Property vs Margin Loan vs Internally Geared Funds

I have mentioned in a previous post that I don’t like to buy a house. Instead, from experience, I find that it’s best to invest in ETFs. The reason is because ETFs give you flexibility to invest in what you want. If you buy a house as an investment, you are leveraging into one house, and although the general property market may behave one way it’s very hard to know how your house will perform individually. For example, the house price indexes from the Australian Bureau of Statistics averages out results for a number of different houses. If, say, you have a house in Sydney and Sydney house prices went up 5% this does not mean your house specifically went up 5% but that houses in general in Sydney went up 5%.

Furthermore, if you buy a house to live in, you have nothing but debt (unless you buy a house outright without a mortgage, but this is rare). You have a mortgage that you must pay monthly and any benefit from the investment is in the form of capital gains, which you cannot access until you sell the house. You cannot see capital gains, and you cannot access capital gains. Capital gains are invisible and, if there is suddenly a recession, all your capital gain that may have taken you decades to accumulate may disappear in a matter of weeks or months.

Capital gains do not provide the same sort of comfort that cold hard cash income provides. If you have a house, this problem can easily be fixed if you turn your house into an investment property and rent it out, but even if you had an investment property, the performance of an investment property just doesn’t compare to ETFs, in my opinion. Unless you really know how to pick good property, residential property in general has low yields, and after you pay property management fees, taxes, house repair and maintenance, etc, you don’t end up with much, especially not when compared to ETFs that have been engineered to seek out and pay high dividends.

Property is not a good investment. From my experience with residential property, once you buy a property, suddenly everyone wants money from you and everyone sends in their bills. Once you buy property, you need to pay bank fees, mortgage interest, lawyer fees (for conveyancing), real estate agent commissions, taxes (stamp duty and land tax), and property manager fees. Once something goes wrong in your house (e.g. the shower breaks) you need to get a repairman in to fix it, and he send you a bill as well.

Investing in high-dividend paying ETFs is completely different. You use an online broker (e.g. CommSec) to buy ETFs listed on a stock exchange, and then you sit back and watch money flow into your bank account. That’s it.

What about leverage?

One of the benefits of property is leverage. Because you borrow money from the bank, you have more assets exposed to the market, which means potentially higher gains. However, leverage works both ways. If the asset price does not go up enough to compensate you for the interest expense, you will lose money, and when you are leveraged, you will lose a lot of money.

That being said, leverage is a legitimate strategy if you want to accept higher risk to get higher returns. You are effectively moving up the efficient frontier.

Leverage is easy to achieve using ETFs. There are two options: (1) invest in leveraged ETF (e.g. the Betashares Gear Australian Equity Fund (ASX: GEAR)) or (2) apply for a margin loan to borrow money from the bank to buy stocks or ETFs.

Based on the modelling I have done, all these options (property, margin loan, and leveraged ETFs) have somewhat similar returns, so it doesn’t matter which you do so long as you feel comfortable with the risk you are taking. However, that being said, I think that out of these three choices, property is the worst because once you sign up to borrow money from the bank, you have a monthly mortgage that you must pay. You basically have a noose around your neck. If you don’t pay it, the bank will sell your house, and you will incur substantial transaction costs. When you have a margin loan, many people will try to scare you about the dreaded so-called “margin call” but this I think is overblown. The bank will only step in to induce a margin call when your debt levels are high relative to the value of your assets (they look at your loan-to-value ratio or LVR). They do this because, if you have a high LVR, the risk you are taking is too high, and the bank will get worried that the size of your debt will be too high relative to the size of your assets, which means you may owe the bank money that you may not pay. As part of their risk management, banks will monitor your LVR and intervene to lower your LVR if you raise it too much. This applies not only with stocks but also with property.

Banks will intervene to lower your LVR if you have not been paying your mortgage. If you miss a mortgage payment or two, the bank may allow it because your LVR will not be too high, but if it goes on for too long and your debt levels start to rise too much, the bank will intervene to sell your property. Therefore, regardless of whether you have a property or a margin loan, the bank will still intervene if the LVR is too high. So long as you keep watch of your LVR and make sure it is not too high, you will be fine.

When managing your LVR, the problem with property is that you have zero control over your portfolio. Once you buy your house, there’s littel you can do to affect the volatility of the asset. You have zero control. However, if you own a portfolio of shares or ETFs, you can control how much volatility there is in the portfolio by buying specific listed assets. Managing volatility is important to managing your LVR because volatility affects the value of the portfolio, which of course impacts the denominator in the LVR. If you use a margin loan to leverage, say, into the Chinese stock market (e.g. the iShares China Large-Cap ETF (ASX: IZZ)) then the risk you face (and therefore the probability of a margin call) will be much higher than if, say, you invest in stable assets such as global infrastructure (e.g. via the AMP Capital Global Infrastructure Securities Fund (ASX: GLIN)).

