Betashares Active Australian Hybrids Fund (ASX: HBRD)

I have always been interested in the latest ETFs in Australia. Most people are collectors e.g. they collect stamps, coins, antiques, wine, or wristwatches. I personally like to collect investments. As such I has bought and continue to hold countless investments across many different asset classes. The problem with a passion in e.g. wine or wristwatches is that it may not be profitable (unless the wine or watch is so rare it goes up in value) but an obsession or passion in investments is one you can indulge in without any guilt.

The latest ETF I have researched and purchased is the Betashares Active Australian Hybrids Fund (HBRD). The reason why I have purchased HBRD is because I feel at this stage I have an overweight exposure to stocks, so I want to reduce the risk of my portfolio. However, reducing risk usually involves investing in cash, bonds, or gold. However, these asset classes (with the exception of corporate bonds) pay low passive income thanks to the current low interest rate environment. Investing in HBRD allows me to reduce risk while at the same time getting about 4% or 5% passive income paid monthly.

For a few years now I have been worried about the valuations of stocks and property, but I have been surprised that these assets continue to go up, so the derisking of my portfolio over the last few years has certainly cost me money as I have missed out on large price appreciation. (I also missed out on the cryptocurrency boom as well.) Nevertheless, I have little regrets because I believe in diversification i.e. spreading money across everything. My plan is to gain freedom by slowly building passive income through steady and consistent investment fueled by a minimalist lifestyle. I also believe it is better to be safe than sorry. I’d rather walk steadily towards my goal rather than run there in order to save some time and potentially slip and fall. As they say, everything looks good in hindsight.

What is a hybrid?

All investments have a risk-reward trade-off. The more risk you take, the more potential reward you have. For example, cash or government bonds are safe investments. Government bonds are guaranteed by government. In Australia, cash deposits are mostly government guaranteed as well. However, if you invest in government bonds or cash, you will earn little interest, perhaps 1% or 2% if you’re lucky. Bonds are merely IOUs. If you buy a bond, you are effectively lending money and in return you receive regular interest payments (called a coupon) as well as your money back after a certain period.

In contrast to bonds, stocks are risky investments. Buying stocks allows the stockholder to vote (e.g. for who becomes a director) and allows the stockholder to earn dividends, which are simply payments made by the company to stockholders from profits. Stocks are risker than bonds because bondholders are paid before stockholders. If there is profit made by the company, bondholders are paid first and remaining profit is paid to stockholders. This also applies in the event of bankruptcy. Because stocks are riskier, companies need to pay higher dividends in order to compensate investors for taking on more risk. Dividends from Australian bank stocks such as CBA pay dividends of about 8% currently, but stock prices are volitile and can fluctuate wildly. Although bank stocks pay higher passive income, you are risking capital loss and dividend cuts should the banks become unprofitable.

Hybrids are assets that are a hybrid of bonds and stocks. When you buy a hybrid, you receive regular income as you would a bond. However, under certain circumstances within the hybrid contract, the asset may be converted into equity. All hybrids are different, so it is difficult to generalise. Some hybrids have characteristics that make them more like bonds whereas others have characteristics that make them more like stocks. Regardless, hybrids sit between bonds and stocks on the risk-reward continuum and so can be expected to be less risky than stocks while still paying reasonably high income.

Why buy a hybrid ETF

As explained earlier, every hybrid is different. In order to understand whether a particular hybrid is more bond-like or stock-like, a careful study of the terms and conditions is required. Hybrids are complex investments and as such is suited to active management and oversight by experts, which is what HBRD provides.

Conclusion

Although a good case can be made for active management in hybrids, active management has its issues. You are putting your trust in people, which is generally not a good idea. Nevertheless, I do not intend to put everything into HBRD but will instead spread money across lower risk investments with high passive income. There are another ETF also issued by Betashares that invests in corporate bonds (ASX: CRED). Corporate bonds are higher risk than government bonds thereby allowing higher yields. CRED also pays monthly income, which is very attractive for people who live off passive income (such as myself).

One of the frustrations with hybrids is that there is very little information about it. For example, if you research cryptocurrencies such as bitcoin on the internet, you will find a neverending flood of information, YouTube videos, etc. Bitcoin is a global investment that everyone can access. Hybrids, on the other hand, have few exchanges and are mostly purchased by institutional investors off exchanges. There is little information on the internet about hybrids.

Another consideration is that HBRD purchases hybrids from Australian banks, which are heavily exposed to the Australian housing market. There are currently fears of a slowdown in the property market. Nevertheless, Australian banks do not hold the property itself but rather the mortgages used to buy the property. So long as borrowers keep making their interest payments and paying their fees, revenue should be unharmed. Hybrids are issued all around the world, so the returns on hybrids should correlate with global interest rates. In the recent rising interest rate environment, this should mean higher returns from hybrids but more interest cost for Australian banks as wholesale credit becomes more expensive. Nevertheless, Australian banks do have considerable market power allowing them to respond to rising cost of global wholesale credit by raising interest rates or fees.

