Heresy! Prepare the stake and firelighters, for I am about to commit passive investing heresy most foul. I am going to invest part of our Slow & Steady portfolio into an active fund.
I can see the mob forming now. Loathing hangs in the air like smoke, torches spark, lips snarl, my mother turns her back.
But allow me to… explain.
We need inflation protection. When inflation runs amok, the only reliable guard is inflation-linked bonds. Yes, equities outpace inflation over the long term but they’re likely to be mauled when price rises get out of control. Witness the -74% smashing of UK equities from 1972 to 1975.
As for gold and commodities more broadly – neither are dependable allies.
No, it has to be inflation-linked bonds and I believe there’s an active fund that addresses the needs of the Slow & Steady portfolio better than any rival index tracker.
The answers to three questions explain my thinking:
- When is it okay to choose an active fund?
- What is it about this fund that makes it the chosen one?
- What’s wrong with the competing index trackers?
Let’s go through these questions, and then you can burn me as a heretic and scare the children with my blackened bones.
My championing of passive investing and index trackers is not ideological. It’s pure pragmatism based on the overwhelming evidence that low-cost investments and strategic asset allocation win better results for investors (as a group) than high cost investments and market-timing techniques.
I’ll choose an active fund when:
- It’s cheap.
- Its purpose is aligned with my strategic asset allocation objectives.
- It’s not a black box. In other words, its workings are reasonably well communicated, and the manager’s freedom of action is so constrained that I don’t have to worry they’ll be piling into palladium futures next week.
- It serves my needs better than any equivalent index trackers.
I believe my chosen fund meets these tests.
What’s the active fund?
It’s the Royal London Short Duration Global Index-Linked Fund – hedged to the pound.
This fund mostly trades in the high-quality, low volatility, inflation-linked government bonds needed to protect the Slow and Steady portfolio from high and unexpected inflation.
It’s cheap at 0.25% OCF – the same price you’d expect to pay for a global government bond index tracker that’s hedged to the pound. It’s not as cheap as the Vanguard UK inflation-linked gilt fund it’s replacing in our model portfolio. But that fund and others like it have a major problem.
The problem with UK inflation-linked gilt funds of all stripes is that they harbour real interest rate risk. They’re like prime beef cows carrying a nasty brain disease you’d rather not take a chance on.
- UK inflation-linked gilt funds are dominated by long bonds.
- Long bonds are likely to suffer most if real interest rates rise.
- Real interest rates have been bouncing along the historical bottom since the Global Financial Crisis.
- If rates rebound then the long bond vulnerability of inflation-linked gilt funds could drown out their anti-inflation benefit – and stiff you with significant losses.
The fix is a fund that invests in shorter duration inflation-linked bonds. This way you get inflation-protection with lower real interest rate risk. A short duration fund will still take a hit if interest rates rise, but it’s less sensitive because it quickly replaces low yielding bonds as they mature with higher yielding versions.
The only shortish inflation-linked UK gilt funds I can find come with eye-watering price tags because they must be bought through approved financial advisors.
In contrast the Royal London fund is reasonably priced, widely available, and its global inflation-linked bonds can stand in for gilts due to their high quality and returns that are hedged back to the pound.
The Royal London holdings have a short average duration of 5. This means the fund stands to lose 5% of its value in the face of a 1% interest rate rise – which compares well with a 21% loss for the Vanguard inflation-linked fund in the face of the same rate rise1.
The fund holds a diversified portfolio of bonds with credit ratings that are mostly as high or higher than UK equivalents.
Global inflation-linked bonds won’t precisely match UK inflation rates but the evidence suggests they’re reassuringly close and owning them adds a diversification benefit to boot. And more than 20% of the fund’s holdings are in UK bonds.
The Royal London fund has existed for over three years and stuck to its mission of investing mainly in global inflation-linked and UK bonds.
It can invest in conventional bonds, corporate bonds, and in fixed income instruments with a lower credit rating than enjoyed by the UK government. But Royal London publishes plenty of information so I can keep an eye on things and sell if the managers head off the map.
I’m comfortable that the fund fulfils the Slow & Steady’s anti-inflation asset allocation requirements now and in the probable future.
I’m not interested in the fund’s recent performance. This move is about building fit-for-purpose inflation-proofing into the portfolio; short-term results are irrelevant. I expect this allocation to hand us a slightly negative return in the years ahead, given how low bond yields are and the market’s low inflation expectations.
So I’ll keep our inflation-linked bond asset allocation at 5% for now, but build it up quite quickly to 50% (of the total fixed income allocation) as our time horizon ticks down.
With plenty of recovery time still on our portfolio clock, I think we’re currently better served by mostly holding conventional government bonds with greater powers to counterbalance equity losses during a recession.
Must you do this?
There is an index tracker alternative: the Legal & General Global Inflation Linked Bond Index Fund.
I could happily invest in this fund, too. The trade-offs are:
- It’s an index tracker so there’s no need to worry about mission creep.
