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The quixotic quest to live off a natural yield from ETFs and other passive funds [Members]
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Excellent, thought provoking piece. Yes to following it up as you suggest.
As a decumulator in principle (though with other income that is at the mo good enough) I can confirm that selling out of an ISA in particular is really, really hard. To the extend that I’ve only ever done it once, to the tune of about five grand, and that was needing to raise as much liquid capital as poss to carry two houses while moving. The Flexible ISA is your friend in that sort of edge case, if you can put it back.
I’d say there’s a strong case to go purist passive while in accumulation, and perhaps migrate to an IT strategy across time in decumulation. That could soften the decumulation decision-making stuff as time goes by, while preserving the maximal passive ‘advantage’ in accumulation, where the problem of deciding how much to sell down just doesn’t really apply, most specifically in the case of a SIPP where you just don’t have the option before 55.
This is great @TI – thank you. I’ve read your HYP and the excellent @Greybeard articles many times and very much agree with the psychological side of following such an approach in retirement. Plus 1 for further articles – esp on portfolio options including ITs.
I seem to remember Monevator flirting with the High Yield Portfolio approach back in the mists of time. It’s an idea that I have pursued since 2010 when I put one together inside a SIPP.
Over that period of time I have added no new money, but it’s now worth approximately 3.5 times what I paid for it and generates twice as much income (in nominal terms) as it did in 2o13 (when I started tracking it properly).
The running “natural yield” currently sits at around 4.8%.
The money that this HYP throws off is not enough to live off in itself – and all my ISA investments are in passive funds (so with much more of a Total Return mindset) – but as I get ever closer to 55 I really like having this bedrock of what has proved to be a pretty reliable and resilient income stream over the years.
I would be very interested in reading your further thoughts on this topic !
Great article, would love to see more articles on dividends, read a few a of those greybeard ones, so would be nice to add a few up to date ones.
Interesting @TI,
“Dividends have grown – with bumps – ahead of inflation over the long-term.”
Why? (That’s what interests me) If markets are efficient, and any efficiency gains from production, management etc are visible on a listed company’s annual report – spurring competition, then how do dividends keep growing ahead of inflation? – Better marketing? Wider moats? Better customer retention?
Is it basically because the world is more and more reliant on owning the means of production and less so upon being part of the means of production?
A conundrum to me this one is.
🙂
JimJim
An interesting piece. I have been wondering what to do about future income if I kick the bucket before my loving, but non-financially interested/competent, spouse.
I had already thought that shifting to income investment might make sense for two reasons. i) There will be a ‘floor’ of defined benefit pensions which can be topped up in a relatively simple and comprehensible way with income investments. ii)We have an autistic adult son who needs to be provided for, so the whole ‘die with nothing’ strategy is a non-starter. We need to leave a good stash for him.
Excellent article. Thank you.
I’m entirely unconvinced but fascinated to hear that I am in the mainstream in looking at the total return of my SIPP. Most discussion I’ve read online had made me think I was in the minority. A lot of people seem to be reassured by the natural income view. I see it as an illusion.
It might be that being a money market and futures trader in a former life taught me to see total return as the only thing that matters. (Ignoring different tax treatments as I do in a SIPP)
Really useful article @TI. Given the very poor performance of my investment trusts compared to my passive trackers over the last 2 years, I plan to sell out of my ITs when they recover and reinvest in the more ‘reliable’ passive trackers. However you’ve prompted me to consider a combination of ‘dividend hero’ ITs with passives because, if I am just taking a natural yield from these ITs, it doesn’t really matter about discounts widening or out of fashion sectors providing that the IT can still pay the dividend.
Oh and yes please @TI, more on income generating passive index funds / ETFs and portfolio construction. You could also throw a few Investment Trust thoughts in there too .
