The return premiums are the radioactive elements of passive investing. On the one-hand they’re potent sources of energy for your portfolio. On the other, they’re complex, risky, and must be handled with caution if they’re not to make your hair fall out.

But what if there was a way to combine the various elements in the reactor chamber of your portfolio so that the risks were reduced and the energy retained?

Well, it turns out there is…

By blending the right premiums (also known as risk factors) you can produce a more diversified portfolio that has the potential to outperform the market.

The key is to choose factors that have a long track record of delivering strong returns and that have little or even negative correlations with each other.

This way, when one factor is having a meltdown there’s a good chance that one of the others is keeping the lights on.

Complementary risk factors

Though cold hard stats are hard to come by, certain risk factors have been shown to work across global markets – including the UK.

The strongest factors have been:

• Value – it’s beaten the market by 4.9% per year in the US and 3.6% in the UK.

• Momentum – beaten the market by 9.6% in the US.

• Profitability – beaten the market by 4% in the US.

Note that passive investors can only expect to gain roughly 50% of the premium (i.e. the outperformance) because we don’t do things like shorting equities.

Still, an extra percentage point or so added onto your annual performance is well worth collecting when you consider that equities have historically averaged only a 5% real return per year.

Better yet, value has had a negative correlation with profitability and momentum, while profitability has had a low correlation with momentum.

The learned Professor Novy-Marx – who discovered the profitability premium – spells out the benefits:

“Over time, tilts towards value, momentum and profitability have outperformed the market, and due to the diversification benefits, a combined portfolio of these three has provided much higher reward per unit of risk and a significant reduction in extreme risk or losses.”

How high is the potential reward?

• Novy-Marx has shown that a dollar invested in the US market in July 1973 grew to over $80 by the end of 2011.

• But if you’d invested it in profitable, value companies with momentum then your dollar would have grown to $955 (before expenses).

That’s a 1,093% increase.

Monevator’s factor flirty portfolio

So how much profitability, momentum and value should you add to your portfolio? Ideally, you’d just forecast the expected returns for each factor, grind them through a mean variance optimizer, wave your magic wand and conjure up the perfect portfolio.

In reality, because nobody can predict the future, even the experts just equal weight them.

Mr. Antti Ilmanen of AQR – a US fund house that leads the way in factor investing – says:

“Because we believe that each of the styles offers similar long-term efficacy, a good starting point for a strategic risk allocation is roughly equal risk-weighting the applicable styles in each of the six asset groups we trade. We believe this can capture the maximum amount of diversification and can lead to the most consistent returns long-term.”

The equity portion of a portfolio heavily weighted towards risk factors could look like this:

• 50% total market (beta)
• 10% value
• 10% momentum
• 10% profitability
• 10% emerging markets
• 10% global property

You would use developed world index funds or ETFs to buy the market as well as the risk factors. Adding an emerging market and a global property tracker bolts-on further diversification.

You could reduce your allocation to beta and increase your risk factor holdings further, but know that the further you drift from the market portfolio, the greater the chance you’ll experience tracking error regret whenever a simple market tracker beats all your fancy funds.

That’s the greatest danger you’ll face if you follow a factor-based strategy.

Individual risk factors can trail the market for years, so you’ll need discipline and courage to keep rebalancing back to languishing funds – all in the face of pundits proclaiming ‘value is dead’ when they need to reach for a cheap headline.

Happily, the author Jared Kizer has shown that at least one factor has outperformed 96% of the time, so hopefully there will always be one asset keeping the flame alive.1

And over time, performance volatility will be your friend, as it’s your chance to scoop a bonus as you rebalance back to your strategic asset allocations – in other words, a classic ‘sell high, buy low’ strategy.

You can always add the small cap and low volatility factors, too, but remember you’ll need to find space for them from the equity part of your portfolio. (Don’t steal from your allocation to bonds, for example!)

Remember that your equities-bond split is the most critical asset allocation decision you’ll make – the one that makes the biggest difference to your ride.

Multi-factor

Many experts believe that a blend of factors is better than a collection of single malts. In the US, you can buy a single multi-factor fund that adds a profitability and momentum screen to a small value strategy.

In other words, you can buy a fund of small, cheap, profitable winners.

Nothing like that yet exists in the UK for DIY investors, although Lyxor’s Quality Income ETF has taken an early stab.

