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Investment Property 1 Has Been Sold

Investment Property 1 Has Been Sold

The first of our investment properties (IP) has officially been sold¬†ūüéČūüĎŹ

This is part of our strategy for creating a passive income to fund our lifestyle in retirement. The investment properties had a different purpose in our original strategy for reaching financial independence, but they now will be sold off over the next few years when the time is right.

 

What Was The Return?

I’m so glad I can finally crunch all the numbers for you accurately now it’s been sold because you never quite know how much your true return will be until you actually sell your investment property.

Without a doubt the most interesting question on most peoples minds would be:

‘So how much did you make?’

To cut a long story short, we had an annualized after-tax return of 36.48%. 

If you’re interested in all the finer details of how we arrived at that figure please read on.

 

The Numbers

This IP was built in south-east Melbourne for $340K in 2013. I lived in it originally to receive the FHOG.

Buying expenses

  • $30,000 – Deposit ($9,000 from me plus $21,000 FHOG)
    • I borrowed 91.33% of the property plus LMI. I would not recommend this but that’s what I had and the banks were allowing it back then. I wouldn’t have got that loan in today’s¬†market.
  • $4,634 – LMI even though my parents could have gone guarantor¬†(no hands out for me)

I built this house so there were no expenses for conveyancing or stamp duty. All the loaned money went to the builder who was selling land and house packages.

I had a loan of $319,815 (the LMI got attached to the loan plus some other expenses).

Actual money spent so far: $9,000 

Sweat Equity

  • $3,840 – Landscaping. A new garden for the front, back and sides. Plants, pots, mulch, stones etc.
  • $12,000 – Built a deck. Materials, building permit, labour help costs
  • $1,400 – Concreating
  • $4,410 – Other costs. Materials, Skip bins, money spent on food and other things while renovating etc.

I spent countless weekends with my old man and mum going up to the house to add value to it. This not only saved us money, but I also learnt a bunch of new skills. Win-win.

Total: $22,061

Actual money spent so far: $31,061

Cash Flow/Holding Costs

 

Cash FlowYear 1Year 2Year 3Year 4Year 5
Rent – All Expenses-$7,590-$3,929-$2,744-$3,047-$5,841
Depreciation-$8,228-$8,283-$7,445-$6,858-$6,641
Tax Refund$2,654$4,519$3,770$3,664$4,618
Total-$4,935$589$1,025$617-$1,223

 

Total cash flow over the 5 years = -$3,927

Notes:

  • The first year I had to live in the house for 6 months receive the FHOG. This meant that I couldn’t claim all of the expenses for that year. Only for the 6 months I had it as an investment
  • I ended the lease with the tenants and cleaned the house up a bit which is why year 5 is so expensive. I had to cover interest repayments for a few months before the house was sold.
  • Depreciation is not including in the cash flow because it’s not an actual loss of cash flow whereas the tax refund is money coming into my account
  • I used the diminishing value method for depreciation. Don’t ask me why it somehow depreciates more in year 2 than year 1¬†ūü§∑, that was what was on the report.
  • Tax refunds are based on the 37c tax bracket

Actual money spent so far: $34,986

Selling Costs

  • $700 – Conveyancing (had a friend do it cheap)
  • $2,210 – Used an online agent to sell the property. No way I’m paying 2.5% plus marketing just to list it on RealEstate.com and host a few open days
  • $3,850 – Staging. Maybe unnecessary but I like to think it worked

Total Selling Costs: $6,760

Total money committed to this investment over 5 years: $41,746

The IP was sold last month for $512,500

I invested $41,746 of my own money and received $197,697 in return over a 5 year period.

 

ROI vs ROI On Money Invested

Way too often when anti-property commentators are trying to convince investors that another market has had superior returns over the last X amount of years they usually leave out the most important part of the equation.

Property investors use leverage to buy their investments.

Without factoring in leverage, I don’t understand how anyone can make blanket statements about the true returns of real estate. It’s not comparing apples with apples.

With that said, I want to provide you with both returns numbers so I can further illustrate the point that the only real return number you should be measuring is how much money you put in and how much you get out.

ROI

Capital Gain =¬†(gain from investment ‚Äď cost of investment) / cost of investment

= ($512,500 –¬†$386,821) / $386,821 = 32.49%

Annualized Capital Gain = 5.79%

 

Gross Yield = Annual Rent / Purchase Price * 100

= $18,720 / $340,000 *100

Gross Rental Yield = 5.51%

 

Net Yield = (Annual Rent –¬†Annual Costs)/ Purchase Price * 100

= $15,985 / $340,000 *100

Net Rental Yield = 4.70%

 

Total Annualized Return

8.28% + 4.70% = 12.98%

Notes:

  • I’m¬†not 100% sure I can simply plus the two return figures together since one is annualized and the other is just an average rent of $360 per week (maths wizards please correct me). But the overall point still stands that the investment doesn’t look great without leverage.
  • The above calculations are assuming that we buy the property outright. This would mean no interest repayments or LMI costs.
  • 12.98% may sound like a decent return, but what’s not factored in is the 100s of hours of labour and travel spent on this property to achieve this result. Considering you could have got better returns from shares over the same time period with no work required, you’d be mad to buy an investment property outright.
  • I have not factored in the replacement costs as the house depreciates. This hidden bill will rear its head eventually. Something shares don’t suffer from.

 

ROI On Money Invested

This one is a lot easier to work out and the true measure of the investment, not an assumption.

ROI =¬†(gain from investment ‚Äď cost of investment) / cost of investment

= ($197,697 – $41,746) / $41,746 = 373.57%

Annualized Total Return = 36.48%

 

Tax?

In an extremely fortunate turn of events, IP1 became my PPOR after I first moved in to receive the FHOG.

Even though I rented it out, I never bought another house to live in which was not specifically planned but worked out incredibly well. There’s a special rule where you can treat your dwelling as your main residence after you move out for up to six years even if it’s used to produce an income.

Believe it or not, this means that I don’t have to pay a single cent of tax due to the¬†CGT exemption for main residence rule ūüėĪūü§Ď.

 

My Experience With IP1

Investment property 1 taught me more life lessons than any investment in the future ever will.

It was the first house I ever bought, renovated, sacrificed countless weekend adding value to it with my old man helping me out and a whole raft of issues that I had to figure out along the way. From dealing with tenants, discovering how many hoops you have to jump through with banks, lodging insurance claims, rushing to finish the concreting in 38-degree heat (would not recommend), hosting open days and so much more.

Some say property investing can be passive. IP1 was definitely not passive!

It was hard work which did eventually pay off in the long run. Now, how much of its success can I take credit for? That’s a very good question.

Looking back in hindsight I can point out a few key things that happened that I had nothing to do with and was 100% luck

  • FHOG being available boosted my deposit meaning I only had to put down $9K (crazy)
  • The banks lending criteria was completely different back then. No way I get a loan in today’s market only having $9K to put down
  • For the majority of my loan, interest rates were being cut. Every couple of months I had to pay less and less in interest which at the time seemed cool but it’s only with hindsight I can truly understand how fortunate of a time it was to be in real estate. It has only been the last 18 months I have seen my I/O loans rise in rates
  • Melbourne experienced a property boom basically the whole time I had the property. It was only the last 3 months that the prices started to drop and the loans market really tightened their belt. The property was actually under contract before I sold, but it fell through because the buyer couldn’t get finance. I experience this two more time (not officially under contract though) before I had a buyer who was cashed up. Based on what similar properties were selling for, I estimated that IP1 dropped by around $30K since the start of 2018.

I fully admit that all of the above was unforeseen, I was just hoping for the property to keep up with inflation and use leverage to amplify the gains.

One of my favourite quotes of all time comes from the Roman philosopher Seneca.

