Good reads from around the Web.

It’s a truth universally acknowledged that anyone in possession – or pursuit – of a fortune will run up against a financial services industry determined to make life more complicated for them, in order to extract their portion of silver.

So passive investors should be concerned that the fast-complicating ETF sector is set to become more convoluted still.

The profusion of ETF types – synthetic, leveraged, short, sector-focussed, actively managed, and more – has already moved ETFs far from their origins as simple stock market-listed index funds.

And now Rick Ferri warns that rule changes by the SEC to make it easier for companies to launch ‘self-indexing’ ETFs will make things murkier still.

Ferri writes:

Soon there will be self-indexed ETFs that don’t follow any published index.

They’re secret.

Only the fund providers themselves will know how the index is constructed – and what’s in it – even though the ETFs will be marketed as passive indexing.

That authority behind the change, the SEC, is a US body, so initially this is a concern for US investors (and those who buy US-listed ETFs).

But where the US leads in ‘innovation’, the UK eagerly scampers behind.

As a result we will also need to be doubly alert to what we’re investing in.

That’s probably okay for Monevator readers. We’re all well aware of the need to check out which index our fund follows, how it is invested, where it is domiciled, and what it costs to run.

But the ordinary and clueless man or woman in the street hasn’t the foggiest.

Ferri notes:

If self-indexing sounds a lot like active management, it should, because that’s essentially what it is.

The requirements for self-index ETF holdings are identical to the website disclosure requirements applicable to actively-managed ETFs. So, why not just call this active management?

I suppose some ETF providers may conceivably use self-indexing to create real-but-cheaper ETFs that offer broad market exposure while saving some money paid to index companies.

But others will produce exotic ETFs that cost more to run and that are benchmarked – and marketed – using their own made-up indexes. These will be designed to either sell investors an exciting active ‘story’, or to provide a more flattering benchmark for performance than a vanilla index would.

Ho hum. As I said last week, the so-called ‘lazy portfolios’ will meet the needs of the vast majority of people who want to save and invest for their future.

[continue reading…]

I’m pleased to introduce another post by Pete Comley, author of Monkey With A Pin and a much-debated Monevator article last year extolling the virtues of cash. This time it’s inflation that Pete has in his sights…

Most people think inflation is just one of those things that happens. That like the rain, it is a fact of life and almost appears like a random act of God. We have always had inflation and ever will. It is meant to be around 2%, but sometimes it goes higher and (much less often) a bit lower.

End of discussion.

But if you look back into history, it was not always like that.

The following graph shows the UK inflation index – including the best attempts to historically replicate it where applicable – since 1750.

History of UK inflation (ONS & House of Commons Research Paper 02/44, July 11, 2002)

What this graph of inflation shows us is that for nearly 200 years, prices in the UK went up and down in a zigzag, largely influenced by good and bad harvests.

The graph also shows the impact of war. During conflicts, resource shortages and massive increases in money supply led to sharp price rises. However the graph shows that after the Napoleonic Wars and World War I, there followed a period during which prices to a certain extent came back down again.

But inflation did not come down after World War II. Since that time, UK prices have taken a very different direction. They have moved continually upwards.

To understand why – and what it means for us today – we need to understand the economic situation back then.

Britain’s Financial Dunkirk

After the war in 1945, Britain’s finances were in a mess.

We had won the war, but in the process government debt had soared to 237% of GDP. The Americans had given us billions and then, after VJ day, demanded we pay it back. To make matters worse from this perspective, the UK had just elected a new Labour government that had promised to spend even more cash to nationalize everything.

The famous John Maynard Keynes, then working for the Treasury, said Britain faced a ‘Financial Dunkirk’.

But roll on just 25 years and Britain’s debt to GDP ratio had reduced to around 50%. A remarkable achievement!

How was this economic miracle pulled off by a country that was often described in the 1960s and 1970s as the sick man of Europe?

According to some detailed analysis of deleveraging by Ray Dalio of Bridgewater Associates, virtually all of the debt was just inflated away.

The UK’s ever increasing tab behind the bar

If you look at the government debt statistics, you’ll find that over that period, the UK did not net pay off any of that debt. Instead it actually increased debt, from £2.6bn in 1947 to £3.3bn in 1970.

Moreover, if you start pouring over the debt numbers – as I did for my latest book – you’ll notice that no UK government has had a written plan to pay down its debts since Sir Robert Warpole in the 1720s! The government debt tab behind the Treasury bar has been rising for hundreds of years. You are still paying for the Battle of Waterloo today.

There are basically three ways governments can deal with their debts, if they don’t plan to pay off the capital.

• Firstly they can make the payments easier to afford. For example, following the Napoleonic Wars, productivity increased massively in Victorian times, as did the population, and so UK debts became a much smaller proportion of our tax take.

• The second option is default. The UK likes to pride itself that it has not formally defaulted on government debt – although it has rewritten its debt contracts like War Loans, which some might class as a default.

• The third option is to just inflate the value of the debts away.

Given the lack of much real productivity growth, the third route was the one that the UK (and other countries) decided to follow after 1945.

