miss a fair few sectors/areas over the long-term, especially if you go ‘all in’ with a lump sum and never rebalance. (Reinvesting income could overcome that to some extent, admittedly, as other sectors fall out of favour).
@Investor: OK, fair enough, I was taking into account the lack of capital repayment. Good on you for not caring about your kids, ungrateful little rats 🙂
My remaining serious point is that annuity rates are dependent on mortality data whereas your HYP yield is not (directly). On the other hand, you could introduce a mortality dependence, by liquidating your £100k portfolio and thereafter living exclusively on a diet of Big Macs, chips, deep fried Mars Bars, tequila and Monte Cristo cigars. Should be good for 50 grand a year or so. Have fun!
“… thereafter living exclusively on a diet of Big Macs, chips, deep fried Mars Bars, tequila and Monte Cristo cigars…”
Well, you’ve just described my last 8 hours, give or take! 😉
Another interesting article. Being quite new to all this (and a fair way away from retirement), my current thoughts are to diversify by splitting between a HYP and annuity on retirement.
Being just a passive investor at the moment (but always tempted to have a dabble away from index trackers) I think it would be wise at some point in the future create my own demo HYP well in advance of retirement, in order to get the hang of it before retirement.
@Jonny — Glad you liked it. You won’t necessarily have to abandon passive investing on retirement, even to stay invested in equities. You might just switch to receive income, and possibly switch to something like Vanguard’s equity income tracker. Or not. Lots of time to decide!
There is no need to switch to income assets in retirement. Total return is what matters, and taking some money as capital gains rather than income or dividends makes lots of sense tax-wise.
Even when investments are wrapped (ISAs or pensions) there is no sense going for a holding mix with a smaller total return simply to get higher yields.
@gadgetmind — In principle you’re right of course. In practice many people are terrible at choosing, running, rebalancing, and realising total return assets. In my view it’s a recipe in many hands for chasing performance and overtrading etc. Buying for income imposes a discipline and spending it as it comes rather than juggling capital gains for many when retired! Each to their own though.
> rather than juggling capital gains for many when retired!
I’m under 50 yet have enough capital gains to provide me with much juggling on a unicycle until state pension age.
I’ve even had to teach my 18yo daughter about CGT as I put some speculative shares into a bare trust for her in 2008 and they’ve proven to be 20 baggers.
I guess I shouldn’t complain, but I will. 🙂
@gadgetmind — Sure, I concede if you can reliably pick 20 baggers then my generalisations do not apply…
Reliably … if only!
@Gadgetmind — Ahem. Exactly! 😉
Incidentally, by ‘juggle capital gains’ I am not talking so much about the resultant tax hassles, which I agree are the nice kind of problem to have (and can be a sensible part of tax planning).
I mean deciding what to sell and what not to sell. Anyone who has had gains knows it’s all too easy to sell your winners early etc (as you might have done with your daughters shares, etc).
Focusing on income avoids all that, if you’re psychologically attuned to the approach, which perhaps you’re not.
Agree cats can get skinned in all sorts of ways, poor blighters! 🙂
Daughter’s shares are being sold down in CG allowance sized tranches. She’s probably going to start a S&S ISA this year, but she has a savings account that pays 5% interest, and that continues to be a sensible option.
But you’re right about income. It’s because the income portfolio can be left alone that went for this option for my wife. It’s a close approximation to a Motley Fool HYP, with 20 holdings in good divi payers with good divi cover. I was lucky (and brave!) to be buying over last summer, so already have good capital growth, and have a yield of around 5.5% pa (unguaranteed!). I intend to keep adding to this as and when opportunities arise.
Dunno what’s best to do come retirement. My wife will have loads of unwrapped holdings, and sizeable ISA pots. I’ve currently got an income stream in the plan at 5.3% pa from both, which can be a combination of dividends and using capital gains allowances. My spreadsheet shows unwrapped investments being sold down every year to fund ISA subscriptions, but does it make any sense to be subscribing to ISAs and also taking income from them? Probably not!
Instead, we’ll probably keep good dividend producing assets, sell down my wife’s unwrapped holdings in Personal Assets, RIT and Ruffer, and use the money from this to subscribe to ISAs (or at least avoid drawing on them) and as income.
Anyway, I’m currently in accumulation mode, and need only worry about these issues when deciding what assets to accumulate where.
mmm very interesting for me………..
im putting together a HYP but thinking about selling it and going for vanguard equity income index fund instead. it depends if theres really much difference in yield between them. not sure there is?
if I sell my HYP [im up £1000 on capital gains and I love the divs coming in but I find im glued to the news and what Neil Woodford is
saying and doing all the time. not sure if im a suitable person for HYP ?. investment trusts sound good but you have to wait and buy on discount .it all depends if theres going to be a big difference in yields etc whether i go ahead and sell my HYP. my HYP will return a total yield at present of 4% and I think vanguards equity income fund is just around or just under 4% . I suppose im abit nervous too as how it would fair in market crash as the IUKD didn’t do well at all I believe . any thoughts anyone?