Seneca

I’m a big believer that you can create your own luck. Whilst I still think that the majority of the return from IP1 came from an uncontrollable event (market boomed), there were things that definitely helped bolster the profits that were in my control.

  • I actually identified the FHOG as an opportunity not to be missed. I signed my contract on the 29th of June which was one day before they scraped the FHOG all together back in 2012. This opportunity was available to all my friends, but most of them did not take it
  • I realised that it was unlikely for me to make a lot of money if I paid for everyone else to do the work for me. I looked to physically add value where I could and since I was full of enthusiasm and energy back then. Countless weekends were spent working on the house. Sacrifices were happily made if that meant I could reach my goal of FIRE quicker
  • I sought advice from experienced¬†property investors who knew what to look for when investing…my parents of course! I understand this luxury isn’t available to every but it’s worth seeking one out if you can. There were small things that helped the investment like buying near public transport, schools,¬†amenities, easy access to the M1, in an area with strong employment options and projects scheduled for the future etc.
  • Getting out of my comfort zone to learn new things such as selling IP1 online saving over $15K in commission fees. The experience I gained from negotiating the deals was invaluable. Some might argue that a skilled and experienced agent could have secured a better sale price. That may be true but we’ll never know. What I do know is that I saved over $15K doing it myself and I’m choosing to save $15K over potentially getting a higher profit every day of the week!

 

Why Did I Sell?

The strategy moving forward is to sell all the investment properties and transition to a more cash flow portfolio of ETFs/LICs. IP1 was the first cab off the rank for the following reasons

  1. The market had gone bananas and I was very keen to lock in that profit and not risk something happening, which sorta happened with the market pullback in the last few months. But I’m very happy with the return we got so no complaints here ūüôā
  2. I would have reached 6 years next year which would have affected the main residence status for tax purposes. This means that I would have had to pay taxes on part of the sale
  3. There was some upkeep work that I was fed up with. IP2 and IP3 are part of a body corp which takes care of a lot of the maintenance.
  4. Whilst IP1 had gone up considerably in value, the cash flow was still shithouse! Technically positive cash flow after the tax refund during the last few years (apart from the selling year due to the extra costs). It still was nowhere near as good as what shares could offer for half the investment.

 

Conclusion

Overall IP1 has been a very successful investment in terms of both return and life skills obtained. I was very fortunate to be in the market during the time I was and I’m pretty confident in saying that I’m most likely never going to make as much money in any other investment ever again.

This may sound like a bummer but the truth is that IP1 was a hell of a lot of work! I can’t be effed doing all that again and I doubt I will have as lucky timings with the market twice. It’s a risk I don’t have to take and Strategy 3 suits our current lifestyle better being so passive.

What’s really hard to measure and has not been factored into the above return is all the physical work required. It was essentially a side hustle I did on weekends (not every weekend but a lot). If I deducted the hours worked * an hourly rate, the return would be less.

I’m still a fan of property investing for the right investor, but¬†I am no longer the right investor and will continue with our strategy of selling off the other two IPs when the times right.¬† It’s my opinion that there are more problems to solve with real estate and more opportunities for those who seek the challenge vs shares.

How has your experience been with real estate? I would love to hear from others positive or negative in the comment section below¬†ūüĎá

 

 

ETFs vs LICs and Strategy 3 Revisited

ETFs vs LICs and Strategy 3 Revisited

Okay, so if you’ve been following me for any length of time you probably know that I’m a big fan of ETFs.

You know, those little exchange-traded¬†funds that grant instant diversification with rock-bottom management fees to provide a great return for extremely little effort. It’s no wonder that famous investors like¬†Warren Buffet and Mark Cuban (US billionaire) are also big fans.

Buffet has been quoted as saying:

“Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time.”

I wrote about the benefits of index investing briefly¬†in ‘Our Investing Strategy Explained‘ post.

I’ve been a big fan ever since reading the Bogleheads Guide to Investing about 3 years ago. And I put my money where my mouth is and currently have over $160K invested in ETFs.

 

“So if ETFs are so great, what the hell are LICs and why should I care? “

 

I’m so glad you asked.

Let’s begin.

 

Listed Investment Companies

GuideToLICs2

FYI when I refer to LICs, I’m referring to the older ‘granddaddy‘ LICs like AFI, ARGO, Milton etc.¬†

 

Listed Investment Companies (LICs) are first created by an initial public offering (IPO). Money is raised and a fixed number of shares are created for each investor. The money raised is then used for investing in assets such as a basket of shares which together make up the net asset value (NAV) of the LIC.

The shares of the LIC are traded on the stock exchange where investors are able to buy and sell when the market is open.

Sound familiar?

It should because, in a nutshell, ETFs are essentially doing the same thing. But there are key differences.

 

 

Key Differences

There may be more differences than what I’m about to go over, but the ones below are the key differences in my eyes and the ones that reflect my investing decisions.

Same but different

 

Management Fees

ETFs tend to have a lower MER than the equivalent LIC but it’s not as bad as it sounds. If you stick to the older LICs (Argo, AFI, Milton etc.) the highest MER is around 0.18% which is not that bad. It’s still more than double that of an Australian index ETF such a BetaShares A200 (0.07%) though.

The management fees reflect the investment style of the two structures.

ETFs track an index or benchmark whereas LICs try to outperform the index. But given the low MER of the older LICs, some active management is acceptable in my view. I only have issues where the fund managers charge > 1.0% for their services.

WINNER: Generally ETFs

 

Legal Structure/NAV

ETFs are a trust structure whereas LICs are a company as the name ‘Listed Investment Company‘ would imply.

This has some semi-big ramifications.

I’m going to try to keep to as simple as possible because we’re about to get technical here for a second.

To truly understand the differences between ETFs and LICs we must first understand how they operate and what’s the difference between Open-End and Closed-End

Closed-Ended

LICs are closed-ended.

This means that when the LIC had its IPO and raised the capital to start the company, a certain number of shares are issued. Once the company has been established and begins investing the capital on the behalf of shareholders, no more shares are issues. New investors wanting to join the LIC have to buy already issued shares on the exchange. The LIC does not create new shares to deal with demand.

Imagine a new LIC that has started with 4 investors each putting in $1. The LIC currently has a Net Asset Value (NAV) of $4 and there are 4 shares issued to each investor.

Fake LIC

Those four shares that own the LIC are each worth $1 according to the NAV. But those shares are bought and sold on the market. And depending on how bullish or bearish the market is on Fake LIC, will determine how much the share price will drift away from its NAV value either up or down.

If someone offers 1 unit of Fake LIC for 80c, this is what’s called trading at a discount. If someone offers the same unit for $1.20 it’s known as trading at a premium. LICs can drift away from the actual NAV quite a bit.

Can LICs ever increase the number of shares? Yes, they can raise capital and issue new shares just like any other company but this only happens every so often and not something that’s done daily like ETFs.

 

Open-Ended

ETFs, on the other hand, are open-ended and can create or redeem new shares in accordance with the market demand. If someone wants to enter the fund, they don’t need to trade with a current shareholder¬†of the fund (like the LIC does). The fund can create a new share.

Conversely, if someone wants to cash out their share. The fund has to come up with a way to get the cash which may mean selling assets within the fund to give the investor their money.

But who sets the price of each unit? 

When an Investor wants to buy or sell their units on the exchange, there is a market maker on the other side of the trade. The price they offer is generally very close to the Net Asset Value of the fund.

This is why you can’t really trade an ETF at a discount or premium to the NAV.

WINNER: LICs. The ability to trade at a discount is desirable but the company not having to sell assets during a crisis to meet demand is a big plus. 

 

Investment Style

Traditionally ETFs track an index or benchmark whereas LICs try to outperform the index.