Does this natural yield approach sound like crazy talk? No, I would say it seems an obvious and natural thing to do, but as with other areas in finance, “obvious” does not mean it is the best approach. It seems obvious to most people that paying expert fund managers has to be better than buying cheap passive tracker funds. After all, all the fund manager has to do is avoid the rubbish stocks. That should be easy enough shouldn’t it?
“Crucially though, you aspire to leave your capital untouched. You only spend the ‘natural’ income that your investments pay out.”
The fallacy at the heart of statements like this is that by taking dividend income, you are leaving your capital untouched. For investment in ordinary shares, this is just not the case. What happens the day a share becomes ex-dividend? Its price drops by the dividend per share. If you have a share worth £1 and 2p per share dividend is declared, then all else remaining equal, the share will be worth 98p when the share goes ex-dividend.
I think the incorrect idea of “capital untouched” comes about from 2 sources. The first is because the number of shares does not change, but number of shares unchanged is not the same thing as capital unchanged. This is a form of anchoring. The capital changes all the time as the share price changes. A share going ex-dividend is one reason for a change in share price.
The second reason comes about from the assumption that dividend income is of the same nature as that from fixed income products, such as bonds, preference shares and deposits. For fixed income products there is an actual contractual income that accrues daily. For ordinary shares, income comes from profits (ultimately). As an ordinary shareholder you already own these profits, so when part of the profits is paid to you as a dividend you are no better off. In contrast, every day you hold a fixed income product you really are better off by another day’s interest.
That is not to say there are not reasons why some might favour equity income investing, but the idea that you are leaving your capital untouched is entirely bogus.
I am trying to set up one of my wife’s ISAs such that she could use it as a pseudo pension after my sad demise. One advantage is she wouldn’t have to make selling decisions or execute trades, just take out the cash balance.
One disadvantage is that many multi asset funds don’t really pay much income. Even if they offer income units the passive funds tend to be invested in acc. sub funds so only part of the income flows through.
20 years down the line in de accumulation with 55% of yearly income coming from a passive portfolio in 2 ISAs and 2 SIPPs
(Other income from a Teachers Pension and 2 State Pensions)
3 index funds only -2 equity and 1 bond plus 2 years living expenses in Instant Access Cash ISAs
Withdrawal rate oscillates around 3.5%
Use Total Return -all funds in Acc mode-just sell appropriate tranche of fund units once a year while maintaining desired asset allocation
Tends to be mostly equities that are sold-they grow the fastest!-tends to be from ISAs where I store my equities -so frequently have a tax free year
Simple cheap and easy to understand though probably not by my better half!
(I absolutely understand the wish of investors to replace that workplace monthly salary but I couldn’t save enough for that)
xxd09
Great article. I tend to (perhaps too fanatically) link any thinking about yield to the tax implications, rather than any militant desire for income above all else. Where the tax situation suits though, I love it…
Don’t tell Finumus, but it’s meant the largest holding in our FIC by far is JGGI, a global investment trust that ‘artificially’ promises to pay out 4% of NAV as dividend each year. Aside from that one investment trust I’m an index fund addict. I’m perplexed why there aren’t more products that artificially boost dividend and draw from capital reserves/sell down assets where required, there must be a (growing) market for them. I’d love a VWRL that paid 20% yield and sold down capital over time to cover it! The FIC would be delighted…
@xxdo9
The other thing that may have influenced my thinking (away from the natural yield) is that I’ve been a contractor for over 10 years. I’m not at all used to a monthly salary.
The amounts of money I live off are pretty disconnected from my earnings. I get paid a daily rate. This was especially true before the IR35 rule change when I had my own limited company.
I create a ‘monthly salary’ by selling o.34% (4%/12) of my SIPP every month. Psychologically I prefer a monthy ‘paycheck’ and also thought, without any proof, that there might be a possible benefit to regular withdrawals – a kind of pound cost averaging in reverse?
Everything is in Vanguard LS60 so that makes it very simple. Like xxdo9 I also have 2 years of expenses in a savings account in case the market or the platform goes (temporarily) pearshaped. Selling funds is free, so the only costs are the platform and fund fees.
