When an investing concept is designed to appeal to your emotion, tread carefully. We all want security and nourishment and that’s precisely the draw of the low volatility – market-beating returns with less risk than yer average clutch of ticking time-bomb equities.

There are known problems with low volatility, but if you still want a slice of this action then what do you need to know?

The two faces of low volatility

Below you’ll find a handy list of the low volatility Exchange Traded Funds (ETFs) available to UK investors.

But before we get into it, you should know that – like the other return premiums – there’s more than one way to skin the low volatility cat.

In most cases, a low vol ETF will track an index that falls into one of two broad categories:

• Low volatility index: Ranks the equities of its parent index according to their return volatility over the last 12 months or 24 months or whatever timeframe the rules dictate. Lower volatility equities are over-weighted in the index and higher volatility members are under-weighted.

• Minimum variance index: Also weights equities according to their historical volatility, but then analyses the correlations between the equities in order to reduce volatility at the portfolio level.

Which is best? Well, according to the paper A Study of Low Volatility Portfolio Construction Methods from Research Affiliates:

We find no evidence that one low volatility portfolio construction methodology stands out from a returns perspective.

Okay, that makes things  easier – but it doesn’t mean you should just pick any ETF out of a hat.

So how do they differ?

All low volatility ETFs are known to skew towards defensive sectors of the economy, such as healthcare and utilities.

However minimum variance strategies typically impose greater constraints on the concentrations of individual equities, sectors and countries within the index. For example, MSCI rules that sector weights must remain within 5% of the weights in the parent index.

By contrast ‘naive’ low volatility strategies generally do not cap constituents. This means they can become highly concentrated in the healthcare and utility sectors at times. Similarly Japan will often loom large in World ETFs that follow low volatility strategies.

The Research Affiliates paper found the minimum variance approach is likely to be:

• More diversified.

• More costly, due to higher turnover.

• More effective at reducing volatility where the index tracks dissimilar markets, such as emerging markets.

While there wasn’t much in it, the authors tentatively concluded:

While [minimum variance] portfolios generally have the lower volatility, heuristic approaches [naive low volatility] tend to have the higher long-term returns. (We caution against comparing low volatility strategies on the basis of short-term performance.) The resulting Sharpe ratios are statistically similar.

The historical record of low volatility shows that it’s generally beaten the market during declines and taken a beating during upswings.

This means your blackest periods of doubt are likely to come during extended bull runs when the low volatility slice of your portfolio is lagging the herd like a lame elephant.

You’ll have to resist the temptation to abandon it at its lowest ebb if it’s ever to come good for you.

What should I look for?

While the research concludes that there is little to choose between the various strategies, you should know what matters to you as an investor.

• If you don’t like concentrated bets then err towards minimum variance.

• If return is all that counts then naive low volatility may be the way to go.

Of course, there aren’t any guarantees – fate does not give us advance notice of its plans. But at least you’ll know you’ve put out the welcome mat.

And such good value, too

It’s thought that low volatility outperforms partly because it overlaps with the value premium. So you could compare the value signal strength of your target low vol ETFs using Morningstar’s Fund Compare tool.

Jump to the equity valuation section and look for the lowest numbers in the following categories:

• Price/Prospective Earnings
• Price/Cash Flow
• Price/Book

You can compare sector and country concentrations using Fund Compare, too, although past returns will be of little use because low volatility ETFs are still very young.

Check out the ETF’s factsheet for important info such as how many holdings it has (the more the better) and make sure you read up about the index on the index provider’s site, so you broadly understand how it works.

A low volatility ETF hitlist for UK passive investors

Here’s the low volatility range currently available, organised by asset class:

Source: Author’s research.

Source: Author’s research.

Source: Author’s research.

Source: Author’s research.

Source: Author’s research.

Low volatility in your portfolio

Regardless of the comfy name, low volatility ETFs are equity products and they will still take a hit during a market tumble. If you decide to use them in your portfolio, the money should come out of the equity portion of your asset allocation.

If you think you’re likely to regret a long period of market lagging performance – and few of us wouldn’t – then I’d suggest you limit your low volatility bet to a 5-15% slice of your equity allocation.

Take it steady,

The Accumulator

1. Note: Global usually means developed world.[↩]
2. Or TER. Learn more about the difference[↩]

Good reads from around the Web.

Lots of amateur investors daydream about being the next great stock picker – a contrary-minded Buffett for the 21st Century.

But very few people are wired right (or perhaps that should be wired wrong…)

For most, being a contrarian investor gets no further than reading a magazine article about being a contrarian investor, and then investing in whatever shares or funds it suggests.

And that just isn’t going to cut it over the four or five decades of a lifetime of buccaneering investing.

As Patrick O’Shaughnessy of Millennial Invest wrote this week in a piece on the virtues of cheap yet scary-looking companies:

To buy into a terrifying portfolio, you need to have a contrary mindset.

This mindset is almost sociopathic, because it requires not just ignoring the crowd, but actively trading against it.