If you actually look into what is in the portfolios of Australian ETFs such as A200 or VAS and compare them with the old LICs, there is a lot of crossover. The whole active vs passive debate is more of a debate when the active fund managers are charging big fees (>1.0%).

I’ve got no issues with a little bit of active management as long as the MER is low. In fact, I like that most of the ‘Grand Daddy’ LICs have a focus on income. This is important to me and something that is reflected with historic returns for those LICs (more on that later).

One issue I do have with LICs is that they can and sometimes do change investment style. The fund manager that has a fantastic track record might retire or get offered a higher wage at another fund. I personally like the fact that most ETFs are legally obligated to track an index and can’t diverge from that strategy no matter what the managers are thinking.

Some would argue that being able to see waves in the market and adjust accordingly is a good thing.

WINNER: Tie. I prefer to track an index but don’t mind a little bit of active management as long as the fees are kept to a minimum.¬†

 

Retained Earnings

ETFs are a trust and they must distribute their income each year to unitholders. The income from assets within the funds such as dividends, get passed directly from the fund to the unitholder.

ETF Income flow

Because LICs are a company, they can receive income from the assets they own (usually dividends from shares), pay the company tax rate of 30% and keep that income in the fund for as long as they want. Then at a later date, the manager can decide to pass it on, usually as a fully franked dividend to the shareholders of the LIC.

LIC Income flow

This means that the income from ETFs are often lumpy and inconsistent because the market may do well some years and bad others. But if the LIC retains some income from the good years, they can distribute it in those bad years to make it more smooth and consistent.

Sounds like a good thing right? 

This one is something that’s been on my mind for a while.

The ‘smoothing’ of income is often touted as a benefit whenever any debate comes up between ETFs and LICs.

I beg to differ.

I personally don’t want the LIC to retain any of my income. I would much rather they pass on every single dollar to me so I can make the judgement call on what to do with it whether that be reinvested or spent.

This might be a plus to some but it’s an annoyance to me and something I really wish they didn’t do.

WINNER: ETFs. This is my personal preference. 

 

DSSP/BSP

Without going into too much detail, Dividend Substitution Share Plan (DSSP) and¬†Bonus Share Plan (BSP) are offered by two LICs (AFIC and Whitefield respectively). It’s basically a plan offered by those two LICs which allow the investor to forgo the dividend in exchange for extra shares.

This means you don’t pay income tax and get more share instead. It’s great for high-income earners.

This is not offered by any ETF and is unique to the two LICs mentioned above.

If you want to read more about it, check out fellow FIRE blogger¬†Carpe Dividendum’s excellent article.

WINNER: LICs

Fully Franked Dividends

This is actually not a difference but I want to clear up a common misconception about the franked dividends that LICs are able to pay out.

Some investors think that LICs can magically produce more income from the same basket of shares because they often pay out a fully franked dividend whereas an equivalent ETF might only distribute a partially franked dividend.

Let’s say for example that a LIC and an ETF both invested in the same company that paid out an 80% franked dividend of $70 dollars.

Here’s how that money would reach the investor using a LIC.

LIC Franking

Note that the end result for this investor who is in the 37% tax bracket is a grossed-up dividend of $59.22 after tax.

 

So how does it play out in an ETF structure?

ETF franking

 

The end result for the investor is exactly the same. A grossed-up dividend of $59.22 after tax.

WINNER: Franking does not matter when comparing LICs to ETFs.

 

In a nutshell, the key differences are:

TypeManagement Fees (MER)Investment StyleLegal StructureNet Asset Value (NAV)DSSP
ETFAs low as 0.04%Passive. Usually tracks an index and does not seek to outperform.TrustTrades on, or very close to NAVNo
LICAlthough slightly higher for an equivalent ETF, the old LICs generally are all under around 0.18%.Active. Seeks to outperform an index over the long term.CompanyCan trade at a discount or premium to the NAV of the fund.Yes

 

So Which One’s Better?

HomerThinking

If you’ve made it this far, I can almost hear your cries.

‘Just tell me which ones better FFS!’

After consuming all that info above, you’ll be rewarded with a clear and concise answer as to which investment is superior and what you should do.

And here comes the most annoying answer…

They are both great.

Both have pros and cons but either ETFs or LICs are suitable for FIRE chaser in Australia looking to generate a passive income. The most important thing is to understand the pros and cons for yourself and then you can make an informed decision as everyone’s needs, investment style, and¬†appetite for risk are different.

The last point is often overlooked, it’s not so much about trying to achieve the maximum return in my eyes. It’s about choosing a strategy that will generate that passive income but more importantly, a strategy that you’ll be comfortable with through thick and thin. Because any portfolio is easy to hold in a bull market (see negative gearing). But it’s when the shit hits the fan that you’ll really appreciate a well thought out strategy that you’ll feel comfortable in when everyone else is running for the exit.

 

Conclusion

Peter loves Homer

ETFs and LICs are similar yet different. They shouldn’t be seen as enemies, more like best friends and depending on your mood, you might want to hang out with one or the other…maybe there’s room in your portfolio party for both?… Which leads me to talk about…

 

Strategy 3?

If you have read ‘Our Investing Strategy Explained‘, I have been thinking more and more about a dividend focussed portfolio which mainly consists of Aussie shares since they offer a great yield plus franking credits. They certainly feel like the ultimate passive investment to fund early retirement. And our end goal, after all, is to create a passive income stream to retire on.

So after much research, learning from other dividend focussed investors such as Peter Thornhill and Dave at Strong Money Australia and much toing and froing, I have decided to direct all future capital into high yielding Aussie shares in the form of ETFs and LICs.

We currently have nearly $100K in international securities which makes this decision a little bit easier. We are basically accepting the risk of lesser diversification in order to gain a higher dividend yield through Aussie shares.

I completely understand the risk and acknowledge that an internationally diversified portfolio will most likely outperform an all Aussie one in terms of total return. However, I’m confident in saying that the international portfolio will not offer the same level of dividend yield that the Aussie one will.

I wrote a little bit more about my reasoning to move to strategy 3 in our September 2018 Net Worth Update.

 

Historic Returns

I would like to take a second to illustrate just how similar the returns are between most of the older LICs and Australian Index ETFs.

I’m going to be using the historical data of Vanguards VAS ETF because the A200 was only created this year and VAS has been around nearly 10 years. Since they are so similar it should be a fair comparison. And I’m choosing 4 of the most common older LICs for comparisons.

Below are the returns for investing $1M on the 21st of May 2009 (creation date for VAS) in each of the LICs and VAS.

LICs VAS Returns Historic

It’s no surprise that the majority of the LICs returned more dividends than VAS. This is their main focus after all and a primary reason I’m investing in them.

Argo was a surprise returning significantly less than the others in terms of capital gains and dividends.

Maybe even more surprising is that VAS is smack bang in the middle of the pack for total returns. I guess that this just further illustrates that it’s hard to beat the index consistently over a long period of time. Some LICs might be able to do it (in this case MLT and BKI) but others won’t.

 

ETFs AND LICs?

Yes, I’m utilising a combination of an ETF and LICs for the Aussie portion of my portfolio which is what I have decided to focus on for the foreseeable future.

Here’s how it’s gonna work.

I will be purchasing either one of two LICs or one ETF once a month to the tune of around $5K.

 

Why 1 ETF and 2 LICs?

I have already been into why I think ETFs are so great if you’re looking to get exposure into the Aussie market and want to invest in an index style. BetaShares A200 or VAS are the obvious choices in my opinion and with the A200’s MER being half the price of VAS, it’s a clear choice for me.

One of the biggest pros for ETFs for me is that they do not try to pick winners and divulge from an indexing strategy.

LICs, on the other hand, can and do suffer from a fund manager change or investment style redirection.

This scares me.