There is a much easier way of leveraging that involves zero risk of a margin call, and this is by investing in internally geared funds. With internally geared funds, you don’t borrow. Rather, you take your money and invest it in the fund. The fund manager collects your money (as well as money from other investors) and uses this to borrow money from the bank in order to invest in stocks. Because debt is handled by the fund manager (rather than you yourself), you don’t owe anyone anything ever. Betashares currently offer two listed internally geared ETFs: GEAR, which leverages into Australian stocks; and GGUS, which leverages into US stocks.

According to the Betashares website, the fund is “‘internally geared’, meaning all gearing obligations are met by the Fund, such that there are no possibilities of margin calls for investors.”

Gearing via an internally geared ETF, in my opinion, is the optimal strategy unless you want to borrow money yourself so you can claim the interest expense as a tax deduction. However, that being said, if you borrow money yourself, because you are only one man (or woman), you will typically pay between 4 to 6 per cent at current rates, but if you invest in a leveraged ETF, the fund manager is responsible for borrowing, and the fund manager has access to low institutional interest rates (supposedly around 3%) thanks to its buying power. You are therefore able to gain even greater leverage with internally leveraged ETFs.

Conclusion 

I used to be very much against gearing because I strongly believe that debt is slavery, but now I accept that gearing can be a legitimate strategy so long as you have robust downside protection. I believe that no matter what you do (when investing and in life in general), it’s good to take risk because more risk provides greater return, but risk must be managed. It is okay to take risk so long as you have a safety net or a fallback plan if everything goes wrong.

Why I Use ETFs

I am not the only dividend investor on the internet. It turns out there are plenty more. Through Twitter alone I have found many other bloggers who blog about dividend investing, which I think is great because it allows us all to learn from each other.

What I have noticed from reading the blogs of other dividend investors is that most of them seem to invest in individual stocks, and lots of them. They may hold shares in thousands of different companies.

Most of these bloggers give monthly updates where they break down how much they receive from each share. Most even go further and report on how much they spend. They divide their spending into categories such as groceries, mortgage payment, repairs on the house, gas bills, etc.

I thought for a second maybe I should do the same, but honestly I don’t really know how much I spend, and I don’t really know how I spend it.

I also personally don’t think it’s necessary to record everything you spend down to such a minute detail. It may be great to know that for one month you spent $500 on groceries but more important than knowing what you’re spending money on is knowing how much you’re spending overall.

I believe in keeping things simple, and for saving money I recommend the David Bach recommendation, which is “pay yourself first.”

In other words, talk to HR and have them send, say, 20% of your salary into your normal bank account and then set up another bank account where 80% of your salary goes. For the bank account that gets 80% of your salary, leave it alone. Let the cash accumulate. Meanwhile, try to simply live off the money in the bank account with 20% of your salary coming into it.

By doing this, you don’t need to worry about calculating whether you have spent $x on entertainment or $y on groceries. You just know that you’re spending 20% (or whatever percentage suits you). At the end of the day, it’s how much you spend that matters, not what you spend it on.

Every once in a while, access the money in the bank account where 80% of your salary is going and then use that money to buy ETFs.

Why ETFs? Why not research and buy stocks in companies that pay high dividends?

Personally, I believe it’s much easier to invest in ETFs. There are many ETFs in the market dedicated to paying high income. These are the ETFs I recommend for dividend investors. You could do your own work, but it’s much easier to let a fund manager do the work for you and let him or her take a small fee.

In Australia, there are actively managed ETFs that use options and futures to generate more income and to manage risk by lowering volatility.

Many people believe that low cost index funds are best, and I used to believe the same, but I have noticed over time that low cost passive index funds simply don’t produce much income.

It is certainly more risky to invest in an actively managed ETF because you are relying on the skills of the fund manager, but this problem is easily fixed by simply diversifying across different income-focused actively managed ETFs.

Most importantly, I believe in keeping things simple. We don’t need to make things complicated. Having your savings automated and then simply investing your savings in high-yield ETFs is a very simple plan that allow you to build passive income from dividends without much effort. All you need to do is stay employed and maintain your 80% savings rate.

This is exactly what I did. I aimed for an 80% savings rate. However, when I started working I invested in normal Vanguard low cost index funds but was disappointed in the sporadic and low income I got, so I slowly started to put money into funds that were more tailored for income investors.

