The Problem with HVST (Betashares Australian Dividend Harvester Fund)

For probably two years now I have been buying up the Betashares Australian Dividend Harvester Fund (HVST), which is a exchange traded managed fund listed on the ASX. The appeal of this fund is that it pays a very high dividend yield (about 10% to 14%) and pays this dividend monthly. The monthly dividend payment normally gets paid into my bank account in the middle of the month, and every payment is roughly the same. Hence HVST makes living off dividends very easy. This is why I have accumulated over $100k worth of HVST.

However, it is becoming increasingly clear that there are many flaws with this fund, the main one being that it has not performed well in the last few year compared to the ASX 200.

HVST vs ASX 200 from 2014 to 2017
HVST has significantly underperformed the ASX 200 over the last few years (chart from CommSec).

That being said, I am not criticizing the fund or Betashares. I was well aware that the dividend harvesting technique employed by the firm would result in less upside when markets were going up. This is a result of the fund manager buying high dividend paying stock just before dividends are paid and then selling the stock after the dividend is paid. As stock prices normally go down after dividend payment (as the company’s value goes down in line with its reduction in cash) then naturally a dividend harvesting technique would result in lower capital gains.

Something else surprising is that during downturns in the ASX 200, HVST also went down considerably as well, which makes me question the firm’s risk management overlay employed. According to the article Managing risk: the toxic combination of market downturns and withdrawals in retirement on the Betashares Blog:

One way to help manage sequencing risk is to apply a dynamic risk exposure strategy, which seeks to reduce downside market risk…. BetaShares combined its expertise with Milliman to launch the BetaShares Australian Dividend Harvester Fund (managed fund) last November. The fund invests in large-cap Australian shares with the objective of delivering franked income that is at least double the yield of the Australian broad sharemarket while reducing volatility and managing downside risk.

Based on this description, I was hoping that the fund’s risk management overlay would reduce downside movements, but the chart of the performance of HVST against XJO shows that when XJO turns downwards, HVST goes down by as much. When XJO goes up, HVST tends not to go up much if at all, which results in HVST falling by about 20% over the last few years while XJO has managed to increase in value by a modest 5% during the same time period.

As I said, this does not mean I will not continue to invest in this fund. The regular and high monthly dividend payments are extremely convenient, and any capital losses made by the fund over time, in my opinion, can be compensated for by investing in ETFs in riskier sectors e.g. investing in tech stocks, emerging market, or small caps or even by investing in internally leveraged ETFs such as GEAR. For example, if you invest half your money in HVST and half in GEAR, you get the convenience of monthly regular dividends from HVST and any capital loss is compensated for with your investment in GEAR which should magnify upside market moves. Note that a limitation of the half HVST and half GEAR strategy is that when the market goes down, GEAR will go down significantly as well. Furthermore, another problem with both GEAR and HVST is that they have management expense ratios that are significantly higher than broad-based index ETFs mostly from Vanguard or iShares. Both HVST and GEAR have management expense ratios of 0.80 percent whereas Vanguard’s VAS is 0.14 percent and iShares’s IVV is 0.04 percent.

Nevertheless, I do recommend many products from Betashares. One ETF that I am interested in from Betashares is their new sustainable ETF called the Betashares Global Sustainability Leaders ETF (ETHI). I normally buy ETFs in batches of $10k to $25k at a time, so I intend to buy a batch of ETHI and write a blog post about it later. I have mostly positive views about Betashares as they provide a great deal of innovative ETFs.

Update 18 June 2017: The poor price performance of HVST is explained in the Betashares blog article Capital vs. Total Return: How to correctly assess your Fund’s performance. If performance includes income as well as franking credits, the gross performance of HVST looks more favourable.

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.

Protecting Yourself From GFC 2

I’ve been very lucky in that I started working full-time in 2009, which is right when the GFC hit. When I started working full-time, I started saving up about $50k per year. I was able to do this because I lived with my parents and didn’t have too much to spend on other than internet and food, so I plowed the money into shares, ETFs, and mutual funds. Luckily for me, the stock market recovered heavily after GFC when central banks around the world decided to print money to prop up stock markets.

Recently, I have become concerned about a potential GFC 2, so lately I’ve been reading books about technical analysis in an attempt to try to figure out when to sell before a crash.

Below is a graph of the ASX200 for the past year with bollinger bands overlaid. Notice how if you sold when the index hits the bottom band and bought when the index hits the top band, you’d capture all the gains and avoid all the losses.

Bollinger bands on the ASX200 August 2015 (source: Yahoo7 Finance)
Bollinger bands on the ASX200 August 2015 (source: Yahoo7 Finance)

A problem I have is that a lot of the assets I have are illiquid. Shares are diversified and selling each one would be time consuming. Real estate is incredibly illiquid, and I don’t have to explain why. Taking money out from mutual funds requires you to fill in various forms and wait many weeks. Furthermore, selling assets may have unwanted tax implications. I’ve been a believer in buy and hold for a long time, but I am starting to have my doubts.

Rather than bother with selling assets, a better idea is to use leveraged inverse ETFs. One that has been recently issued on the ASX is the Betashares Australian Equity Strong Bear Hedge Fund (ASX: BBOZ). (Note that this is supposedly not technically an ETF.) How does this fund work? As the website says, “A 1% fall in the Australian share market on a given day can be expected to deliver a 2.0% to 2.75% increase in the value of the Fund (and vice versa).”

If GFC 2 hits again, rather than watch half my wealth disappear, I can protect a portion of it by buying a large amount of BBOZ. The gains in this BBOZ will compensate for any losses. Obviously the more cash I can save up, the more BBOZ I can buy and the more protected I will be. Furthermore, buying at the right time is essential. The bollinger band patterns on the ASX200 are interesting, but I hope to study the markets further to see if I can find any clues as to when GFC2 will hit.