Unfortunately my SIPP provider does not allow an automatic percentage monthly withdrawal (they insist on a fixed amount in pounds) so I have to calculate that each month and manually adjust if it is too far off what it should be. I did have a look around with a view to maybe changing provider but it is surprisingly difficult to find information on the practicalities of how each broker allows you to manage drawdown.
Interesting article, thanks. Tax considerations will obviously depend on personal circumstances but it is perhaps worth making some general points. Investments held in ISAs or pensions are, for different reasons, tax-neutral in terms of income derived from interest, dividends or capital gains. Withdrawals from ISAs are tax-free. Withdrawals from pensions (beyond the 25% tax-free component) are all taxable at income tax rates whether derived from interest, dividends or capital gains. But for investments held in taxable general investment accounts, the differential rates of taxation applied with decreasing severity to interest, dividends and capital gains clearly point towards adopting a total return approach and not over-weighting the higher yielding assets preferred by those seeking the comfort of natural yield.
Thats a damn good idea to have a lifestrategy type product that pays out a fixed % as a dividend. Would be very handy. You could pick what % you want depending on what SWR you like the sound of, could come in 0.25 increments from 2 to 4.
Another potential use-case for natural yield is when you’re transitioning rather than cliff-edging from accumulation to decumulation. That’s sort of what I’m doing so I’m taking a bit of natural yield from parts of the portfolio, some of which are dividend hero type ITs that I purchased especially for that purpose.
The use of natural yield as a drawdown/investment policy is superficially attractive.
A rising dividend may well be the mark of a “good” company but it is neither a necessary or sufficient condition. There will be many “good” companies that are very profitably reinvesting all income generated in the business.
Companies may return surplus funds to shareholders via buybacks etc
The biggest danger is that a high and rising dividend is seen as the mark of a good company and Goodharts law applies, ‘When a measure becomes a target, it ceases to be a good measure’
Dividends become a target, companies paying high dividends are often borrowing substantially and dividends become a return of that borrowed money…
Have an investment policy and have a drawdown policy, they don’t have to be one and the same.
Yes please! I have invested in two of the venerable IT’s on Greybeard’s list. An update on that list would be great. City of London has done very well in preserving the capital as well as giving dividends, I think but Murray’s slightly less well at preserving the capital.
The question with Modigliani-Miller is always: Peanut or Chocolate?
More seriously: I also have a soft-spot for this strategy, even though I know it’s completely irrational.
The challenge is you are creating a “factor-tilt” that’s different from the market and that’s an active bet that may, or may-not, pay off. But there’s not really a rational reason to make it.
Agree with @Zip – why aren’t there more trusts/funds that are Vanguard LifeStrategy like (but cheaper) and pay out a fixed fraction monthly income?
Hi @TI
Great stuff – enjoyed this, and another vote for further, follow-up articles, please.
I am currently in Year 1 of SIPP drawdown (age 55 and ¾), based on investment trusts’ natural yield, and Greybeard’s writings were greatly appreciated in the years spent researching What To Do.
In part, it is psychological – plus fear of the sequence of return risk which I find/found unnerving. I didn’t really find much written on practical steps to de-accumulate with the TR approach (other than ‘just sell units’ / ‘use your cash buffer’ (I have one of these, too)) and suspect it would take too much mental energy in deciding on when to sell those precious units/shares.
Thanks again, and look forward to further writings on this topic.
Thanks for another great article would love to read further thoughts on this.
I appreciate its irrational but personally feel until I’ve built a reasonably steady level of cash flow, I fear I will never feel comfortable to an extent regardless of the size of my loot pile!