- It’s less diversified because it’s ex-UK – so no UK bonds at all.
- It’s a touch more expensive at 0.27% OCF.
- Its duration of 8 carries slightly more interest rate risk. However, that duration still fits with our model portfolio’s remaining 12-year time horizon.
There isn’t a huge amount in it. If you’re uncomfortable with going over to the active side, and have a time horizon greater than eight years, then the L&G fund is worth researching. (Shout out to Monevator reader Mr Optimistic for reminding me of both these global linker funds in the comments to the last episode of the Slow & Steady portfolio).
Incidentally, the real interest rate risk embedded in the Vanguard inflation-linked fund hasn’t materialised in the four years we’ve held it. And it has performed creditably for us: 8.93% annualised return, which ranks fourth out of seven funds.
But the results aren’t the point. What matters is we can’t rely on it to play its part in our portfolio and we have better alternatives.
Using an active fund like this does not change our passive investing stance in my view. We’re not market-timing, we’re not choosing the fund because we think it’s hot. We haven’t abandoned our investment principles. We are simply using the best fund available to meet our long-term asset allocation needs and to protect ourselves from foreseeable risk.
Hot! Hot! Hot!
I don’t know if I’ve done enough to extinguish the purifying flames. Hopefully the wood bundles are being taken away and I’m welcome back to the fold as a black sheep rather than roast lamb.
Either way, the Slow & Steady Portfolio has had a smoking quarter. It’s recovered much of the ground lost between October and December, with our annualised return now clocking in at a healthy 9.15%. Check it out in EyeBurn Neuro-vision:
The Slow and Steady portfolio is Monevator’s model passive investing portfolio. It was set up at the start of 2011 with £3,000. An extra £955 is invested every quarter into a diversified set of index funds, tilted towards equities. You can read the origin story and catch up on all the previous passive portfolio posts.
So as mentioned ever so briefly above, we’re selling off our Vanguard UK Inflation-Linked Gilt Index Fund. We’ll replace it with the Royal London Short Duration Global Index-Linked Fund.
Every quarter we also contribute £955 in new cash that’s split between our seven funds according to our predetermined asset allocation. The Royal London fund therefore picks up the share of new cash allocated to inflation-linked bonds: £47.75 or 5%.
We rebalance using Larry Swedroe’s 5/25 rule but that hasn’t been activated this quarter, therefore our trades play out like this:
Vanguard FTSE UK All-Share Index Trust – OCF 0.08%
Fund identifier: GB00B3X7QG63
New purchase: £47.75
Buy 0.236 units @ £202.44
Target allocation: 5%
Developed world ex-UK equities
Vanguard FTSE Developed World ex-UK Equity Index Fund – OCF 0.15%
Fund identifier: GB00B59G4Q73
New purchase: £353.35
Buy 1.007 units @ £350.93
Target allocation: 37%
Global small cap equities
Vanguard Global Small-Cap Index Fund – OCF 0.38%
Fund identifier: IE00B3X1NT05
New purchase: £57.30
Buy 0.2 units @ £285.94
Target allocation: 6%
Emerging market equities
iShares Emerging Markets Equity Index Fund D – OCF 0.26%
Fund identifier: GB00B84DY642
New purchase: £95.50
Buy 59.95 units @ £1.59
Target allocation: 10%
iShares Global Property Securities Equity Index Fund D – OCF 0.22%
Fund identifier: GB00B5BFJG71
New purchase: £57.30
Buy 25.963 units @ £2.21
Target allocation: 6%
Vanguard UK Government Bond Index – OCF 0.15%
Fund identifier: IE00B1S75374
New purchase: £296.05
Buy 1.744 units @ £169.72
Target allocation: 31%
UK index-linked gilts [Previous allocation, getting sold]
Vanguard UK Inflation-Linked Gilt Index Fund – OCF 0.15%
Fund identifier: GB00B45Q9038
Sell all: £2185.46
Sell 10.964 units @ £199.34
Target allocation: 5%
Global index-linked bonds [Previous allocation, getting bought]
Royal London Short Duration Global Index-Linked Fund – OCF 0.25%
Fund identifier: GB00BD050F05
New purchase: £2233.21
Buy 2157.691 units @ £1.04
Target allocation: 5%
New investment = £955
Trading cost = £0
Platform fee = 0.25% per annum.
This model portfolio is notionally held with Cavendish Online. Take a look at our online broker table for other good platform options. Look at flat fee brokers if your ISA portfolio is worth substantially more than £25,000. The Slow & Steady portfolio is now worth £45,000 but the fee saving isn’t quite juicy enough for us to push the button on the move yet.
Average portfolio OCF = 0.18%
If all this seems too much like hard work then you can buy a diversified portfolio using an all-in-one fund such as Vanguard’s LifeStrategy series.
Take it steady,
- In principle, all things being equal, and all manner of extra caveats that could fill the internet. [↩]