Over time, I noticed that I had enough money coming in from my investments to cover my living costs, so I instructed HR to send 100% of my salary to the bank account earmarked for savings. All my investment income is send to my normal transaction account for spending. I am therefore literally living off dividends. Hence the name of this blog. All my salary is invested and all the income from investments is spent.

Why live like this? Simply, if you learn to live off dividends, you condition your mind to live a standard of living that can be maintained even of you lose your job. This means that regardless of whether you work or not, your standard of living is exactly the same. Your life is unaffected by work, which means you don’t need to worry too much about sucking up to the manager. This takes away a lot of stress.

Most people, if they start earning more, automatically start spending more. They’ll let the money get to their head, think they deserve to spend more because they earn more, and then they become addicted to the spending and must therefore keep working, even if their enthusiasm for the job wanes over time.

If you live off dividends, you have the freedom to quit or move jobs, or take time off work to pursue other opportunities, knowing that you are capable of simply living off your investments because that’s what you’ve even doing for many years.

The Problem with Index Funds and Superannuation

Work has been tough for me, and when I talk to people about it (that is, complain and whine about it), they either tell me to just quit or to endure it because “that’s the way it is.”

I would love to quit and retire right now in my early thirties, but I don’t feel like I have enough passive income. Passive income is a great measure of how much freedom you have. When I was younger, I set myself a goal of producing $1000 per month in passive income (mainly from dividends from shares), and I achieved that about half a year ago.

When I was very young, I was investing in boring and ordinary low-cost index funds. I also in eating in a few direct shares here and there. If you read any personal finance blog nowadays (e.g. Mister Money Mustache), this is the advice they give you: invest in a wide range of low-cost index funds. Most of these people invest with Vanguard. Many mainstream personal finance bloggers also advise you to put your money into tax sheltered retirement accounts. As many of these people are American, the advice is to plow as much of your salary into 401(k) and IRA accounts. In Australia, we have retirement accounts as well. Everyone who works has what is called a superannuation fund (or super fund). Employers must by law put in 9% of an employee’s salary into this fund. Employees can then elect to salary sacrifice a portion of his salary into the super fund in order to save on tax as any income going into a super fund is taxed at 15% rather than whatever a person’s marginal income tax rate it (usually 30%).

So I have been following this advice. I have invested in low-cost index funds and I have plowed a lot of my salary into retirement accounts. However, about six months ago, when my passive income reached $1000 per month, I decided to change plans.

The problem is that most mainstream low-cost index funds do not pay much passive income. For example, the ETF issued by Vanguard Australia that invests in the US (Vanguard Total Stock Market ETF) has a very impressive management cost of 0.05% per annum (extremely low) but has a dividend indicated gross yield of 1.87% according to Bloomberg. Furthermore, superannuation funds lock up your money until you are around 65 (i.e. too long). It is clear then that if you are investing in low-cost index funds and plowing your salary into retirement accounts, your passive income will grow, but it will not grow much, and because passive income is the key to freedom, I needed to make a change.

It should be noted that superannuation laws are very strict in Australia. As far as I am concerned (and I am very happy to be corrected) it is virtually impossible for anyone to have access to his super until he is 65 (i.e. very old). In the US, intelligent bloggers have found loopholes that allow them to access their retirement accounts early (see these blog posts by the Mad Fientist: Roth IRA Horse Race and Retire Even Earlier). The only arrangement that comes even close in Australia is the “transition to retirement” plan where you can take out money from super to top up any existing income if you take it out as an income stream. However, you need to be around 55 to 60 to be eligible for this.

Salary sacrificing into superannuation is definitely helping me build wealth, but this wealth could only be accessed far into the future, which meant that I had to wait until I was really old before I can be rich. I was building up too much future wealth while sacrificing present freedom. I started to realize all this when circumstances at work became difficult. Basically I had been saving up hard for about seven years but only had a passive income of about $1000 per month. I realized that most of my money was locked up in super as well as low-yielding investments.

My plan now is to take a hit with taxes, pay more, but focus on investing in funds that pay double-digit (over 10%) yield. Once I get about $4000 per month in passive income, I plan to quit my job and focus on trying to find a way to make money online. I am tired of working for a manager.

Rewards Programs are Usually Not Worth It

Myer sent me a $20 card as I am part of its rewards program.

I went to Myer one day and noticed that just about everything there was over $20, so no matter what I buy, I’d have to spend my own money.

This made me realize that a company can easily give away $20 vouchers to customers and fund it by lifting the prices of everything in the store by $20.