To mitigate this risk, I’ll be spreading our capital out between two LICs even though what they’re investing in is incredibly similar and might look silly from a diversification point of view. But I don’t really care if others think it’s silly, if it helps me sleep at night then it’s all gravy baby!

The other reason I’m buying multiple LICs is to have a greater chance to be involved in a¬†Dividend Substitution Share Plan.

So what am I buying and how am I deciding what to purchase? 

ETF

A200
MER: 0.07%
Benchmark: Solactive Australia 200 Index

Why it’s in our portfolio:
BetaShares A200 made it’s way into our portfolio last month after Vanguard failed to respond and lower their management fee for VAS which is currently double that of the A200.

Given that the returns for the last decade between the ASX200 vs ASX300 (pictured below) were incredibly similar.

A200vsA300

Source: https://au.spindices.com/indices/equity/sp-asx-300

I’m choosing the ETF with the lower management fee every day of the week.

 

LICs

AFI
MER: 0.14%
Benchmark: XJOAI (ASX:200)

Why we will be investing:
Other than being a dividend focussed LIC with a MER of 0.14%, AFI is only one of two LICs that offer DSSP. The other LIC is Whitefield (WHF) and that has a MER of 0.35% which is too high for my liking.

A very good detailed review about this LIC can be found by the ever so insightful SMA. Check it out.

 

MLT
MER: 0.12%
Benchmark: XOAI

Why we will be investing:
Milton’s very low MER of 0.12% was attractive and we needed to spread our risk across another LIC so after much research, Milton it was. Milton also seems to be a bit more on the active side compared to the other older LICs which is another hedge against something happening with the index.

Full SMA review if you’re interested.

When To Buy?

So if I’m going to be directing all future capital into Aussie shares through LICs and A200 ETF. When do I know which one to buy since they are all essentially¬†the same investment (Aussie shares)?

Here’s what I’ll be doing each month when we have saved up $5K and are ready to invest:

  1. Check both AFI and Milton’s NAV compared to their share price on the ASX to see if they are trading at a premium or discount (currently developing a web app to make this easier)
  2. Invest in whichever LIC is trading at the biggest discount
  3. If both LICs are trading at a premium, buy A200

 

That’s It…For Now

As of writing this article, for my circumstances and goals, I believe that an Australian based portfolio consisting of ETFs and LICs is the best strategy to produce a passive income for me to achieve financial independence so I can have the freedom to retire early.

But as I’ve always said, if I come across something that’s better than what I’m doing, I’ll make the switch.

My mind is always open to new ideas and strategies.

But that’s it for now… until strategy 4 rears its head¬†ūüėą

Savings Review 17/18

Savings Review 17/18

Since we do all of our accounting at the end of the financial year it only makes sense to see how we did in terms of savings in July.

You can check out last years review here, but to sum up 16/17, we achieved a savings rate of 63%.

So how did we do this year?

Let’s get into the numbers.

 

Savings Rate For 17/18 Financial Year

Our savings rate for last financial year was… 66%

We earned $141,497 (after tax)

And spent $47,999

Sooooo happy with 66%! At the end of 2017, I posted our¬†financial goals for 2018 and one of those goals was to achieve a savings rate of 65% or above. We ended up coming in last year at 64%¬†ūüė≠ haha, so I’m very pleased for us to reach 66% at the end of this financial year. Hopefully, we can carry it through until the end of the calendar year¬†ūüôŹ.

Breakdown Of Spending

So what did our precious $$$’s go?

Spendings.17.18

And in pie form

PieForm

There are a few little issues with the tracking categories for this year because¬†Pocketbook had a major revision of their categories and it resulted in a few double ups and what Pocketbook thought something should have been categorized as and my interpretation. For example ‘Car’ was a major category for me using this software, but Pocketbook replaced a lot of my ‘Car’ transactions as the new category ‘Transport’. There’s also ‘Holiday and Travel’ and ‘Holidays’. The overall numbers are correct just some of the categories might not make much sense.

A few interesting things to note about this year’s breakdown compared to last years.

Rent and groceries still dominate the top spots so no changes there.

Interestingly ‘Food and Drinks’ came in at number 3. This category includes alcohol and going out for breakfast and dinners. It’s really no surprise that it’s number 3 for the last 12 months. Since I changed jobs at the start of 2017, we made the move back to our hometown which has resulted in us being a lot more social. We go out for drinks on Friday nights (in Summer) and get to hang out with friends a lot more. This has resulted in a lot more money being spent on social things but I have to admit, it’s been absolutely fantastic and well worth the extra spending.

A positive from the move was that we are now driving on average, less than 400km a week compared to our old commute to work. This has resulted in us being home a lot earlier, generally feeling a lot better because we’re not stuck in our cars so much and $1,523 difference in fuel mainly from our shorter work commute.

Amazingly we spent nearly the exact amount on groceries which is very interesting.

The lack of weddings certainly helped our savings rate. But interestingly enough, we have booked a lot more¬†holidays than the previous financial year. I have a feeling that’s because we went to so many weddings in 16/17, it scratched that holiday ich that usually starts pestering in the colder months.

We spent nearly $2k less on presents which makes sense due to the lack of weddings.

And all the other stuff is pretty much on par.

 

What About You?

It’s so important to track your spendings. It’s always my number tip for people to reach FIRE quicker. I’m stoked with a savings rate of 66%! But it can always be better.

How do you stack up? Maybe 66% is easy street for you or near impossible for others. Remeber, it’s not so much about killing yourself to achieve a higher savings rate, rather acknowledging¬†where your dollars go each month and being at peace with that or changing it up if you’re not happy with the current status quo. But you’ll never know unless your start tracking¬†ūüďą

So what’s your savings rate?

Our Investing Strategy Explained

Our Investing Strategy Explained

If you follow any online FIRE blogger whether it be an Aussie or international, you might start to see a pattern that emerges more often than not.

The majority of these early retirees are living off an income stream generated by returns from Index Investing. 

In this post, I’m going to go into detail about how I first started investing for financial independence and how my strategy evolved over the years.

 

In the Beginning

InTheBeginning3

I first came across the term and concept of financial independence in a book called ‘Rich Dad Poor Dad’ by Robert Kiyosaki. It really struck a chord with me because it was so simple. You buy assets that make you money and eventually you will get to a point where you have so many assets that make so much money that you don’t have to work to live.

Mind = blown.

Now I was already pretty good at the saving and frugal part. But I had never invested in anything outside of a savings account. This leads me to pick up my next book in my quest towards FIRE, ‘From 0 To 130 Properties In 3.5 Years’ By Steve McKnight. Because if you live in Australia the most popular investing class by a country mile is without a doubt, Real Estate.¬†

It makes sense too, most of our parents have seen/experienced incredible real estate booms without any real crashes in the last 25 years. My parents also invested in real estate so there was a comforting sense of guidance I could draw from when choosing this asset class. Mum and dad had been through it before and could mentor me.

Real estate is easy to grasp too. You buy a house, you rent it out and collect rent, the rent covers the expenses (hopefully), you sell it later at a higher price and make a profit. The other popular strategy with real estate is that you buy strong cash flow properties (where there is a surplus of rent after all expenses) and live off the rent, but this strategy is very hard to do in today’s market because of the low rental yields in Australia.

With time on my side for letting my investments grow for decades, my first investing strategy was to create an income stream through real estate.

 

Strategy 1 – Real Estate

The very first investing strategy I had, went something like this.

If I could buy 10 investment properties (IP) and hold them for 10 years, I could sell half of them and pay off all my debts. I would then have 5 houses pulling in rent with no interest repayments which would mean the majority would come to me.

