Here at Monevator, a frequent request is for a post on exploiting the low costs and diversification of ETFs to generate an income in retirement.

And being the resident Monevator writer on all things retirement, the request has naturally landed in my inbox.

That said, it arrived with a faint air of apology. Our proprietor, The Investor, knows all too well that I have nailed my flag to investment trusts as a vehicle for retirement income.

Curate’s egg

I do hold ETFs in both of my SIPPs. I’m fully open to their merits in the wealth accumulation phase of the retirement investing journey.

But for the decaccumulation1 phase of the journey, I reckon that they have their drawbacks compared to active options.

Are those drawbacks of a terminal, show-stopping nature? For some investors, probably not.

Are the drawbacks permanent, and unlikely to ever change? Once again, perhaps not.

From a standing start, ETFs have grown into a $3 trillion phenomenon in a remarkably short time. Tomorrow’s ETFs might assuage my concerns in a way that today’s fail to.

So as a thought exercise, let’s explore how a portfolio of income-yielding ETFs might work, and see how those drawbacks manifest themselves.

Low-cost passive investing

The obvious attraction of an ETF portfolio is that many ETFs are attractively low-cost in terms of the fees that charge.

Moreover, in a financial world where many charges are rising, the largest ETF providers are cutting fees.

But that cheapness comes at a price: passivity. Basically, computer algorithms do the buying and selling, slavishly adhering to an index that the ETF in question tracks.

This is great for investors gunning for capital growth, as we at Monevator have long argued.

Statistically-speaking, passive investing beats active investing over the long term – and ETFs are generally the cheapest form of accessing those passive investments.

Capital growth, yes. Income, no.

But do passive investments suit an investor gunning for income, not capital growth?

Here I think the arguments are less clear.

I personally know of no studies claiming that passive investments do outperform active investments on the income front – an omission that is naturally of extreme interest to someone contemplating a retirement that might be funded by them.

So ETFs are great if you have investments large enough so as to be able to live off the natural yield that (say) a FTSE All-Share or FTSE 250 index tracker throws off.

Or, for that matter, a passive mix of corporate bonds and gilts; passively-focused ETFs can hold baskets of these fixed-income investments, too.

But for everyone else looking to be generate a passive income in retirement, you’ll probably be wanting the ETF to do something a little racier on the income front.

Smart filtering

So what might that raciness encompass? Inevitably, it comes down to ETFs characterised not so much by ‘passive’ versus ‘active’, but as ‘dumb’ versus ‘smart’.

In other words, the computer algorithm will be buying and selling stocks with a view to making selective pre-programmed judgements on characteristics such as yield, P/E, market capitalisation, and even dividend record.

Now we’re talking!

However that smartness comes at a cost – literally. For while passive ETFs are cheap, smart ETFs are rather more expensive.

In some cases, expensive enough to be within hailing distance of a straightforward actively-managed investment trust or low-cost fund.

Train wreck

Quite apart from cost, there’s another dimension to consider. Suppose the computer gets it wrong?

It can happen. Take the hapless investors who piled into one of the very earliest ‘smart’ income-focused ETFs, iShares’ FTSE UK Dividend Plus (IUKD), extolling its smart stock-picking, low charges, and general all-round wonderfulness.

Launched in 2005, IUKD flourished for 18 months, delivering a FTSE-beating share price and a growing income. And then came the credit crunch and ensuing recession.

Suddenly, IUKD’s ‘smart’ algorithm and stock-picking process looked monumentally dumb. Piling into higher-yielding shares had caused it to overload with just those shares that were about to crash –and in some cases, burn.

Eleven years after its launch, IUKD is still underwater:

IUKD’s share price (blue) versus the FTSE 100 (red) from 2005-2017

What about the all-important income? Here again, it’s not a pretty picture. The income plunged, too:

IUKD’s annual dividend distributions since 2006

As you can see, in only one year since the credit crunch – 2015 – has IUKD’s income beaten its first year’s dividend distribution.

Dashed expectations

Investors hoping for a steadily-rising income stream, of the sort that many investment trusts deliver year on year – with a good number of investment trusts boasting a rising dividend for several decades – will have been bitterly disappointed.

Not only has their capital been seriously eroded, but their income is down both in absolute terms and in relative terms – that is, relative to what they might have expected from either a purely passive ETF, or an actively managed investment trust or fund.

The good news? Thanks to the low cost of an ETF, investors in IUKD will have paid a TER/OCF ongoing expense ratio of just 0.40%.