An inflation whodunnit

So how did this change in UK government attitude towards inflation come about? Who or what was responsible?

Culprit #1: Hugh Dalton

Clement Attlee’s post-war Chancellor must bear some of the blame for instilling an inflation policy into UK governments and the Treasury.

Hugh Dalton was one of the few Chancellors that the UK has ever had who really understood economics and public finance . He wrote some the first textbooks on the subject in 1923.

‘Comrade Hugh’ as he was known passionately strived against passive rentiers. Ideally he would have got the rich to directly pay off the debts after the war.

Instead he decided on way of making cash and bond holders pay by ensuring he kept interest rates low whilst fostering inflation – a policy that today we call financial repression.

Culprit #2: John Maynard Keynes

Some of the responsibility also lies with John Maynard Keynes, although it was probably not intentional on his part.

Many aspects of Keynes’ economic thinking as expressed in his General Theory came to be adopted by postwar governments, both here and in the US. In particular, politicians somewhat simplistically interpreted Keynes’ writings as saying that if you wanted full employment you had to have a certain level of positive inflation.

Therefore policy makers started adopting a positive inflation attitude.

A good example of this was in 1952 when the Federal Reserve in the US was granted greater independence, and specifically tasked to maintain “low inflation”.

Culprit #3: Bretton Woods

What the US decided about inflation had a positive impact on the UK because of the Bretton Woods monetary system.

This in effect pegged the pound to the dollar, so inflation being created in the US was then exported to the UK. Both countries then benefited from the reduced burden of their debts in real terms.

Inflation today

We have inherited that system where having positive inflation is built into the very structure of our economy. And the Bank of England is tasked with ensuring we always have it, targeting a rate of around 2%.

The government has allowed contracts to be created that also stoke inflation – think rail fares that go up every year by above RPI, and the recent rises in tuition fees. They are but two examples. Indeed recently Merryn King was bemoaning the fact that nearly half of our inflation was caused by these government regulated prices.

As a result of the UK government’s bias to inflation, prices in the UK have gone up over a half since 2000.

Inflation since 2000 (Source: ONS)

The need for inflation in the economy is arguably more important now than ever, due to the escalating nature of UK government debts. Our budget deficit of £120bn a year is adding very quickly to our total public debt.

Indeed if you look at our projected debts for the next few years in inflation-adjusted terms (as opposed to a ratio of GDP) you can see the reason why inflation must continue in the UK, and why it will almost certainly will be helped higher by Mark Carney in some way.

[Many will see the Bank of England’s new linking of the inflation target with a 7% unemployment threshold as a move in this direction – The Investor].

UK inflation adjusted public debt1

Why inflation is a real danger to you now

The impact of inflation – and how you might avoid the consequences of inflation – has been well-covered on Monevator in the last few years.

What I think few people have fully appreciated though is that inflation now – even at 2-3% a year – has suddenly become a problem for us in a way it was not, even just five years ago.

As I discussed on Monevator last year, cash deposits for decades kept up with inflation. Even after subtracting basic rate tax, savings accounts were usually able to preserve wealth.

That all changed with quantitative easing, and more recently with the government’s Funding for Lending scheme. Interest rates are now a long way below inflation and I think they are likely to remain there for many years to come, ensuring anyone with cash will see its real value eroded.

An even larger concern in my mind is what is happening to wage inflation. Because of the recession, many workers have effectively struck an unwritten deal with their employers that they’ll take little or no inflationary rises in return for keeping their jobs. Average wage inflation is 0.9% vs RPI at 3.3%.

Moreover if you look at the latest four years of data for average gross income for all UK households, it has not grown a penny. Against that RPI is up 12.5%. We are all becoming poorer because of inflation.

Why income matters is that it also affects how effective inflation can be in helping reduce the burden of household debts, such as mortgages. It is all very well inflation being above 3%, but if you’ve not had a pay increase, inflation is not going to erode the real value of your debt.

In my view before we all rush to load up on ultra-cheap mortgages, we need to check we’re in a job that is certain to be awarded inflation-linked pay rises.

What history teaches us

Inflation is not a random act of god, like the rain. It is also not a mere by-product of a set of economic variables.

Inflation serves a specific purpose and has been effectively government policy since World War II.

Pete Comley’s book, Inflation Tax: The Plan to Deal with the Debts, is now available from Amazon and other retailers.

1. Data source: http://www.ukpublicspending.co.uk for 1750–2011; Public Sector Finances Databank for 2012 onwards; data for 2013–2018 are government estimates; data adjusted by RPI. RPI is assumed to be 3% pa for 2013–2018 [↩]

Razor-brained Monevator reader Chris recently emailed to ask us whether some investors are better off holding foreign-listed Exchange Traded Funds (ETFs) in place of our native species, on the grounds that you suffer less from the ravages of withholding tax.

Well, I’ve done some digging. And it turns out that Chris has a very good point…

American withholding tax in London

Let’s zero in on the foreign-listed ETFs we’re mostly likely to want: US ETFs.

For the avoidance of doubt, when I say foreign-listed, I mean ETFs traded on foreign exchanges as opposed to the London Stock Exchange.