The maths roughly looked like this:

EquityLoansRent @ 5.2 YieldExpenses
10 X IP$3M$2.4$156K$175K

 

And after 10 years, assuming that rent and expenses (but not interest repayments) have increased with inflation @ 2.5%

EquityLoansRentExpenses
10 X IP$6M$2.4$200K$180K

 

It’s important to note that while some expenses like rates, maintenance, water bills etc. would increase with inflation, the loan amount never changes. This is actually an advantage of leveraging your investments. You take out a loan in today’s¬†dollars but can pay them off years later after inflation has eroded them. Which is often why you hear people say that debt is a good hedge against inflation.

And then I would sell 5 IPs and it would look like this

EquityLoansRentExpenses
5 X IP$3M$0$100K$15K

 

I was well on my way with this strategy and bought my third IP in 2015 which was around the same time as I discovered MMM and index investing which I will go into later.

This strategy has worked for thousands of Aussie and isn’t anything new.

So why did I decide to change my strategy?

  1. Strategy 1 relies on capital growth.
    • You can see in the first table that there is nearly a $20K difference between the rent and expenses. What is not factored in here is negative gearing. All my properties right now are negatively geared but cash flow positive. Because of the tax refund I receive, the properties pay for themselves. But I could never actually retire off this cash flow which is why the capital gains are imperative. Without it, the strategy simply doesn’t work. And capital gains only works if someone buys your assets at a higher price than what you paid for it. I never felt comfortable breaking even or making a tiny profit each year with the hopes that 10 years down the track it would all pay off. I felt that investing should be a snowball approach where you start with a small trickle of passive income and see it grow into a raging torrent over the years.
  2. Active Investment
    • There’s no way around it. Managing property requires time and effort. When I first started I had all the enthusiasm and motivation in the world and wanted to do everything I could to reach FIRE as quickly as possible. If that meant some sweat equity then I was all for it. But roughly 5 years later my motivation for doing all the extra stuff has fallen off a cliff. I would much rather focus on other things than worrying about and managing my investments. To be fair, my properties aren’t too much of a hassle, but getting to 10 IPs would be a lot.
  3. Lending conditions changed
    • It was around about 2016 when the APRA (Australian Prudential Regulation Authority) really made it hard for investors to withdraw equity and refinance their loans. This was to try and curb risky lending and make it harder for property investors. Interest rates were raised on all of my loans and the number of hoops I had to jump through for my last equity withdrawal was 10 times harder than in 2014 and 2015. Looking back now, I was very fortunate to get into property when I did. Interest rates were being cut and banks were financing loans a lot easier.¬†In mid-2016 I could not get another loan for a 4th property which meant my dream of 10 properties was out of reach.

But if I’m not going to reach financial independence through real estate, then how else am I going to create a passive income stream?

 

Strategy 2 – Index Investing

I think I can speak for a lot of people when I say Mr. Money Mustache has a way of writing that people relate to. I guess it’s why he is so popular. When I read The Shockingly Simple Math Behind Early Retirement it just made sense. And his article about Index Investing really clicked with me and would be what I consider the catalyst¬†for my desire to learn more about the stock market.

It’s quite funny to see peoples reactions when they discover you have 6 figure sums invested in the stock market.

“That’s so risky though. Don’t you ever get scared you’re going to lose it all? One minute it’s there, next it just vanishes. I wouldn’t feel safe having so much money in the stock market, I only invest in things I can see and touch.”

I too once thought like this because of the constant news outlets reporting on the stock market crashes and how billions were wiped out in mere hours. Scary stuff.

But if you actually take the time to understand how the stock market works and what index investing is, I think you would be pleasantly surprised to find out all the positives that come with this investing approach.

 

What is an Index?

Indices cover almost every industry sector and asset class, including Australian and international shares, property, bonds, and cash. There are companies that conduct and publish financial research and analysis on stocks, bonds, and commodities to create indices. One of the more popular companies that publish these indices is¬†Standard & Poor’s¬†(S&P).

Have you ever listened to the news and heard them talk about the All Ordinaries (also know as All Ords) and wondered what it is? The All Ords is Australia’s oldest index of shares and consist of the 500 largest companies by market capitalization.

Let’s take a look at the S&P/ASX 200 (top 200 companies trading on the ASX by market cap) historic data since 1992:

ASX200

Here is the Dow Jones (US index) for around the last 60 years.

DowJones2

And lastly, here is the Financial Times Stock Exchange (FTSE) 100 Index which is the top 100 companies listed on the London Stock Exchange by market cap.

UK FTSE 100

 

What is Index Investing?

You might notice a few trends from the above graphs like the dot-com crash around 1999 to 2003, or the GFC in 2008 or the constant peaks and troughs through the years.

But what is glaringly obvious is the overall trend in each countries index is up.

And these graphs don’t include the most important part. The entire time throughout these decades, those companies that are trending up or down, are paying dividends (or reinvesting them) each year! So combine the capital growth from the above graphs with dividends and you get the idea. The overall markets, given enough time, trend upwards!

This is a fundamental principle of index investing.

It’s hard to predict which companies are going to do well over the next 20-30 years. In fact, it’s almost impossible. A lot of active fund managers try to outperform the index and charge you exuberant management fees with the promise of higher returns. The thinking behind this makes enough sense. The fund managers have an army of analysts working 12 hour days using the latest analytical tools and datasets to ensure that they only choose the ‘best’ companies to invest your money in. But as history has shown, only a very small % of investors/fund managers are able to consistently over a long period of time (20 years+) beat the index.

Rather than trying to guess which investments will outperform in the future, index managers replicate a particular market or sector. This means they invest in all or most of the securities in the index.

Indexing is based on the theory that investors as a group cannot beat the market – because they are the market.

 

ETFs/Vanguard

So how do you invest in an entire index?

You could, in theory, buy all the companies within an index at the appropriate weightings. You would get killed in brokerage fees but I guess technically you could do it. But luckily there’s a much easier way.

There exists investment companies that cater to the index investing style and offer investment products that mimic an index with rock-bottom management fees. One of the biggest investment companies that offer these products is Vanguard.

The reason Vanguard and other companies can offer these products at such a low cost is that there is no money spent researching and analyzing which stocks to invest in. Index investing companies simply look at the index data provided by companies such as S&P and remove or add companies from the index plus a bit of paperwork. That’s it!

To put the management fees into perspective, a hedge fund’s fees might be as high as 2.00%. Vanguard charges me 0.04% for my US index ETF that I invest in.

To put it another way, if I had $1M in the hedge fund. They would charge me $20K a year for management fees. Vanguard would charge me $400 bucks. The difference of $19,600 reinvested at 8% over 30 years is $2.4 Million!!!

You can either invest directly with the Vanguards fund or you can buy ETFs which are exactly the same investment products but traded on the stock exchange. There is also a difference in management fees. You can read up a bit more about the difference in this article How To Buy ETFs.