Generating cashflow meaningful to my future (though not likely sustainable) feels currently possible but just reiterates the importance of utilising the ISA limit each year.
c£15k of income from a combination of 3 sources totalling £300k capital; £100k bonds/cash at interest rate 3.5%, £100k invested in selective high dividend yield shares @ 7% (yes I know let me dream these are sustainable for longer term!), £100k in diversified high yield at 4%…. As xxd09 said, I also never be able to save enough to match monthly salary, but cash flow as outlined would give me a lot of confidence to fire; combined with no mortgage, future SIPPs to access and state pension to come.
Would love to hear others thoughts on how something reasonable could be structured. @TI will wait patiently for the next article! Thanks
> other than ‘just sell units’ / ‘use your cash buffer’
I think some of that attitude is young ‘uns who know they will live forever and are in accumulation. If they are lucky they will grow older and perhaps priorities may change. It’s all so simple when you have not suffered the slings and arrows of decumulation.
I held a cash buffer of three years essential spend across ten years between leaving work and having enough to feel I was finally clear of the Tesco shelf-stacking danger zone. For sure, I gave up return carry that much deadweight. But I was so shattered after leaving work that I needed the security of being able to punch the evil of work in the mouth if some emergency happened. I was lucky, the emergency never came, but the ability to give it a hefty kick in the nuts is worth something, even if it is strictly speaking irrational.
I aim to use the natural return option, which is slightly irrational for the child-free, but I want the option to change my mind, and Mrs Ermine is significantly younger than me so I think it will end up in good hands if I don’t get to use it all.
Comfort gets more important than speed and ultimate performance as you get older. I understood the cut of Greybeard’s jib with his IT articles, and I get it more now.
But there is a corollary. You have to have more capital to get away with the natural yield than if you optimise the living crap out of everything, though note that high optimisation of everything is generally inimical to resilience. Comfort always comes at the cost of performance, and resilience means keeping reserves in hand, which some people interpret as sub-optimal allocation of capital. So is insurance if you never need it, but that’s the price of an easier night’s sleep.
Bear in mind dividends are significantly tax inefficient in the US compared to share buybacks, so you won’t see as much dividend return from US stocks. For me at least, that makes pursuing a dividend yield approach a non-starter.
Rather early in in my investing career the question of dividends and total return came up a few times
I think the late John Bogle of Vanguard thought that dividends were a distraction -were probably often maintained at the expense of capital growth
Dividends could even in worse case scenarios seriously skew a funds performance as the funds prioritised dividend production over other arguably more important investment decisions
The best policy for an investment fund manager was to go for the best total return he could produce unencumbered by being prioritised by the dividend
Worked for me over the last 20+ years but who knows going forward……..?
xxd09
From my research, it seems there is no debate over which strategy delivers higher returns for investors. So this is largely a psychological one – helping with the mental accounting required to navigate drawdown. But then again, if you want full certainty over your cashflows, why not just create a bond ladder?
I think we are in an interesting moment because we as investors can have income and capital growth. I continue to bang the drum about how attractive listed infrastructure looks now (Greencoat, INPP, etc) as you can effectively lock in real returns on par with equities with strong dividend income (6%+), which has a strong inflation linkage.
Capital Gearing makes this case in their latest quarterly update:
Infrastructure was the poorest performer among the risk assets as infrastructure trusts traded at large discounts to their NAVs on investor concerns over rising interest rates. These vehicles have good long term track records, relatively low risk investment portfolios and offer prospective returns of around 6% real.
https://capitalgearingtrust.com/document/q4-2023-report/
@all — Thanks for the great feedback and thoughtful comments. A lot to digest here.
I certainly agree that a reason one might consider an income-orientated approach is behavioural rather than in any expectation of higher returns. I say as much in the piece. 🙂
However I do think that positioning risks underweighting the importance of ‘behavioural’, not just in terms of having a strategy that one can stick with, but also in terms of having a strategy one *enjoys* (or at least hates less) than another. (Perhaps ‘operational’ would be more useful a word, coming as it does without the baggage of ‘behavioural bias’ terminology?)