Most people can’t do that. They run with a herd even when they think they’re standing apart from it.

That’s surely for the best, given that more than seven billion of us are trying to get along on this little planet.

Gold given the finger

The wannabees come and go.

Remember when any mention of gold brought out dozens of precious metal bugs to call you an idiot, no matter what you wrote?

For all the noise they mostly seemed to think the same thing – that the dollar was about to collapse, and that a Neo-Aztec Kingdom of Gold was set to emerge from spare bedrooms and basement PC dens across the land. Conspiracy theorists who’d buried Krugerrands under their lawns would inherit the earth.

We’re still waiting.

Who knows, things are precarious enough that even I wouldn’t write off the gold bugs’ predictions entirely. But one thing I’m sure of is that the love-in for gold a few years back was as contrary as feeling a bit sad when Robin Williams died.

Look at this graph of the assets amassed at the height of gold mania by the US gold tracking ETF – ticker GLD – as posted by Ben Carlson on A Wealth of Common Sense:

At that peak in summer 2011, GLD became the largest single ETF in terms of assets – bigger than even the mightiest S&P 500 tracker.

But since then, Ben says:

…the fair-weather gold investors have been shaken out, and then some, in the latest drawdown.

Although the GLD fund’s performance is down by a quarter, the total assets invested in GLD are down by 60%.

In other words, GLD’s assets have shrunken far, far faster than the gold price.

Meanwhile the SPY stock market index tracker has returned 60% in gains, and it’s doubled in terms of assets.

Golden brown

This isn’t a post to say that stocks will always beat precious metals, or that you should race out and buy the S&P 500.

(If anything it makes me want to trickle money into a gold ETF!)

It’s more a reminder that like teenage goths who feel they’re uniquely dark snowflakes but all seem to shop at the same branch of Emos ‘R’ Us when you see them outside a Marilyn Manson concert, so any investor who has gone off the beaten-track mob-handed is likely not blazing a trail but heading for a cliff.

This stuff is hard, for all of us.

[continue reading…]

Had you’d asked me 15 years ago how I planned to fund my retirement, my answer would have been straightforward.

• A certain proportion of my retirement income would come from a modest defined benefit pension, built up in the 1980s.

• The state pension would make up another modest slug of income

• The balance would come from an annuity, after I’d cashed in my pension savings.

These days, my thinking is a little more nuanced.

In particular I’m a hell of a lot less enamoured of annuities than I used to be. And a hell of a lot more interested in the alternatives.

Poor value annuities

For one thing, in the intervening years annuities have had something of a bad press.

Thousands of Equitable Life ‘With-Profits’ annuitants, for example, got royally shafted. Having exchanged their pension pot in exchange for an income for life, in the early 2000s they saw their incomes effectively halved – or worse — as the board of Equitable Life scrambled to conserve cash. Hardly a just reward for responsible saving.

Around the same time, annuity rates began a headlong plunge from which they’ve yet to recover.

Blame greater longevity, and increasingly derisory bond and gilt yields.

Hence the growing attraction of income drawdown, introduced by the government in 1995 to offer an alternative to annuities.

Income drawdown: Mine, all mine!

Income drawdown provides pension savers with the option of each year ‘drawing down’ a little of their pension pot, gradually consuming the income and eating bit-by-bit into the capital.

So instead of handing over your entire pension pot to an annuity provider in exchange for a guaranteed income, you draw down upon the capital sum that you’ve accumulated – deaccumulating, in today’s jargon.

At all times your pension pot remains yours – because you’re not handing it over to the annuity provider – and, upon death, what’s left can be passed on to your heirs.

Of course there are some downsides to income drawdown:

• There are charges that you don’t get with annuities.

• If you consume your capital too fast, you’ll drain your pot dry.

• Market volatility can mean that capital consumption when markets are down is especially expensive.

The biggie is that an annuity income is nailed-on for life when you buy it – albeit at a pretty poor rate today – which gives you security in exchange for flexibility.

Income from drawdown isn’t secure.

The annuity empire fights back

While miserly annuity rates have attracted a bad press in recent years, income drawdown hasn’t had that good a press, either.

I, for one, was initially put off – no, horrified – by some of the charges being levied by the Independent Financial Advisers and specialist firms offering income drawdown schemes.

Not to put too fine a point on it, some of the same firms that had been offering precipice bonds and zero-coupon bonds now seemed to be offering expensive income drawdown schemes.

Moreover, the traditional annuity providers apparently flooded the finance pages of the weekend press with scare stories. (Cynical? Moi?)

Take this one from the Daily Telegraph in 2012, which began:

Income drawdown: the pension that could leave you penniless

Avoiding annuities could give you more to live on to start with, but your money could soon run out if markets go against you.

The article warned that retired people who took the maximum income from their policies would empty their pensions by the age of 92 – even allowing for a relatively benign investment climate.

Er, yes. But why would you have continued to drawdown at maximum levels if you saw that starting to happen?