 

Why We Decided To Move To Index Investing 

I joined finances with my partner in 2016 and we made the decision to start investing in ETFs (index investing). After reviewing the two asset classes a year later, we knew that we wanted to continue to go down the path of index investing. Here are the reasons why we decided to move away from real estate:

  1. Diversification
    • With our current three fund portfolio, we have exposure to over 6,000 companies in over 30 different¬†countries. Our three properties are all located within Australia (different states mind you) and while I think it’s unlikely that they would all tank at the same time there is the possibility of a recession to hit Australia. If that were the case, those properties would almost certainly drop in value. And Investing Strategy 1 relies on capital gains to work. If something like that did happen, they have enough cash flow to make it through but who knows how long it might take for them to recover and ultimately gain enough value for the strategy to work. I might be waiting for decades.
      The odds of the entire world tanking over a long period of time is not completely out of the realms of possibilities, but it’s a lot less likely than one country going into recession.
  2. Liquidity
    • If we ever needed the money that was locked in the properties. It might take 6+ months to sell them and go through the whole process. With ETFs, I can put in a sell order and literally have the money in my account within 3 days. This means that selling off parts of your portfolio to fund your retirement is possible.
  3. Cash flow
    • This is probably the biggest reason why we made the move. The path towards freedom is a lot clearer with ETFs. We know that we will need roughly $1 million in the market to generate enough returns each year to live off forever. The high cash flow/liquidity makes index investing a popular choice for FIRE chasers.
  4. No more banks
    • Investing in ETFs does not require lengthy loaning processes. Leverage can have its place but it’s not required.
  5. Passive income
    • Some may argue that real estate can be passive, and to some degree, I guess it is. But from my experiences with real estate, such jobs as collecting rent, doing paperwork, dealing with tenants, responding to emails, maintaining the properties etc. can add up to be a part-time job. You will not find a more passive income stream with the same returns as what ETFs offer. And I also love the fact that the more ETFs you have does not mean more work. More properties¬† = more work. But you will do the same amount of paperwork come tax time on a $50K portfolio vs a $3M one.
  6. I don’t have to be an expert
    • I believe that you need to know your shit when investing in real estate. I wouldn’t be comfortable investing in a property unless I knew the ins and outs of the area like the back of my hand. Where are the jobs coming from? What’s the population growth like? What’s the unemployment rate like? And on and on I could go.
      The only thing I have to work out each time I buy ETFs is what I need to buy to rebalance my portfolio. That’s it! I don’t need to keep up to date with the latest trends or what’s the hot stock right now or any of that crap.

 

Our Plan Detailed

If you read my monthly net worth posts you can see that we invest in a three-fund portfolio. I’m going to go into details about why we invest in each fund and how ultimately they will enable us to reach FIRE.

Management Fees: I prioritize a low MER (Management Expense Ratio aka management fees) above almost everything else because paying less in management fees is a guaranteed returned and when it comes to investing in general, almost everything else is speculation to a certain degree.

Given my obsession with management fees, you can understand that Vanguard was an easy choice as an ETF provider since they offer some of the lowest MERs in Australia.

This is what our Strategy 2 looks like in pie form

Strat2Pie

Let me explain each fund and why it’s in our portfolio

VAS
MER: 0.14%
Benchmark: S&P/ASX 300 Index

Why it’s in our portfolio:
Some people will argue that Australia is such a small percentage of the world’s markets (around 2% last time I checked) that it’s not diversified enough and you’re better off going global for that diversification. I generally agree with that and what’s even worse is that out of my three funds, VAS has the highest MER at 0.14%.

So why do I invest in it?

Two words… Franking credits.

I’m not going to go into the technical details of how they work (Pat wrote a great article about that if you’re interested) but essentially they are an advantage that Australian companies can give Australia investors.

Australian companies for whatever reason emphasize higher dividends vs capital growth. I’m not 100% sure why this is, but please feel free to let me know in the comments for all those smarty pants out there.¬† Anyway, this high dividends plus franking credits means that VAS pumps out a solid stream of dividends each year. The franking credits are too good of an opportunity to pass upon and are why VAS takes up 40% of our portfolio.

**A200**

A few months ago BetaShares released the A200 ETF.

It is essentially the same product as Vanguards VAS ETF except the A200 invests in the top 200 companies of the ASX instead of the top 300. Something to note is that the bottom 100 companies in VAS only make up 2.5% of the total in terms of market cap. So while the A200 is less diversified than VAS, it’s not as bad as it sounds.

The A200 boasts a MER of just 0.07%.

That’s half the price in management fees vs VAS!

I will be moving to the A200 if Vanguard does not respond with a lower MER next time we buy.

No one knows if VAS is going to outperform A200 moving forward. But what we all know, is that right now you will be paying double the price in management fees if you invest with VAS.

I won’t sell VAS moving forward, but I will be buying A200 instead.

VTS
MER: 0.04%
Benchmark: CRSP US Total Market Index

Why it’s in our portfolio:
Diversification? Tick (the US make up around 40% of the entire world market)
Good Returns? Tick
Rock bottom MER? Tick!

How can you possibly go past this ETF if you’re looking for a low-cost diversified ETF? At 0.04%, that’s the lowest management fee of any ASX ETF I can think of off the top of my head. I have often thought about going 100% VTS because I value a low MER with the highest regard. But the franking credits keep pulling me back to VAS and complete world exposure is why we finish with VEU.

VEU
MER: 0.11%
Benchmark: FTSE All-World ex US Index

Why it’s in our portfolio:
VEU rounds off our diversification by giving us the entire world minus the US at a very reasonable MER of 0.11%. And since we also invest in VTS, this means that with just three funds, we have exposure to the largest companies on planet earth.

 

Think about what would need to happen for us to lose all our money. Companies like Apple, Microsoft, Google, Exxon, Facebook, Commonwealth Bank, ANZ, Westpac, Shell, Samsung, Toyota, GM Motors, Telstra, Johnson & Johnson etc. would all have to go bust. All of them! I just can’t see that happening. And if some of those companies do go down the drain, they are simply replaced in the index by the next company with the highest market cap. And because the index is only giving a small weighting to individual companies (less than 1%), you won’t see it affect your portfolio. The only time a significant drop occurs is when the entire market as a whole is down (like what happened in 2008).

 

The 4% rule

 

The 4% rule is based on the 1998 paper called the Trinity Study¬†and to put it simply, it means you should, in theory, be able to live off 4% of your portfolio. It’s an American study and is meant to last for 30 years so it’s not full proof by any means. But this is what we are using when calculating ‘our’ financial independence number.

So if we have a portfolio of $1M, we could live on $40K a year and never run out of money (it also factors in inflation).

 

How Much Do We Need?

 

We are currently on track for this F/Y to have spent a touch under $50K. That’s absolutely everything we spend to live our current life. It also factors in rent.

We do plan to own our own home one day which means that factoring in a fully paid off house, we spend about $38K a year.

Which would mean that we need a fully paid off house plus $950,000 in ETFs to generate enough income each year (factoring in inflation) to become financially independent! But being on the conservative side of things, I think a cool one million will be the target.

 

How It’s Going To Work

 

Let’s imagine, for argument’s sake, that we had reached our $1M portfolio goal with all the appropriate weightings for VAS (40%), VTS (30%), and VEU (30%) exactly one year ago (19/06/2017).

After one year, this is what the performance of that portfolio would look like thanks to ShareSights amazing ability to create dummy portfolios with historical data.

 

Strat1sharesights

And if we look at how each fund performed for the last 12 months we get this.

Strat2Sharesight2

Total Return for the 3 funds was $131,276 for the last 12 months!!!

A few things to remember though:

  • We need to factor in inflation. If we assume 2.5%, that means that our real return was $127,964.
  • The last few years have basically been a bull run for the whole world. This portfolio is not going to return these numbers every year. But that’s ok, what we need to do in the good years is not spend extra, but keep that surplus in the portfolio so when the bear market does come (and it will) there is enough to carry us through to the next bull.
  • By looking at the total return, it would appear that VEU did really bad and VTS did really well. But how we actually should measure the returns is in percentage. Which looks like this
    Strat2Sharesight3
    VAS and VEU are a lot closer when comparing % returns. VAS has a higher weighting which is why it returns more dollars when it’s very close in percentage terms.
  • We are aiming to achieve around an 8% return on average from the stock market. So 13.13% is a fantastic year!

 

The Dividend Part

 

You can see from the above graph that we received $34,265 from dividends in 12 months…¬†Notbad¬†This is pretty good but you can clearly see from the fund breakdown where the majority of the dividends came from. VAS of course. Australian shares just pump out those juicy franked dividends like no other which is great.

But what’s probably even more important to note, is how low the dividends were for VEU and especially VTS considering VTS made an overall gain of 18.92%! You won’t get much better than that and it still only paid out a lousy 1.83% yield.