Consider a situation where a rock solid institution / the government will give you £1,000 today or a guaranteed £2,000 in ten years time. With a discount rate of 7% (it’s guaranteed, remember, so that’s generous) you should take the deal (because it’s more than you’d expect to get by taking £1,000 and investing it yourself at 7%).
What if I offered an 80% chance of £3,000 but 20% of £0? You should in theory still take the future offer (expected value is a huge £2,400) but the uncertainty makes the decision more difficult and ‘behavioural’. And it might come down to how important £2,000 is to you, versus the high potential for £3,000.
What if your future capital projection was subject to extreme wobbles on the way, so that by year five you were predicted to only receive £500, even if eventually you did get £2,400?
It’s stretching the analogy here without going into more maths, but the point is most of us would far prefer certainty over a slowly escalating and steady pot from left to right over a graph of future value that looks like a U (where we’d have to live through a deep trough in the middle, before a big payout at the end).
Now, my example is about capital returns, and as such isn’t relevant per se to the income investing example. I’m just pointing out that behavioural biases can be understandable, or even I feel acceptable trades if they deliver other benefits.
Re: an income strategy, let’s say my portfolio had to live through sometime of a U shaped ten years, or even a W shape.
In one scenario I draw down my 4% a year, selling and rebalancing as I go. In the other I live off the income that’s kicked out and needn’t even look at my portfolio’s capital value in theory.
We’ll assume for the sake of argument (perhaps unrealistically) that income just ticks up with inflation over the ten years.
Clearly selling the portfolio down through the turbulence is going to be more dramatic in this scenario. Perhaps markedly so! Maybe your £1m has become £500,000 in year five and yet you still have to go into your portfolio and decide to what £40,000 (ignoring inflation) you are going to sell.
In contrast, someone following an income strategy just looks in the nominated bank account at the collated dividends and goes to the shops.
How much higher would the overall return from the capital drawdown strategy have to be for it to be worth the grief to you?
1%? 5%? 50%?
Keep in mind too that deccumulation is (legacies aside) accompanied by shrinking time horizons. It’s not like when you’re in your 20s and 30s and can blithely stick 40 years into a compound interest calculator…
Just on @naeclue’s point that dividends still entail capital reductions (because share prices drop ex-dividend date) of course this is true but (a) it is not an active selling decision by the investor, which is the point and (b) in as much as it comprises not “leaving capital untouched”, we could if accepting this premise say a 4% drawdown de-accumulator is doubling their capital selling (because of course their portfolios include dividend paying companies going ex-dividend too) and then rebase the discussion from there. But not only is this clumsy, I don’t really accept the premise as useful (though I take the important point, which is as I also say in the article that dividends are not ‘free’ money somehow magicked out of company balance sheets).
Anyway, I am not saying income is the right approach for everyone in deccumulation.
Honestly, I think it might be the right approach for only a minority. Perhaps only those more ready to venture into active naughtiness, who aren’t overly reassured by backtests and data mining versus their own (very possibly misguided) judgement, and certainly those with a bit more cash to (a) afford it and (b) afford a possibly more variable income.
Either way though, I certainly don’t believe that only performance or expected returns should drive the decision, as I’ve belaboured in the piece! 🙂
I think having a preference for investments with a higher income yield to try to avoid make selling decisions, or being easier to live with, is fair enough. All I would say is consider the potential disadvantages as well and don’t fall for statements claiming you are “preserving capital”, or other wrong/questionable claims.
One disadvantage to consider is the cost. Let’s assume you want to invest globally and passively, but in something with a higher yield than a World tracker. The FTSE Global All Cap Index had a historic yield at the end of December of about 2.1%. But that is before costs. For UK investors the biggest costs will be dividend withholding tax and the management charge. The Vanguard FTSE Global All Cap Index Fund has a management charge of 0.23% and a historic dividend yield of 1.7%, implying dividend withholding tax of about 0.17%. That seems low to me, but will do. It is possible to find ETFs that yield more, such as the Vanguard FTSE All-World High Dividend Yield UCITS ETF, with historic yield (after taxes and fees) of 3.31%, but this will come with higher taxes, higher fees and higher rebalancing charges. According to Vanguard the transaction costs are 8bps, compared with 3bps for the cap weighted World ETF, with 29bps vs 22bps ongoing charges. I would guess the extra dividend withholding taxes would be about 20bps, so around 32bps in total more than the cap weighted fund, or ~0.3%.