This demonstrates why most rewards programs are not worth it. Even if you are getting a discount, that discount cannot come out of nowhere. It is normally funded for by higher prices. Even if you are getting a free product from points accrued over many months, you have really paid for that product when you overspent numerous times earlier in order to accrue those points.

Rewards programs can be useful for products that are unique that you would have bought anyway. For example, there is a cafe near my work I usually use. I like this cafe because it is one of few Melbourne CBD cafes that give you the option of using almond milk in its coffee. The cafe also has friendly staff. Because I would go to this cafe anyway, I figure it makes sense to use their rewards or loyalty program to get “free” coffee every once in a while.

Don’t Aspire to Buy and Live in Your Own Home

There is much talk of a housing affordability crisis in Australia. Average house prices in Melbourne and Sydney are reaching $600,000 or even more.

However, for young people looking to buy a house, my recommendation is that you do not buy.

Instead, go to your parents and negotiate with them an arrangement whereby you pay, say, $300 per month to live with them. Depending on how nice your parents are, they may even allow you to live with them for free.

If this is not an option, try to arrange to share a house with other people.

If you do buy a house, consider ways you can offset the burden of a big mortgage, such as renting out spare rooms.

I know a friend who, after purchasing a house, decided to renovate the garage so it was liveable. He lived in his garage and rented out the rest of the house. The rent was pretty much able to cover the mortgage repayments, which meant he was able to pay off the mortgage in about six years.

I have lived with my parents for the past five years and have been able to save up about $60k per year. After five years that adds up to about $300k, but rather than invest in property, I prefer to invest in shares, index funds, and managed funds. Nevertheless, shares have gone up in value in the last five or six years, and my net worth has increased at a rate of about $100k per year, which gives a net worth of about $500k now.

It doesn’t matter whether you invest in shares or property. Both are good investments. However, I believe shares are better because they usually make more money and because you generally pay less tax (although this depends on which country you live in).

To sum up, try to live with your parents. If you rent, try to rent with others. If you buy, rent out the rooms. Any of these three strategies frees up money to allow you to invest. You’re not really investing much if so much of what you earn goes towards paying interest, which is the situation most people have when they take out a massive mortgage to buy their dream home. It is true that rent money is dead money, but interest is also dead money.

The main benefit of real estate as an investment is the ability to borrow money to invest. If you are able to borrow more money, you have more assets exposed to the market, which means returns are higher. However, this can be achieved via index funds or shares simply by getting a margin loan (i.e. borrowing to invest) and/or investing in internally leveraged ETFs (i.e. investing in a fund that borrows to invest).

Note that just because you can use debt to make more money, it doesn’t mean you should. Borrowing to invest can be profitable, but there are many assumptions you are making about interest rates and returns. With leveraged ETFs, fund managers usually use dividends to pay off their own debt, which means the investment produces very little income. Furthermore, when you borrow to invest, you usually need to make regular monthly repayments. These regular monthly repayments diminish the value you get from any passive income you may receive from dividends or rent. Debt is anti-passive income and therefore anti-freedom. Borrowing money from the bank makes you are slave to the bank.

There is a myth pervasive in Australia and many other countries that renters are second class citizens who must aspire to own a home because owning a home makes money. This is a lie. What matters is how fast your net worth increases. Most people who buy a home have such massive mortgages with huge interest repayments that their net worth increases very slowly because any progress made when the price of the house goes up is quickly lost when they have to pay interest. Their net worth would have grown faster if they had rented a cheap place and socked the saved money into index funds.

It is not just interest. Buying a house is also associated with massive fees to accountants, real estate agents, and lawyers, as well as huge taxes (such as stamp duty in Australia). All these bring down the growth of your net worth, often by more than people expect.

When most people at my work “invest” in property, I never hear them talk about the rate of growth of net worth, rental yields, or variability of prices. They seem more keen to talk about how nice the patio is, whether the kitchen has a granite bench, and whether it has period styling. All this is bling that distracts them from the massive expenses associated with property.

Don’t bother buying a house. They are clunky massive assets that are taxed heavily and usually produce little returns. They tie you to one place and stifle your movements.

Passive Income vs Laptop Income vs 9 to 5 Income

You do what you want, when you want, with whom you want, wherever you want, how you want.

I am a strong believer in passive income, which is defined as income you earn from doing nothing. Passive income includes dividends from shares, interest from savings accounts, or even revenue from Amazon eBook sales or Adsense revenue from YouTube videos.

However, passive income tends to be low. Interest from a bank account will give you about 3 per cent. Depending on which shares you buy, dividend yield tends to be around 6 percent or so, although it varies across companies and across countries. An investment that I invest in that currently pays a yield of about 12 per cent is the Betashares Australian Dividend Harvester Fund.