We needed $38K last year. But this year inflation (2.5%) adds another $950 dollars. So we now need $38,950 to maintain our lifestyle.

The dividends cover $34,265, which means we’re short $4,685.

 

The Captial Gains Part

 

You know how I was just bagging out VTS because of its putrid dividend yield? Well, boy does it make up for it in the capital gains department!

VTS alone smashed our FIRE number of $38,950 and returned a whopping $51,295 (17.09% Gain!!!). Combine the other two funds and last year well and truly exceeded the 4% rule.

But how do we harvest these capital gains to actually live? The dividends are straightforward because they are paid directly into your account without you having to do anything. The capital gains part is a tad different.

We need to sell off units from our portfolio and realize a capital gain.

WaitWhat

This is the part where a lot of people either don’t fully understand or are not comfortable with.

“Wait, I thought we reach a certain size portfolio and it pumps out a passive income stream we can live off? I don’t want to sell part of my portfolio. What happens if I have to sell it all”

It’s perfectly fine to sell off parts of your portfolio as long as it has the time to recover those losses.

For example, in the above scenario, I need an extra $4,685 which I must get from selling some units from one of the three funds or parts of all of them.

The most obvious fund to sell some units is VTS because it had the best return in the capital gains department and we can lock in those profits by selling. Each unit is now worth $193.190. So a bit of quick maths means I need to sell 24.25 units. Rounding it off and factoring in brokerage fees lets just say we sell 25 units.

$193.19 X 25 = $4,829

We have now made up what we needed to live for that year.

“But we are now down 25 units right?”…¬†Technically right, but the wrong way to look at it.

Firstly, the portfolio grew by $131,276 dollars. We took $38,950 out of that growth to live on which leaves us still up $92,326. When next year rolls around, because of the power of compound interest, it doesn’t matter that we are 25 units down. Assuming we get the exact same returns in percentage terms, we will make more money next year because the starting value of our portfolio is higher than last year even factoring in 25 fewer units.

“But what if I run out of units?”

Highly unlikely. Each year you will have less and less units, but those units should be worth more unless it’s a bad bear market. Even so, we will have over 11,000 units spread across the 3 funds. Every few years they will be worth more and more meaning we will have¬†to sell fewer units each time to make up the difference.

 

What Happens If We Retire And Another GFC Hits

 

This is the worst case scenario for our plan. Because it relies partly on capital gains, a huge downturn in the market straight after we pull the pin would mean we potentially would have to sell units at a rock bottom prices. And it’s possible that our portfolio might shrink too much in the early years and never make a full recovery when the bull markets come back around.

In this situation, I think the answer is pretty obvious.

At absolute worst, I’ll pick up some part-time work. Shit, even 200-300 bucks extra a week would dramatically reduce our reliance on ETFs. $300 a week for a year is over $15K which is 40% of our expenses!

 

Retirement

 

When our portfolio reaches $1M and we have the house fully paid off, I will at that point, declare financial independence.

But what will we then do?

If we are enjoying our lives to the fullest, then there would be no reason to change anything. But what I most likely will do immediately is drop my working days down to 2-3 days a week. From there the possibilities are really endless. Do I want to continue working at my current job? Maybe I only want to do part of my job 2 days a week? Maybe my boss won’t like that, but since I have reached FIRE I will have the power to quit my job without worrying at all.

I don’t plan to ever stop working, to be honest. It will just be 100% enjoyable work and probably not full time unless it’s a passion project. So the odds of neither Mrs. Firebug or I receiving some form of income post retirement is extremely low. This blog is even pulling in some $$$ now and I absolutely love working on it. I couldn’t imagine where it could go if I worked full time on it!

We will always have the portfolio there knowing we are financially independent, but there’s a good chance we will still earn some form of income from something fun ūüôā

 

Strategy 3..?

Ok, long read so far I know. But we’re nearly there.

I’m a big believer in the following quote:

Albert

I’m constantly looking for new ways to invest, reduce our spendings, find tax efficient methods etc. It’s half the reason I started this blog. So a whole bunch of people way smarter than me could critique my strategies and explain better ways to do things. And it’s worked an absolute treat so far. The Australian FIRE community is the best for sharing information that will help you get wealthy a lot quicker than if you had gone at it alone.

So when I come across something that makes sense to me and is even better than what I’m currently doing. Why wouldn’t I adopt it?

 

Enter Thornhill

 

The entire reason I invest money is to reach the end goal of financial independence.

To have my assets generate enough income for my partner and I to live off forever.

The key word here is income. In Strategy 2, capital gains are still required because VTS and VEU predominately¬†return capital gains vs dividends. VAS is the cash flow king out of the three because that’s the Australian index and Australia has a high rate of dividends.

Peter Thornhill is the author of the best seller ‘Motivated Money’ which details his investment approach to investing for dividends (mainly in the industrial sector) and not for capital growth.

He explains in his book that dividends are a lot more stable and less impacted by market swings as opposed to the share price. Something that really struck a chord with me is the way he explains intrinsic value. In a nutshell, the real value of a company or any investment, in general, should be determined by how much income it is able to produce over a long period of time. It’s the income that is key. And it’s the income that will either pay the investor (you) the dividend or be retained by the company and consequently have the share prices go up.

This is how it should work, but as we all know. Humans tend to speculate a lot and you end up with assets that have potential but no solid foundation of cash flow being traded for ludicrous amounts of money (BitCoin, Sydney Real Estate etc.).

I’m not saying these assets don’t have value, but the only way that an investor can make a decent return is if they find someone that is willing to buy it at a higher price than what they paid for it.

If the goal is income, why don’t we focus only on investments that yield the best dividends?

Why not go 100% Australian stocks?

Australian shares yield the best dividends AND they give you the bonus of franking credits. These two reasons make a very appealing case for any Aussie investor.

I encourage everyone to read Thornhill’s book ‘Motivated Money’ because he explains the dividend approach a lot better than I can.

Here is a little video of Peter explaining why he looks forward to a GFC event.

 

The more I listen to this guy, the more convinced I am with his approach to investing in Australia.

“Watching the share prices drop is a totally different thing to the cash flow¬†that’s coming out of the portfolio. That is what we are living on, we are not living using the capital as the source of income, it’s generating the income for us” -Peter Thornhill

UPDATE: We have since officially moved to strategy 3 a few months after this article was published.

 

Conclusion

Hopefully, you can come away from this post with a much clearer understanding of how we are planning to reach FIRE in the next coming years. I really wanted to include as much detail in this as possible and try to convey our thoughts behind the investment decisions we are making.

I think it’s common for a lot of Australians to start with real estate but finish with shares. I feel like that is the natural progression that as we get older and don’t have the time or energy required for active investing, the share markets offer a fantastic passive alternative with many other benefits. We are on track with strategy 2 at the moment. But the more I think about strategy 3, the more I’m liking it.

$1M is our official FIRE number. When we reach that plus a house paid off, the goal will be reached. It’s still a few years away no doubt, but we are enjoying the journey and each month we move closer to our destination.

What about your strategy? Are you on a similar path? I would love to hear about how you’re going to reach financial independence in the comment section below.

Vanguard Diversified Index ETFs

Vanguard Diversified Index ETFs

*Nothing written below is financial advice. Always do your own research when dealing with your finances

One ETF to rule them all?