0.3% extra may not sound much, but if you take the expected long term real return as 5%, then the expected cost is an additional 6% of your long term return. Is that worth it to you? It might be, but it is personal matter.
Going off to high yielding ITs or OEICs will likely cost even more and also require taking on fund management risk. Most actively managed funds don’t keep up with the market in the long term, but a bigger risk is that of significant underperformance of the funds you pick.
@TI (though I take the important point, which is as I also say in the article that dividends are not ‘free’ money somehow magicked out of company balance sheets).
This is the important bit! I have read so many times that dividends are somehow free money and capital is preserved if you spend the dividends, but don’t sell.
My mention of the balance sheet prompts another thought, which is that an income investor expects to get paid by cash from the balance sheets of the underlying companies (/bonds) whereas the drawdown-seller investor gets paid by, effectively, the prevailing opinion of the market — because they must sell at market prices to generate their income.
Over the long-term one can be expected to track the other (Ben Graham’s weighing machine versus voting machine) but over the short-term we all know market valuations can diverge markedly more than a company’s long-term cashflow expectations/fundamentals, even if it’s devilishly hard to take advantage of this to beat other market participants in the valuation game (i.e. share trading for profit).
This could be why income investing intuitively feels more stable to me? (And dividends do empirically vary less than market valuations, although profits in any year can dive below zero to losses, which doesn’t happen with capital values unless you go short or use leverage).
@TI, well yes, more to the point, with dividends the money goes from the company’s bank account to your bank account. No selling of stock needed. So how should we value the cash sitting in the company’s bank account and the value of it once transferred to shareholders’ bank accounts and how should the drop in the value of the company be determined? I would suggest the value of the cash is exactly the same, and the value of the company on ex-div date is simply the value which it had the previous day minus the cash which will be paid out. The market takes that view.
I would also suggest that equity income investing intuitively feels more stable because shares superficially seem to behave like bonds or bank deposits. Bonds accrue interest and periodically pay it out. Shares make profits (hopefully) and periodically pay out some of it as dividends. We even talk about “dividend yield”. From an income perspective, we see similarities between shares and bonds, but they really are quite different.
As for “dividends do empirically vary less than market valuations”. Yes on average true and a statement often trotted out in support of investing for dividends, but not a statement of any relevance.
Edit: some argue that companies that pay regular dividends are in some way superior investments to those that don’t. But that is a different sort of argument that might or might not justify a factor tilt. It not does not alter the basic arithmetic.
Long time reader, first time commenter. Love the site in general! Also, please excuse my American English spelling. It’s due to how my spell check is configured for various reasons.
In general I favor the approach of only spending natural yield. But I certainly don’t think it is a silver bullet from a risk management perspective, and favoring this approach leads to my wanting a larger starting portfolio so that I am not overly “reaching for yield”. Maybe it just plays to my naturally conservative tendencies when it comes to the risk of running out.
As a small quibble, in your article, you note that the natural yield approach is guaranteed to leave capital at the end. I think this isn’t actually true. Assuming you’re not drawing down significantly less than the so-called 4% rule (and even if you are), the strategy can literally fail, in that the natural yield may not cover your expenses, and you may be forced to erode capital. Sure, you could just reduce your expenses, but at some point this ceases to be viable. At the end of the day, it’s not clear that this strategy fundamentally lowers your risk any more than adding some amount of equity valuation-based variability to how much you draw down. Although, as you point out, it is simpler in that it is managed for you. Also, it’s also not clear that skewing away from growth stocks actually lowers your risk either, but this would warrant a deeper investigation.