The travails of withholding tax mean that a US-domiciled ETF will pass on dividends to a UK investor minus 30%.

That’s a mighty tax chomp, which you can cut to 15% by filling in a W8-BEN form.

Then once you get your divis over the UK border – hello, here comes Her Majesty’s crack tax troopers, slavering for another pound of flesh.

Basic rate taxpayers can be on their way without further unpleasantness, but higher rate payers must cough up a further 25% in dividend income tax. Top earners hand over another 27.5%.

The good news is that you can flash your US withholding tax bite marks and get 15% knocked off your UK tax bill, because even HMRC knows mercy.

So your total dividend income tax liability is 15% (US) + 10% (UK) = 25% for higher rate tax payers who don’t have their investment in a tax shield such as an ISA.

We’ll come back to the tax avoidance question later.

Destination Ireland or Luxembourg?

As well as being two major Eurovision powers, Ireland and Luxembourg are the domicile of choice for most London-listed ETFs.

Why? Well, for one thing they don’t menace UK investors for withholding tax.

So we’re laughing, right?

Definitely not.

Irish and Luxembourgian ETFs still pay withholding tax to the US on their underlying assets.

In other words, a London-listed S&P 500 ETF will pay 15%1 withholding tax to the US IRS before they pay the balance to you.

So your dividends are shorn of 15% as usual. But again the UK taxman cometh and this time you can’t claim 15% back. The ETF paid it, not you.

That means a higher rate taxpayer suffers 15% (US) + 25% (UK) = 40% tax loss on these US dividends outside of tax wrappers.

So you’re better off with a US-listed ETF, right?

Maybe yes, maybe not

Come now, my poppet, neither of us wants this to end so soon.

Let’s suppose that in comparison to its London listed alternative, the higher dividend payout and slightly cheaper expense ratio of your US-listed ETF outweighed the higher cost of trading and general hassle.

The tax-based fly in your returns ointment would now be if you were to accidentally invest in a non-reporting fund.

Non-reporting funds are bad because their capital gains are taxed as income. In other words, you’ll be taxed on gains at 40% or 45% (rather than 28%) as a higher-rate payer.

Most London-listed equity ETFs apply to HMRC for reporting fund status and are thus subject to normal capital gains taxation. Your typical US fund doesn’t bother, and so falls into the non-reporting camp.

Smashingly, some US-listed ETFs and funds wear Union Jack underpants and have acquired reporting fund status. You can find HMRC’s list here. There are plenty of Vanguard options on the list, so passive investors are well catered for.

Ultimately the calculation will come down to your individual tax position, but:

• Higher-rate taxpayers without ISA space should look into foreign-listed ETFs to fulfill single-country positions.

• Basic rate taxpayers needn’t bother.

• Anyone holding London-listed ETFs in an ISA is fine.

• Stick with London-listed ETFs for multi-country ETFs such as emerging market or global trackers.

• Definitely investigate US-listed ETF options for your SIPP.

Read on for the tax shelter twist in the tale.

Tax bubble wrap

When it comes to withholding tax, ISAs are like paper overcoats versus bullets: irrelevant.

ISAs do protect against UK dividend tax, but generally they don’t admit foreign-listed funds, so they are not a factor in this debate.

SIPPs, however, are more like your lucky cigarello case: they can deflect withholding tax if positioned properly.

The excellent International Investor has written a superb post on which countries cut pension schemes a break.

Happily, US dividends paid into a SIPP are not liable to pay any withholding tax and SIPPs will accept most foreign-listed funds.

The snag is that the Americans still deduct your withholding tax at source. To get away Scot-free, you should choose a broker who can recover the additional 15% for your SIPP. (Not all can).

Tax dodge

I’d like to sign-off now, especially as I imagine this piece has witnessed desertion rates not seen since Napoleon’s retreat from Moscow.

But sadly there’s a couple more withholding tax tricks-of-the-trade that we need to clear up before I go.

Many ETF managers use withholding tax to massage their returns. Here’s how.

Though we know that ETFs generally use Double-Taxation Treaties to pay lower rates of withholding tax (e.g. 15% instead of 30% for ETFs with US holdings) they measure themselves against indices that assume the maximum tax whammy.

If you dig beneath the factsheet, you’ll discover that many ETFs track the Net Total Return version of their index.

For example, the S&P 500 Net TR index will post returns minus 30% withholding tax, but ETFs only pay 15% and can use the difference to close their tracking error.

The second way that ETF managers can exploit withholding tax is through security lending. When the dividend is due, a share can be whisked to a territory with a reduced withholding tax liability.

Lend a French share to a French institution, for example, and no withholding tax is paid whatsoever.

The ETF manager and friend then split the upside and hopefully we enjoy another shaving off the tracking error for bearing the counterparty risk.

Both physical and synthetic ETFs play these games and I haven’t seen any concrete evidence that it makes either type a slam-dunk purchase over the other.

There are far better reasons to buy an ETF, so measure its tracking error as best you can and choose the one that hugs its index like its mama.

Take it steady,

The Accumulator

1. …having diligently filled out their W8-BEN type paperwork. [↩]