OneETF

The majority of the Australian FIRE community roughly subscribes to one of the three combos when it comes to ETFs:

  1.  40% Oz shares (VAS or AFI) 60% international (VGS or equivalent)
    • Pros
      • Great exposure to the entire world with enough Australian¬†shares to take advantage of franking credits
      • Don’t have to fill out a W-8BEN form every couple of years
      • Hedged against the Australian dollar
      • DRP option available
    • Cons
      • Highest management fees¬†(0.164% assuming the above weightings) out of all the three options (more on this later).
      • Have to manually rebalance
  2. 40% Oz shares (VAS or AFI) 60% international (VTS+VEU)
    • Pros
      • Great exposure to the entire world with enough Australian¬†shares to take advantage of franking credits
      • Low management fees (0.101% assuming the above weightings)
      • Greater diversification than the other two options
      • exposure to emerging markets
    • Cons
      • Extra admin to fill out W-8BEN form (less than one hour every few years)
      • DRP option only available for VAS, not VTS or VEU
      • Potential estate issues when you die for VTS and VEU units
      • Have to manually rebalance
  3.  100% Oz shares РDividend focussed (VAS or AFI) (Thornhill approach)
    • Pros
      • Take full advantage of our unique franking credit systems in Australia
      • Dividends are less likely to be affected during a downturn
      • Hedged against the Australian dollar
      • Don’t have to fill out a W-8BEN form every couple of years
      • Low management fees (~0.14%)
    • Cons
      • Not diversified¬†outside of Australia
      • Miss out on international market gains
      • Capital gains traditional low for this strategy
      • Home bias

All three strategies have their merits but they all require rebalancing with the exception of an all Australian ETF. The issue with that strategy is, of course, you don’t have much diversification as Australia is only roughly 2 percent of the world economy. And with how much private debt Australians have right now… if Australia went through a recession the all Australian portfolio would not fare well.

The point is that each one of these strategies is missing something and require manual intervention whether it be rebalancing, extra admin work or more diversification.

Wouldn’t it be good if there was an ETF that took care of all this for you?

 

Vanguard Diversified ETFs

 

Vanguard Diversified ETFs

So what are they exactly and what’s the difference between buying this ETF vs one of the three options mentions above?

To put it simply, any of the four diversified index ETFs above offer a complete one stop shop solution for anyone looking to invest.

They solve a few problems that our three options above had

  • Diversification¬†–¬†Exposure to over 10,000 securities‚ÄĒin just one ETF.
  • Auto Rebalancing
  • DRP option
  • Hedged against the Australian dollar*
  • It wasn’t listed above as a con, but all¬†four diversified index ETFs are actively managed using Vanguard Capital Markets Model (VCMM)

The two big ones that stand out are of course the auto-rebalancing but also maybe surprisingly the active management component.

Rebalancing is not hard to do, but it’s something that if left unattended can most certainly affect the performance of your portfolio over the long term. As for the active management component. You may be wondering why there is any management at all? I thought Vanguard is all about minimal management to keep fees low and it’s really hard to beat the index anyway??? I’m not sure about this part beating the market either but I guess we will have to wait and see how it performs. It uses a modeling system called VCMM to simulate potential outcomes and pick the correct balance for your desired portfolio out of the four options above.

VCMM

*As pointed out by Chris in the comments. The diversified ETFs are not 100% hedged. Please check the PDS for each ETF to find the amount of hedging

Who Is This Suited For?

To be honest, it’s a bloody good product for 99% of people. What they are offering here is as close to the perfect ETF as I’ve ever seen given the management fees and what it offers.

The best thing about this ETF is how idiot proof it is. A completely n00b could buy one of the four diversified ETFs (depending on their investor profile) for the rest of their life and get respectable returns with minimal effort.

People avoid things that appear confusing and hard. That’s why robo investment companies like Acorns¬†and Stockspot are in business. They essentially are providing what this ETF is providing at additional costs because they make investing super easy and friendly. With the other three options listed above, it can be daunting to explain to a complete n00b how to rebalance. As soon as they don’t understand something, the majority of the time they can get spooked and give up altogether.

That’s why this ETF is so special. You can confidently recommend this product to anyone and be sure that they can’t stuff it up or get confused.

  1. Set up a broker account
  2. Buy this ETF when you have the money to do so
  3. Turn on DRP if you want
  4. Do tax when it comes around
  5. Repeat forever

So if this ETF is suited for 99% of people, who is the 1%?

 

Why I Won’t Be Switching To These ETFs

This is something I have been wanting to bring up for a while now.

Has the Australian FIRE community forgotten just how important management fees are?

I have been seeing a lot of people recommend VDHG, which as I have mentioned above is a fantastic product. No doubt about it.

The only issue I have is that at a MER of 0.27%, it’s more than double that of what my MER currently is (0.101% or option 2 above).¬† They are both very low fees, but I plan to have a portfolio of a million+ within the next 5 years and hope to live for another 50 years at least! Now even though the management fees are very low, over a long period of time it does add up!

I have actually been working on a web app recently (so close to being published) that works out lost investment potential from management fees which gives you a visual of what I’m talking about.

combo1

Management fees are unavoidble, but how much you pay is your choice to an extent. I have calculated my current investment potential loss from management fees to be $48K over 50 years at $1M invested.

If I change the management fees to be 0.27% we get the following

combo2

Holy shit!

We went from paying under $50K over 50 years in investment potential loss from management fees to over 5 times that amount at over $250K!

Ok, I need to clear a few things up about the above graphs because it’s a big deal.

What am I actually talking about when I say¬†investment potential loss? I’m referring to how much management fees are costing the investor when you factor in that the money paid to management could have been invested and compounded at 8% return (that’s what the graph is using as a return rate).

If I had $1M in my portfolio with my current weightings I would be paying Vanguard $505 a year. If I had $1M with any of the diversified index ETFs, I would be paying Vanguard $2,700 a year.

The difference between $505 and $2,700 a year over a lifetime adds up!

 

Conclusion

If you’re reading this blog, odds are you’re somewhat interested in personal finance and investing. The question you need to ask yourself is whether or not you are willing to learn, educate yourself and do the extra things required for the lower MER ETF options. Or if you think that the higher MER for the diversified index ETFs are justified. I personally choose to keep my MER as low as possible because paying less in management fees is a guaranteed return. You could argue that the¬†diversified index ETFs will outperform my ETF combo but that is unknown without a crystal ball.

If you don’t know what half of the words in this article are even about, then the¬†diversified index ETFs are most likely the best ETF for you. Just pick your investor profile and off you go. And don’t sweat the extra management fees. If the simplicity of the¬†diversified ETF gets you into investing, you’ve more than made up the difference.

Filling Out A W-8BEN-E Form

Filling Out A W-8BEN-E Form

*Please consult a professional if you’re confused or not sure about anything when filling out a W-8BEN-E form¬†

Do you own a US domiciled ETF or share?  I own 2. VTS and VEU.

If an investment derives its income from the US, it has to pay tax to Uncle Sam. But What happens when I get the dividend from my US ETF or share? The company has already paid tax to the US and now I’m expected to pay full tax on the dividend?

Oh Hell Naw!

This is the purpose of the W-8BEN-E form. It stops double taxation so you don’t pay tax twice in two countries. You need to fill this form out for every ETF (or investment) that is domiciled in the US. If you don’t fill it out, you will get tax twice!

Here is a video of me recently filling out my W-8BEN-E form. I had to fill it out again because I switched my broker account from Commsec to Selfwealth and created a new HIN.


SIDENOTE

I’m sometimes asked why I own these two instead of just buying VGS (or VDHG but that will be covered in an upcoming post).

In a nutshell, I go with VTS+VEU because it offers:

‚Äď Lower management fees
‚Äď Greater diversification
‚Äď Exposure to emerging markets
‚Äď Unhedged against the Australia dollar (I think the AUD is high at the moment)

Don’t be put off investments because¬†you need to fill out a very simple form every 3 years! I understand that it’s a little bit of extra work but seriously, we are trying to reach financial independence here! What’s a couple hour extra filling out a form and doing a little more come tax time for a superior¬†investment.

The FIRE community is constantly recommending putting in a little bit of extra work and taking things to the extreme where others won’t,¬†to enjoy a life other can’t!

 

 

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