Once we catch up with the US, adopting a risk factor strategy will be as simple as buying a low cost total market fund, diversifying with a multi-factor fund, and then diluting your risk with a bond fund.

But if you can’t wait to get started then you can construct a diversified risk-factor portfolio as I’ve just described, using individual ETFs in the iShares or db X-tracker factor ranges.

Take it steady,

The Accumulator

1. Kizer uses size not profitability in his study of factor-based diversification. [↩]

Good reads from around the Web.

The wait is nearly over, glass-half-full-fans of a certain age. National Savings and Investments (NS&I) has revealed the first firm details of its upcoming ‘Pensioner Bonds’.

More is to come with the launch in January, but here’s what NS&I says so far:

What are the bonds?

• Lump sum investments providing capital growth
• Choice of terms – 1-year and 3-year
• Designed to be held for whole term, but can be cashed in early with a penalty equivalent to 90 days’ interest

When do they go on sale?

• January 2015 – exact date to be announced
• Available for a limited period

Who can invest?

• Anyone aged 65 or over
• Invest by yourself or jointly with one other person aged 65 or over

How much can I invest?

• Minimum for each investment £500
• Maximum per person per Issue of each term £10,000

What about interest?

• 1-year Bond 2.80% gross/AER*
• 3-year Bond 4.00% gross/AER*
• Fixed rates, guaranteed for the whole term
• Interest added on each anniversary

The tax position

• Interest taxable and paid net (with basic rate tax taken off)
• Higher and additional rate taxpayers will need to declare their interest to HM Revenue & Customs (HMRC) and pay the extra tax due
• Non taxpayers, and those eligible to have any of their interest taxed at the new 0% rate (which starts from April 2015), can claim back the tax from HMRC
• Sorry, we’re not currently part of the R85 scheme so we can’t pay the interest gross on these Bonds

While the rates may still look laughably low to 60-somethings who remember the days of 10% interest on their savings, the bonds are table-toppers for those who are eligible to put money into them – and the 4% rate looks unbeatable, even with cash ISAs.

Here are a few media takes on these new bonds from:

• The Telegraph
• The Guardian
• The BBC
• ThisIsMoney

[continue reading…]

For years, pension products have been about saving for retirement, with a 1,001 different varieties of tax-advantaged savings vehicles.

In contrast, the purpose of all that saving – the deaccumulation phase of our lives — was not much catered for at all.

With a Stalinist lack of choice that would have made Henry Ford blush, pensioners were largely restricted to purchasing an annuity.

Income drawdown came on the scene in 1995, but only in a form that restricted drawdown amounts to limits set by the Government Actuary’s Department (GAD), in order to prevent retirees from running out of money before they died.

And while annuities and drawdown plans do admittedly come in slightly different flavours from provider to provider, by my count that still adds up to a magnificent total of, er, two distinct pension products.

But after years of minimal innovation in the world of deaccumulation products, I think we’re set to see that number of products increase.

How come? Read on.

Brave new world of pension planning

While you probably don’t need reminding of this, the UK’s liberal new pensions regime comes into force next April.

From then, retirees will be able to access their pension pots more or less at will.

Withdraw the lot, and blow it on a Lamborghini, to quote the infamous words of pensions minister Steve Webb? Certainly, Sir. Or Madam. What colour of Lamborghini?

GAD limits? Forget ‘em. At long last, your pension pot is yours to do with as you wish.

Subject to paying tax on the amount withdrawn – which can quickly tot up to a hefty amount if such withdrawals take you into higher-rate tax bands – there’s more or less total freedom.

Spend, spend, spend your pension

So what will people do with this freedom?

One option, of course, is indeed the Lamborghini (although personally, I’d sooner have a Cessna 172).

The usual suspects in the financial services industry have whipped up the usual froth with a slew of ‘surveys’ showing that people will be tempted to splash out on foreign holidays, pay off the kids’ university fees, and build a conservatory.

Personally, I’m dubious. Having saved all their lives, will people really splurge the lot on a trip to Thailand and a new kitchen?

The more sensible commentators, however, have added another option: still withdrawing the lot, but buying rental property with it.

In property-obsessed Britain, that’s an option with widespread appeal.

Denied the opportunity to be a BTL landlord during their working careers, some pensioners will see retirement as the ideal time to deal with dodgy builders, handle ungrateful tenants, and suffer prolonged income-sapping rental voids.