Income drawdown limits – imposed by the government explicitly to prevent pensioners from consuming their pots too fast, doubtless prompted by articles like the one just mentioned – also made for grim headlines over the years.

When in 2009 the government cut maximum drawdown from 120% to 100% of the gilt-linked (and already reduced) GAD ¹ rates, high-drawing pensioners’ incomes duly fell.

In other words, they couldn’t draw down as much as they has previously assumed – and it would be potentially imprudent to do so.

That wasn’t quite the way the Daily Telegraph pitched it, though.

“Our pension was cut by £9,000 a year”, it shrieked, following it up with a dire headline that pensioners faced a 40% income cut.

Recent developments in retirement income

This sort of reporting, while ostensibly balanced, does little to encourage people to weigh up the pros and cons of annuities versus drawdown.

That’s particularly true if such people are reasonably sophisticated investors, who are used to taking decisions about their financial future, and who are perfectly capable of taking an educated view of the relative upsides and downsides of these two contrasting approaches to the deaccumulation phase of our lives.

People like Monevator readers, in other words.

And to my mind three recent-ish developments have tipped the balance even more in favour of income drawdown, and away from annuities.

Development #1: Equity income beats low annuity rates

In March 2009, the Bank of England cut Bank Rate to a historic low of 0.5%, ostensibly for a few months – perhaps a year at most.

Five and half years on, it’s still there.

And whereas the mood music even a couple of months ago was talking about a rate rise in a few months, the prospect of an imminent rate rise now looks slim, what with signs of a slowing economy here in the UK and further trouble in Europe.

In the meantime, annuity rates reflect these persistently low interest rates.

Consider the following annuity rates, sourced from Hargreaves Lansdown, in respect of a single life, investing £100,000 to buy an Retail Price Index-linked (RPI) annuity.

Source: Hargreaves Lansdown, October 2014

Said differently, someone retiring at 55 is going to do so on an index-linked income of 2.25%. At 60, 2.3%. And at 65, 3.3%.

That’s pretty derisory, when you consider that a portfolio of solid income-oriented, dividend-paying shares could deliver double that yield between the ages of 55 and 64 or so.

Even at 70, your annuity will give you less than many decent dividend picks are paying out today – and with the annuity you’re kissing your capital goodbye, too.

Plus those dividends from shares should rise over time, providing a cushion against inflation. To be sure, not in a smooth and consistent way that’s guaranteed to match RPI. But very likely at a greater clip, overall.

In short, for investors prepared to shoulder the burden of picking shares or income funds – and taking on the risks of equity income – then income drawdown currently offers a higher income – potentially without necessitating any capital drawdown at all – and provides a potential capital bequest to boot.

Development #2: Goodbye, income cap

Remember those shrieking headlines about pensions being cut by £9,000 a year and pensioners facing a 40% income cut?

Er, that was then, and this is now.

As of the Chancellor’s most recent budget, the GAD limit was first sharply relaxed ², and then abandoned altogether in respect of drawdown schemes commencing from next April.

As pensions minister Steve Webb famously observed, there will now be nothing to stop pensioners withdrawing the lot, and blowing it on a Lamborghini.

Nothing, that is, except for the fact that – aside from the tax-free lump sum entitlement – such withdrawals would be at an individual’s highest marginal tax rate, calculated by including the withdrawal as part of annual income.

Ouch.

And nothing apart from the fact – as the government hastened to point out, post-Lamborghini foot-in-mouth – that it rather thought that people who’d been sensible enough to spend a lifetime accumulating a pension would probably be sensible enough not to blow it all at once.

Still, all in all your pension has just become one giant piggy bank, with no limits on how you choose to extract money from it.

Quite a contrast to swapping it for an annuity.

Development #3: Goodbye ‘death tax’

Thirdly and finally, the recent party conference season brought a welcome bribe fillip to pension savers who have an eye on passing on the unused part of their pension to their heirs.

Simply put, the old 55% tax hit levied on your pension estate is to be scrapped, proposes the Chancellor.

• If you die before age 75, your pension can be inherited – and money withdrawn from it at will – with no tax to pay at all.

• If you die after age 75, the inherited pension will attract no tax if the funds are left within in it, but any withdrawal will be at an individual’s highest marginal tax rate.

Again, quite a contrast to an annuity.

The inheritance tax benefits are obvious, and already I’ve read press coverage suggesting that such a system would open the doors to multi-generational ‘trust funds’.

Needless to say, you can’t do this with an annuity, either.

Tipping the balance

So there we have it. Do these changes influence your view of income drawdown? Enough to tip the balance over annuities?

As ever, please do share your thoughts in the comment section below.

Please remember that these are difficult decisions with long-term consequences for your retirement and security, and you may need to seek professional financial advice. Our articles are for education and entertainment only, and are not meant to be taken as individual advice.

1. The Government Actuary’s Department provides key data used as part of the income drawdown calculations.[↩]
2. To 150%, having earlier returned to 120% from the short-lived cut to 100%[↩]