This, of course, is significantly cheaper than the 0.42% TER/OCF ongoing expense ratio charged by (say) the City of London Investment Trust, which has raised its dividend every year for 51 years.

And, which since the end of 2006, has delivered capital growth of 28%, versus the FTSE 100’s more modest 14%.

Sarcastic? Moi?

Striving for the dream

So is the dream of income-investing through ETFs dead?

Well, IUKD is a sample size of one. Other ETF managers have presumably learned from the experience, as will have iShares. The past is no guide to the future and all that.

So next time, in my next post, I’ll sketch out two different ETF portfolios, each intended to exploit ETFs’ virtues in a slightly different way.

One will go for the very biggest ETF providers, and the very lowest charges, and aim to deliver a globally-diversified purely passive income – from equities and fixed income investments – of the sort that you’d expect from a global investment trust or fund.

And being invested in ETFs, you’d expect to achieve that with lower fees.

The second will shop for ‘smart’ income-seeking ETFs, again with a global dimension. I will deliberately aim for a diversified spread of ETFs and ETF providers – following the logic that the algorithms will (hopefully) be sufficiently different so as to minimise the possibility of them all blowing up at the same time, à la IUKD.

Will either of them be attractive enough so as to force me to change my mind, Maynard Keynes-style?

You’ll have to wait and see.

Note: You can read all Greybeard’s previous posts about deaccumulation and retirement.

1. That is, the spending bit! [↩]

What’s the right way to rebalance a portfolio is a question often asked and about as simple to answer as what’s the right way to end a relationship – the results vary according to circumstance and personal style.

A number of different portfolio rebalancing methods exist, but there’s no clear-cut evidence that there is one system to rule them all.

Research by the respected fund shop Dimensional Fund Advisors concludes:

There is no easy one-size-fits-all rebalancing solution. Rebalancing decisions should be driven by the need to maintain an allocation with a risk and return profile appropriate for each investor.

The optimal rebalancing strategy will differ for each investor, depending on their unique sensitivities to deviations from the target allocation, transaction frequency, and tax costs.

When it comes to rebalancing, like so many things in life, it’s doing it that counts, not exactly how you do it.

Calendar rebalancing

So, as passive investors like to keep things simple, you can go easy on yourself and plump for the most straightforward option: Calendar rebalancing.

Just pick a date and your rebalancing frequency:

• Quarterly
• Semi-annually
• Annually
• Every 2-3 years

When the clock strikes, you review how far your current asset allocations have drifted from your target weightings. And then you take action:

1. Sell the out-performers
2. Buy the under-performers
3. Do so in proportions that return your portfolio to its target allocations

This apparent act of madness is banking on mean-reversion; you aim to cash in on the shooting stars before they fall back to Earth, while potentially turning today’s dogs into tomorrow’s winners.

Beware! The more often you rebalance, the more likely you are to curtail the superior returns of the winners before they turn into losers – essentially because you cut the winning run short.

The advantage of frequent rebalancing is that you’re less likely to be over-exposed to an asset on the rampage, and so avoid excess pain when the sell-off begins.

Many finance professionals urge frequent rebalancing as a way of enhancing returns. But reliable evidence for this is scant, as it really depends on how you cut the stats to suit your argument.

The known cost of rebalancing

What is certain is that frequent rebalancing increases trading costs and potentially your tax liabilities. That can be more than enough to wipe out any chance of a rebalancing bonus.

I prefer to rebalance no more than once a year. That gives winning assets a reasonable time to go on a run, but also means I check in often enough to correct any major deviations caused by frothy markets.

Passive investing guru William Bernstein advises:

“Rebalance your portfolio approximately once every few years; more than once per year is probably too often. In taxable portfolios, do so even less frequently.”

The weakness of infrequent calendar rebalancing is that it can leave you exposed to big changes in your portfolio – occurring over short periods of time – when markets are volatile. The answer to that is threshold rebalancing.

Take it steady,

The Accumulator

Good reads from around the Web.

I think we’re nearly all agreed now that UK property prices are too high, and in the South East at historically stretched levels compared to rents or incomes.

(Okay, so my mum is a holdout. She rightly views my housing sob story as leavened by a substantial dollop of my own personal failings… I think she also wants to see a granny annex in her future!)

You do still hear from the odd Barry Blimp who says that it was just as difficult to buy in his day, when he bought a three-bedroom house in Zone 2 in London aged 25-years old on his graduate salary – and that he managed it because he didn’t own an iPhone.