 

Betashares Legg Mason Income ETFs (EINC and RINC)

I invested a fair chunk of money into the Betashares Dividend Harvestor Fund (HVST), and while this fund pays great monthly dividends (approx 14% now), its price performance is lacking, as the chart below shows. (Read The Problem with HVST.)

Screenshot 2018-03-12 at 12.26.37 PM

HVST price as of 12 March 2018 – Source: Bloomberg

To address this issue, I have simply opted for a 50% dividend reinvestment plan, which will see half the dividends go back into buying units in the ETF in order to maintain value. Assuming HVST continues to pay 14% yield and that 50% DRP is enough to prevent capital loss, HVST still provides 7% monthly distributions, which in my opinion is fairly good. Generating sufficient monthly distributions is very convenient for those who live off dividends as waiting three months for the next dividend payment can seem like a long wait.

However, Betashares have now introduced two new ETFs on the ASX (EINC and RINC) based on existing managed funds from fund manager Legg Mason. Based on the performance of the equivalent Legg Mason unlisted managed funds, these ETFs are very promising for those who live off passive income. These ETFs have high dividend income (around 6 to 7 percent yield) paid quarterly, and based on past performance at least, there doesn’t seem to be any issue with loss of capital.

RINC (Betashares Legg Mason Martin Currie Real Asset Income ETF) derives its income from companies that own real assets such as real estate, utilities, and infrastructure whereas EINC (Betashares Legg Mason Martin Currie Equity Income ETF) derives its income from broad Australian equities.

The expense ratio of 0.85% is on the high side but not unsual for this type of fund (income focussed and actively managed). Another potential risk to consider is the impact that rising interest rates can have on many of these investments, especially “bond proxies,” into which RINC and EINC seem to invest exclusively.

Vanguard Australia Diversified ETFs – The Only Investments You’ll Need?

Vanguard has always had diversified managed fund. I remember using these many years ago, but I stopped adding money into these funds as I was distracted by other new investments. However, when I look back the performance of my investments, I am blown away by the returns from these Vanguard diversified managed funds, and they pay regular quarterly distributions into my bank account.

Furthermore, at the end of the financial year, Vanguard provides a full tax summary that you can simply give to your accountant (I use H&R Block). For simplicity and effectiveness, investing in Vanguard and getting H&R Block to manage your taxes is, in my opinion, a foolproof strategy.

One of the main issues with Vanguard’s diversified managed fund was that its fees were quite high. However, recently Vanguard has released their suite of four diversified ETFs:

  • Vanguard Conservative Index ETF (VDCO)
  • Vanguard Balanced Index ETF (VDBA)
  • Vanguard Growth Index ETF (VDGR)
  • Vanguard High Growth Index ETF (VDHG).

Investors now only need to determine how much risk they are willing to tolerate and then allocate money appropriately, e.g. if you are willing to take on more risk then invest in VDHG whereas if you want to take less risk you pick VDCO. Everything else is handled by Vanguard, which makes investing simple and easy.

These ETFs can be purchased off the ASX, which can be done with an online broker such as CommSec. I try to purchase ETFs in $25,000 increments on CommSec as the fee is $30, which is the most bang for your buck.

Most financial advice follows the “age in bonds” principle whereby you own your age in government bonds, e.g. if you’re 30 then 30% of your wealth is in government bonds. Whether you strictly follow “age in bonds” or not, the main principle is that as you are nearing retirement you reduce risk in your portfolio. With Vanguard diversified ETFs, you can simply carry this out by buying VDHG when you’re young but as you get older you start to buy more VDCO to reduce risk. Although not exactly conforming to “age in bonds”, “age in VDCO” is a simple alternative rule-of-thumb. For example, if you’re 30, own 30% VDCO and 70% VDHG. As you buy, simply buy whichever ETF you’re underweight in.

I love to dabble in new exotic investments such as ROBO and cryptocurrencies, but I try to follow the core-satellite approach, which states that you limit exotic investments (the “satellite”) to a small portion of your portfolio (e.g. only 30%) while the bulk of your investments (the “core”) are in low-cost passive index funds. Vanguard’s diversified ETFs are perfect investments to take the role of “core” investments.

More information can be found at Vanguard Australia’s official website on its diversified ETFs.

https://www.vanguardinvestments.com.au/diversifiedETFs/

For those who prefer managed funds rather than ETFs, see below Vanguard Australia’s page on its diversified managed funds.

https://www.vanguardinvestments.com.au/diversified

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.