In terms of potential follow-on articles: I’d be really interested in understanding better how dividend volatility has worked out historically, relative to equity valuation volatility. Also, some analysis on the topic above – how does such a strategy compare risk-wise vs the many variable withdrawal rate strategies.
Excellent piece, thank you. In 2020 the “european” version of LifeStrategy Etf’s was introduced to Italy too. I decided to begin the switch of my old “lazy” portfolio to this new Etf, but I saw immediatly how difficult can be selling something for a nearly-passive investor…hence: I fully agree with what you said! I see it difficult now, how could I find it easier when using the mouse with a trembling hand, in the future? Anyhow, my nearly-passive investor strategy is going on this way: I continue to put money in a 60/40 ptf (Life Strategy and “old” ptf) and I buy good long-term bonds (italian ones are paying more or less 4% at present). Life Strategy is giving a dividend of about 2% per year, rather constant (with a taxation of about 20%). This means that my wife and I are creating the right conditions for receiving an “automatic” income of about 2.7% net p.y. in the coming years, with no need to sell parts of the portfolio, thus avoiding to take tough (and wrong…) decisions about selling in the future, in particular in difficult moments. As usual, thanks and “Ciao!” from Venice!
I have £23k pa in Preference share dividends . It feels a bit toppy given the recent inflation uplift but it is a reassuring amount of tax free income (90% in ISA) to help fund the gap until DB time.
I’ve lost 3-5% in valuation but the yield of over 6% (tax free) is still pretty attractive – I’d like to increase my world tracker allocation from 0% but I’m struggling to buy-in to the S&P500 at current prices.
Natural yield is ideal for a lower stress life, but clearly you do pay the price in other ways. It’s also a nice fit with ISAs as there’s a strong desire not to withdraw capital (or indeed dividends – but you can’t accumulate for ever, even if FiL wants to get to £100m!)
Looking forward to further articles
@TI. I agree with you that the market perceives equity income investing to be more stable. If that hypothesis is true, however, then surely the correct strategy is to short equity income.
Since PV is conserved, the actual volatility of two identical stocks, one with a high dividend and the other with a zero dividend, will be be the same over the long-term. Nonetheless, if the risk is perceived to be lower, the risky discount factors applied will be higher leading you to pay a higher price for the high dividend stock. You overpay for an illusion of lower volatility.
In my view, this is the flaw with all forms of carry investing. Equity income being just another one. Behaviourally, investors are addicted to carry. The like high dividends on equities, high coupons on bonds, higher carry currencies etc. Conversely, investors hate negative carry investing. Given enough time, a systematic value bias arises from that behavioural bias.
Equity income just provides an illusion of stability. By offering lower median/modal vol, it can lure people into overpaying for crap. When the tail event happens, the volatility comes right back.
Moreover, if everyone pretends that dividends are like coupons, the stock actually starts trading like a bond. All those UK income ITs that traded at premiums in 2021 were trading at discounts by 2023, acting just like long duration bonds. If I want bonds, surely I buy bonds, not a stock pretending to be a bond?
As a follow-up comment: I do agree with Naeclue that using dividends does effectively draw down on capital.
Introspecting further, I think the reason why I like the idea of using only natural yield is that it forces a significantly larger portfolio, as I am also a fan of very diverse passive ETFs.
Also thinking through things further, dividends are often (generally?) less tax efficient than capital gains, especially at higher levels of income. So tilting too much toward dividends has that as a downside. There may be exceptions to this in specific jurisdictions, though.
I think a broad analysis of techniques that can reduce the likelihood of tail scenarios, even if at the expense of expected value, would be pretty interesting!
Thanks for this great piece, TI and the comments have been fascinating.
It confirms to me that I have made the right choice to have part of my portfolio paying out income, as I realised that I would find it psychologically difficult deriving all my income in retirement by selling assets.
