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.

1. As I write most income trusts are trading at a premium to their Net Asset Value. [↩]
2. According to Capita Registrars, dividend payouts from UK listed companies rose by roughly a fifth in 2011. They are forecast to rise another 10% in 2012 [↩]

The ideal method for comparing the cost of index trackers is tracking error not the commonly cited but flawed Total Expense Ratio (TER).

Tracking error enables you to dig beneath superficial differences in TER to unmask deeper cost divides between tracker funds.

These cost gulfs can have a significant impact on your eventual returns, as demonstrated by doing a tracking error comparison between three of Britain’s cheapest FTSE All-Share trackers.

But how important is this information, and how can you conduct tracking error comparisons with your own funds?

Read on! But before you do, please check out that FTSE tracker comparison, and take a look at this piece about tracking difference.1

To briefly recap our previous results, we analysed the returns of three FTSE All-Share trackers against their benchmarks:

The Vanguard fund was the clear winner with a tracking error of 0.07% in the last year. The HSBC fund came in a distant second (0.5%), and the Fidelity fund trailed in dead last (0.82%).

How to decide if you are in the wrong fund

So is that job done? Should passive investors across the nation stampede out of their Fidelity FTSE All-Share trackers and into Vanguard’s?

AHAHAHAHAHA! You and I both know it’s never so simple. Where’s the fun in a straightforward decision like that?

Here’s the pros and cons of leaping into action based on the result of our tracking error comparison.

Pros:

• The Vanguard fund bastes its rivals by similar margins in both years that data is available for.

• Vanguard rebalances its fund more frequently to help it stay true to the index. (Vanguard rebalances daily, HSBC quarterly, and Fidelity when the index rebalances).

• Vanguard lends out the fund’s underlying stocks to other market operators. This practice earns commission for the fund that reduces its overall cost and thus its tracking error. Vanguard’s policy enables it to lend out 100% of the fund’s stocks.

•  All of the stock-lending proceeds are returned to the fund – Vanguard doesn’t snaffle any of the upside for the management company’s profit at the expense of its investors. This is so generous, it makes the Good Samaritan look like a git.

• 100% of the Vanguard fund’s stocks may be lent. This is good if you like having your costs reduced, but bad if you’re not so keen on stock-lending risk.

• HSBC will lend up to 70% of its fund’s stock, but it only returns 75% of the proceeds to the fund. The rest goes to HSBC, even though it’s the investors who are on the hook if HSBC can’t get the stocks back.

Cons:

• Tracking error is unlikely to stay constant year in, year out.

• Only two years of data is available for the Vanguard fund. Ideally we’d have five.

• If you’d rather your fund doesn’t hawk out its assets for money then go for Fidelity – it doesn’t lend out any stock from the fund.

• Comparison data may not be 100% reliable.

Tracking error DIY guide

Rather than me clouding the issue with pros and cons and ifs and buts, it might help you to decide if you recreate your own tracking error play-offs.

You can do this by comparing index trackers against their benchmark returns on your favourite chart comparison tool.

I used Hargreaves Lansdown’s charts because they are fabulously user-friendly and they present the returns information in a ready-to-eat table format:

• Search for a fund on Hargreaves Lansdown and click through to its ‘Overview’ page.

• Click on the ‘Charts and performance’ tab.

• Go to ‘Add to chart’ and add your index.

• Add your funds, making sure you click on the right version. E.g. Acc for accumulation units and Inc for income units.

• Also look out for R or Ret for retail funds, as opposed to Inst for institutional funds.

• Add ETFs by clicking on Equity in the ‘Choose your investment’ section.

• Type in the three or four letter ticker symbol for the ETF. e.g. ISF2. (You’ll find the symbol on the ETF’s factsheet.)

• Compare your tracker’s year-by-year returns and cumulative returns against the index.

• Tracking error equals the difference between the index’s return and your tracker’s return.

Obviously the tracker that hugs the index the closest is doing the best job.

In fact, even if your fund is trouncing its index then you’ve got problems, because it’s not doing the job you’ve bought it for. As with mutants, for trackers any deviation is bad.

Make sure you’re comparing the tracker against the index referenced as its benchmark on its factsheet – otherwise the comparison is unfair.

Note that there are even different versions of the same index. So choose the Total Return flavour if you reinvest your dividends, the Price Return index if you don’t.

Tracks of my tears

Plotting tracking error comparisons can be more frustrating than trying to penetrate a call centre telephone menu while The Entertainer plays on perpetual loop.

Matching up FTSE All-Share trackers is reasonably easy because the FTSE All-Share index is recognised by the financial tools available to retail investors.

You are equally in luck if you want to compare against the FTSE 350 Beverages index or the Oslo All-Share.

But comparing emerging market trackers against the MSCI Emerging Markets index? Forget it. Trustnet won’t let you do it, nor Morningstar, Yahoo Finance, or Hargreaves Lansdown. Google Finance will but the results are laughably wrong.

The best I’ve managed in these situations is to plot fund returns against each other to see how synchronised they are, then compared that with published factsheets to see how tightly each fund usually performs against its benchmark.

At least that enables me to see the differences in fund performance, and I can estimate how effectively they track the index. It’s not great but it’s the best I can find right now. If anyone knows better I’d love to hear from you.

There are plenty of factors to consider when choosing a tracker but tracking error is the most important, which makes it a mighty shame that it’s so hard to get clean data for many indices.

Acting on tracking error data is partly a judgement call, partly guesswork, partly deciding on your own tolerance levels.

Personally, if I know I can buy something for half the cost elsewhere then it’s time to swing into action.

Take it steady,

The Accumulator

1. I am referring to tracking difference as tracking error in this piece because that is common parlance. [↩]
2. iShares FTSE 100 [↩]

Good reading from around the Web.

With apologies to the authors below, there is only one must-read this weekend, and that’s Warren Buffett’s annual letter to shareholders.

Unfortunately I can’t yet link to it directly. The letter goes live today, Saturday, at 8am EST, which is 2pm in the UK. That’s after the posting time of this article and its associated email.

And I’ll be at least a pint into the Six Nations rugby by then!

To grab the PDF for yourselves after 8am EST / 2pm GMT, head to the Berkshire Shareholder Letter archive. This year’s letter will be marked ‘2011’.

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