While passive income is excellent because you don’t have to work for it, I do not hate working. I hate my nine-to-five job, but it’s not the actual work I hate. I just hate having a manager tell me what to do, and I am not the only one. Studies show that about 70 percent of Americans hate their job and their bosses and are disengaged.

This is why it is important to earn money online. I call this “laptop income.” It is not as good as passive income but definitely better than the salary from a 9 to 5 job.

Earning money online is not necessarily passive. You may need to post videos on YouTube, run an eCommerce store, send emails, write blog posts, trade shares online, and so forth, but it is work that can be done on your laptop while you are in a cafe. It is work that you can do anywhere where there is internet connection, and you don’t have a boss watching over you.

You do what you want, when you want, with whom you want, wherever you want, how you want.

If you are new to working online, here are three ideas.

  1. Work online: This is not that great because freelance work is a lot like a 9 to 5 job in that you have a client you work for, a client you need to keep happy, but working online means you get to choose who your clients are. Filling in surveys (e.g. at Pureprofile) and completing projects at Upwork or Freelancer can earn you money, but the amounts are not huge. Freelance work can make you serious money if you are talented in a specific area.
  2. Create or build something: This includes blogs, ebooks, YouTube videos, websites, eCommerce stores, etc. This is the best way to make money. You must be a creator rather than a consumer. Rather than watch YouTube videos, make them instead. Rather than read articles, write them. This is where it is important to get rid of distractions because too often distractions from Facebook and other social media can make you too much of a consumer rather than a creator or a builder. I manage distractions by simply putting it off. For example, suppose I am browsing my email and I see a link to an article I need to read. I use the app Pocket to save it and read it later. This is a very useful app. If there is a YouTube video that I feel I need to watch right away, I save it to a playlist where I can watch it later. Put off distractions for later and focus on building and creating things of value.
  3. Monetize what you create or build: This can be achieved using advertisements with, say, Adsense (I prefer to use Anonymous Ads, which pays you in bitcoin and allows you to remain anonymous). That being said, advertising does not make much money. Other options include affiliate links (e.g. via iHerb and Amazon) or even creating your own product or eCommerce store and advertising your own products on your products. Creating and advertising your own products allows you to make the most.

The Dismal Future of the Australian Economy

gold price vs asx200 27 august 2015
GOLD vs the ASX200 (Commsec)

The recent volatility in stock markets has gotten me worried. Everyone keeps telling me to relax because “economic fundamentals are sound,” but when I ask them to explain how this is true, it’s revealed that they don’t really know what they’re talking about. It seems that most people just hope for the best and rationalize away bad news.

The Chinese stock market is certainly wobbly. Some say the Chinese economy is very healthy. After all, they have low debt and a massive foreign exchange reserve. They are the biggest lender nation in the world with the USA the biggest creditor nation. However, we don’t really know much about the true size of China’s debt because there is significant activity in the underground economy that is not transparent, and I’m not too confident in official figures provided by the Chinese government. Of course, China has been manufacturing products from t-shirts to smartphones, but the government has in recent years been intervening in the economy to prop up the stock and property markets. It’s uncertain whether these distortions can be held together by the government or whether the market will eventually strike back.

America has resorted to printing money, which has resulted in surges in the stock and bond markets. However, unemployment is still high and wage growth is low. Printing money doesn’t seem to have done anything other than make the holders of stocks and bonds wealthy (these are mostly wealthy people anyway).

In Australia, our economy used to be dominated by two sectors: the banks and the miners. The miners dug resources from the ground and shipped them to China. China makes goods and ships them to US consumer who buys these goods.

But the American consumer (or consumers from any other developed country) is not buying as much as they did before the GFC. This means China is slowing down, the price of resources is dropping, and the mining sector in Australia is getting crushed. We only have the banks left, and how do they make money? The balance sheets of Australian banks is mostly in loans to consumers who buy real estate. Real estate prices have been going up thanks to profits from mining. In other words, banks do well because house prices have been sustained by profits from the resources sector. Now that mining is dead, what will sustain us? Where are our strong fundamentals? House prices only go up with people buy houses, but to buy houses you need to make money in the first place. You can’t make money from houses without putting money into it in the first place.

Many who have bought stocks have made great wealth from quantitative easing, but now that tears are emerging in a bubbling world economy held together by printed money, it’s time to look at investing in gold.

Gold tends to shoot up significantly when stocks tumble, and when stocks go down, gold tends to go sideways or go up anyway, so there doesn’t seem to be any downside to investing in gold.

Personally, I will be buying this shiny metal from now on.