But even most naysayers have shifted to tell you that fine, yes, house prices are absurd, but what’s so bad about renting anyway?

This view is invariably advanced by people who haven’t rented for decades, and often as not who’s only recent contact with a tenancy contract is the one they just got signed for their latest buy-to-let.

Down and out in London and Bristol and Oxford and…

Meanwhile people who feel locked out of the property market know that it’s not just a matter of being allowed to bang nails into the walls to put up their own IKEA pics.

They can see how not owning housing – geared up via a mortgage to lottery-level winnings for older generations – has left them floundering in the wake.

I see this illustrated all the time with my 40-something London friends.

The majority who bought in their 20s never stop taking holidays, eating out, and buying fancy bits and bobs.

The few who didn’t even avoid having too many Sunday lunches in the local gastropub – or go the other way, throw in the towel, and spend their large yet useless deposits on year-long hedonistic benders. (i.e. A bit of travel).

As for my 20-something friends, they live from paycheck to paycheck and imagine owning a one-bed flat with the same sense of wonder with which the Baby Boomers viewed the moon landings.

Before anyone gets out their tiny violins, I’m not talking about me. My lifetime savings rate has been very high, and my investment returns above average. As a result I’ve amassed a chunky warchest. I could buy, but I don’t.

However I don’t think it’s reasonable to expect an entire generation of bright young people to turn themselves into a Scroogier version of Warren Buffet just to do what their parents did as a matter of course.

Fine, perhaps this is the way the market will be for the foreseeable future. But if we’re being pragmatic then we should at least acknowledge the strain it is putting on social norms.

The return of feudalism

In particular young people – who also face student debts, high rents, low wages, unfunded pensions, and no chance of a BTL windfall – will get relatively poorer even if they do the right thing, unless some sort of action is taken.

Business Insider recapped a Resolution Foundation paper this week that shows how property ownership in the UK is driving inequality.

It notes that:

Britain has changed since 1998.

Back then, it only took workers about three years to save enough money for a down-payment on a house.

Now it takes 20 years, on average.

(Sure Barry, it was just as hard in your day. The kids should shut up and stop drinking cappuccinos, right?)

This graph shows how property ownership is now the major driver of inequality:

Note the divergence on the right hand side (Click to enlarge)

Source: BI/Resolution Foundation

The key is to look at how the lines used to be close together, and now aren’t. It was not ever-thus, in short. Not owning a home didn’t put you on a downward escalator for life.

Raising the White Paper flag

Like most, I don’t see much in the Housing White Paper that looks likely to address the under-supply of new homes in the UK.

Perhaps recent political events might if they curb migration and hence population growth – but then lower immigration could also reduce supply by depleting the workforce. (House builders are already complaining about a skills gap).

Maybe it’s time to think differently. If we can’t build enough extra houses, then perhaps those without houses could get a different kind of tax break, for instance.

It irks me enormously that friends see 10-20% capital gains tax-free growth each and every year on their homes while I face a huge bill if I sell various un-sheltered legacy holdings.

Shouldn’t investments be fungible, especially nowadays when it is so much harder to buy property? Maybe if you don’t own your home you should get a six-figure CGT allowance?

Okay, that’s an aspiring 1%-ers problem. The vast majority of millennials will struggle to even make a dent into the new £20,000 annual ISA allowance that’s coming in April.

Maybe renters could deduct their rent from their income tax bill? It sounds insane, but then crazy ailments may require outlandish treatments.

What the government should not do is row back on the tax changes hitting BTL. If anything it should speed them up. There’s no justification for a policy that actively encourages a minority to get richer, as per the inequality graphs above, while other citizens are locked out.

Oh, and before someone says it, I don’t think inheriting property wealth is the ideal solution. That just compounds the new feudalism of a property owning class and a rootless peasantry that we seem to be sleepwalking into.

Unless like me you want to start taxing inheritances at 90% or similar. And I know very few of you want to do that. 🙂

Here’s a few more property stories from this week:

• Property owners get richer while everyone else gets poorer – Business Insider
• How to own a home by the age of 25 – BBC
• The 30-somethings fleeing London’s property prices – The Guardian
• Can the Government’s Housing White Paper fix the “broken” market? – Telegraph
• Buy-to-let landlords face remortgage crunch [Search result] – FT
• You could buy builders for their high dividends instead of BTL – ThisIsMoney

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