I will still have to sell some, as I won’t have a big enough dividend income portfolio to cover all my spending, but the blow is lessened by the natural yield.
At the moment, I’m getting a yield of around 5% from a large number of investment trusts (and a few individual shares), which I hope to whittle down in number. Some cheaper/passive ETFs as alternatives would be useful to consider.
on the subject of living off dividends, if you go down that route and switch from an acc to an inc version of *the same* fund in order to do so – are you on the hook for cgt, or is it not a *real* disposal if you’re just swapping over like that?
Yes TI, would love to see more articles on this as I’m always torn between the idea of selling capital or living off natural yield. Specific ETFs to consider would be beneficial.
If dividends were based directly on earnings, this might make sense but the reality is very different. Plenty of companies pay no dividend, or a very small one, preferring to invest in the business. Some use buybacks instead. Some overpay, effectively eating themselves. So living off the “natural yield” isn’t really living off income and preserving capital, it’s living off an amount decided somewhat arbitrarily by a company’s board.
I do agree it makes sense behaviorally and to simplify things!
@all — Thanks again for the feedback and additional thoughts!
@Jon B — At the individual company level you are certainly correct. Companies can and do make all sorts of capital allocation decisions, some inspired, many dumb, and often where the dividend is explicitly protected it seems to become an albatross.
However in aggregate something different is going on I’d argue. Over the long-term, market dividends have risen with market profits, more or less, albeit dividend yield has come down in countries like the US where dividends are tax-disadvantaged. (More here nowadays too, I suppose) and buybacks have been favoured.
As for the companies that pay no dividend, bar a few outliers like Berkshire, these can be crudely divided into two categories — companies that are a blue-sky daydream that will never pay a dividend and that you probably don’t want to own unless you’re a trader who can get out in time, and growth companies that become secular growth companies/cash cows, and so eventually do pay dividends (even Apple and Microsoft nowadays).
Something to explore in a future post for sure.
I’d be interested to see how much of a connection there is between dividends and earnings. The fact US stocks pays so much less than the UK is a great example of my point though. Should an investor in the S&P have to live more frugally than one holding shares in the FTSE? Is an investor in Apple who sells 2% of their shares to add to the 0.5% dividend, eating into capital, while the BAT holder living off close to 10% isn’t? It just doesn’t stack up to me but I will be interested to read your follow up articles. Maybe they can change my mind!
For all the well articulated reasons above as to why all investors but particularly private individuals managing their own money are drawn to income and ways to mute equity volatility I wonder why put writing isn’t discussed more as a strategy. Sure it’s derivatives and arguably a tad exotic but is it such a massive leap from passive index investing if you’re just selling out the money puts on those same index funds, not getting into the deeper technicalities of options just selling a sensible nominal amount a bit out the money for a few months at a time (ideally when there’s a bit of volatility) and take the view you’re getting income upfront for the risk of having to buy your favoured index ETF at a discount to the price you would have paid today. I would have thought the reduced drawdowns and the ‘income’ based return would appeal to many but it seems to rarely come up
Love the ZX quote above: “If I want bonds, surely I buy bonds, not a stock pretending to be a bond?”
Equity Income makes no sense to me now, although I used to run a small (5%) part of invested wealth as a HYL portfolio back when the dividend allowance was £5k p.a. (happy days) and I could hold in a GIA.
If you are decumulating then surely lower volatility bonds make more sense if the real yield to maturity is high enough, especially for the ever underated (although generally not underappreciated by MV readers 😉 ) UK ILGs and US TIPS.
It struck me reading the piece linked to below from Noahpinion this morning that the reason that we collectively think that we intuit that yield (income) is more important than price (wealth) (whether or not that’s really the case for equities) is that we do understand that – in aggregate -wealth is normally much less meaningful as a measure than liquid income:
https://open.substack.com/pub/noahpinion/p/theres-not-that-much-wealth-in-the