I jest. At least in part. But I don’t really think that the property option has legs.

Tax take on converting your pension into property

Because however alluring the property dream, there’s that tax hit to consider.

This will see the government claw back 40% of any pension withdrawal (after the 25% tax-free allowance) that takes an individual’s total income above £42,3661 —and 45% of any pension withdrawal that takes it above £150,000.

Yikes! As Hargreaves Lansdown’s Tom McPhail has pointed out, this would see an individual earning £40,000 a year paying a top rate of tax of 45% to withdraw in its entirety a pension pot of £300,000. (Worse, the effective tax charge would be 60%, due to the loss of the personal allowance affecting individuals with annual incomes of over £100,000).

Overall, the effective tax rate on that pension pot as a whole would be 32%.

Of that £300,000 pension, £95,750 would promptly go to the Chancellor, in tax.

A castle, not a pension

After that tax hit, the effectiveness of a property investment as an income-generating solution pales into inconsequence.

To prove the point, the ever-helpful Hargreaves Lansdown (who admittedly isn’t a disinterested bystander in all this) has produced a chart comparing the income from a £300,000 pension pot under three different scenarios:

• #1 – ISA and Drawdown: Take the tax free lump sum, invest it progressively in an ISA, leave the balance in drawdown, take an income from both the ISA and the drawdown.

• #2 – Property: Take all the money in one go, paying tax on 75% of it, reinvest in a property, live off the rental income.

• #3 – ISAs: Take all the money in one go, invest in funds and progressively reinvest it in ISAs, taking an income from the funds (taxed) and the ISAs (tax free).

Here’s what happens over a 20-year period:

Source: Hargreaves Lansdown

Interesting, isn’t it?

For me, the two key takeaways are that the property income never really recovers from that initial tax hit, and that the ISA income – thanks to its tax-free status – progressively catches up with the drawdown option.

Desiderata

So where does that leave us?

In short, desperately hunting for some other sort of pension product – some way of getting an income, in my case while retaining my capital (so no annuities here, thank you) and not suffering an initial tax hit by withdrawing.

• Equities? Fine in theory, but subject to periodic worrying falls in capital value (45% in the 2008-2009 downturn, for instance), and periodic downturns in income flow.

• Fixed-income bonds and gilts? Much depends on the entry point.

• Some judicious mix of the two? Well, yes — but what about other asset classes, such as property? Some bricks and mortar might be good. And so on.

Funds can be dreamt up to do all that, of course. But how much will it cost to manage the resulting mix?

A charge of 1.75% per year, for instance, is about half the market’s present yield.

Not to mention the further income-sapping double-whammy of platform charges levied by some of the major fund supermarkets.

Shares in your pension: British Assets Trust

I was heartened then to read of the proposed changes to British Assets Trust, a venerable investment trust dating from 1898.

The changes in question directly stem from the new pensions regime we’re entering.

Simply put, British Assets Trust proposes to switch fund managers and reposition itself with a multi-asset portfolio, to deliver a pensioner-friendly quarterly stream of dividends that will (it hopes) grow over time.

To quote from the document that the Trust is putting to shareholders:

“The Board believes that [the] proposed strategy for the Company… represents an innovative way to capitalise on the very attractive opportunities presented by recent legislative changes relating to UK pensions, and … is well designed to address the issue of relevance and relative awareness in the post-RDR investment world. The Board believes that… the Company will attract a new investor base, and that the Company will grow, as well as deliver shareholder value.”

As an investment trust, British Assets can be held quite cheaply on most investment platforms and brokerage accounts, and fee-wise isn’t too expensive.

Inside a SIPP, it could throw off a reasonable income. One that is actually geared to the needs of retirees – unlike all those supposedly income-centric funds that investors perversely pile into looking for growth. (That’s you that I’m looking at, Mr Woodford.)

But what is especially noteworthy is that here we have a long-established investment trust – albeit one that is very much on the staid and steady side of the road – explicitly re-purposing itself to attract retirees after next April’s reforms.

Somehow, I don’t think that it will be the only one.

Also, if investment trusts can do it, then I’d hope products such as ETFs can’t be far behind.

And that’ll all be great news for DIY pension planners.

1. Note: For the sake of simplicity, calculated as £10,500 personal allowance for individuals over 65, plus applicable earnings band. Note for pedants: you mileage may vary. [↩]