There is a mountain of evidence that supports index funds being the superior investment for long term sharemarket investing.
Despite this, in Australia, I’m quite hesitant to plough all my savings into our stock market index.
This is because the Australian Sharemarket is quite top heavy. The top 10 companies make up nearly 50% of our entire market value. Almost 40% are in the Financials sector alone!
Over in the US however, it’s a totally different story! The US stockmarket is very well diversified. The top 10 companies only make up around 16% of the entire market value.
There is a great spread across different sectors too, with 20% in Financials and 17% in Technology. Then Consumer Services, Industrials and Health Care sectors all have around 13% each. If I was a US investor, I would use index funds with no hesitation.
Why not just buy a US Index Fund then?
You may be wondering why not just invest in the US stockmarket, since their index is more investor friendly. The simple answer for me is income.
Dividend yields in the US tend to be around 2%. Very low, compared to the 6% we can get here in Australia.
This means 500k in US shares would provide only around 10k of income. The same 500k in Aussie shares would provide 30k of income.
It’s truly a massive difference! You would need three times as much savings to be able to retire on this income stream.
Remember, our focus is creating a passive income stream to live on. The more sustainable income we can get from our investments, the less we need to save in order to reach financial independence.
Crunching the numbers and comparing income streams is so critical to early retirement, it can’t be overstated. Unfortunately, it’s not just a case of ‘investing’ and eventually it will work out.
Index funds are awesome. You won’t under-perform the market at any stage because index funds match the market index.
The evidence is heavily on the side of indexing, with many professionals failing to outperform the index over time. This is especially true in the US, where fees tend to be higher and a higher percentage of managed funds lose to the index, than here in Australia.
You can be comforted that in 50 years from now, the index will definitely still be around and its value much higher. That makes long term investing about as easy as possible. You will own all the most valuable companies on the market and your index fund will only keep the surviving companies over the years.
But, by owning every company in the index, you also inevitably own some crappy ones. This can be fine, since it’s not obvious which companies are going to do poorly in the future.
If a company does do poorly and falls out of the top 300 (in the case of the ASX 300), you will no longer own it. Owning the index also means owning companies in order of their market size, whether they pay dividends or not.
Index funds are an excellent option, but I think LICs (Listed Investment Companies) are a good substitute for Australian investors wanting to retire early and live on their dividend income stream. (I’ve reviewed a number of Aussie LICs here.)
Here’s a few reasons why I prefer LICs for investing in Aussie Shares
— The LICs portfolio of shares are often more diversified than the index. Argo’s portfolio – see here
— Most invest with a focus on dividend paying companies that can provide income that grows faster than inflation. (Of huge importance for early retirees).
— The dividends paid are often more consistent and more stable than the index. (Investing nerd side note: Because the LICs operate as a ‘company’, they have control over how much dividends they pay out so they can smooth the dividends over time. Index funds operate as a ‘trust’ structure which forces them to pay out all earnings, including capital gains from re-balancing the index. This tends to make the income from the index fund quite lumpy and uneven which can also trigger some capital gains taxes.)
— Some have shown the ability to outperform the index over the long term. Though that gives no guarantees for the future, of course.
— You can own multiple LICs, such as ones that focus on small-mid sized companies. This gives you further diversification in the top heavy Aussie Sharemarket. (Our index is dominated by banks and mining).
— There is sometimes the opportunity to participate in Share Purchase Plans, allowing you to buy more shares at a discount with no brokerage fees.
But wait there’s more….
— Quality LICs tend to avoid companies that pay very low or no dividends, such as speculative resources companies. This improves the income of the portfolio and generates a higher level of dividends for shareholders.
— LICs usually offer Dividend Reinvestment Plans (DRP) – this gives you the option to reinvest your dividend payment, often at a discount without paying brokerage. You will still receive the franking credits and are still required to declare the income.
— Some LICs also offer a Bonus Share Plan (BSP), sometimes called Dividend Substitution Share Plan (DSSP) – where you are able to forgo your dividend in exchange for more shares in the company, often at a discount and pay no brokerage or tax. This can be incredibly tax effective for those in a higher tax bracket. No income needs to be declared because no cash changed hands. I wrote in more detail about this here – The Surprising Tax Efficiency of Dividend Investing
A warning though…
It’s not all roses and rainbows! With LICs there are more risks.
There are plenty of fund managers out there that have delivered poor results for shareholders and in many cases you’d be better off with an Index Fund.
The manager may start making poor investment decisions or some talented team members may leave. They could also increase their fees unexpectedly. Realistically, fees are much more likely to be lower in the future. Still a risk though.
Some of the risks are manageable though, by owning multiple LICs and those run by managers with a great long term track record, that is more reliant on their investment process, rather than the magic skill of one individual.
Low fee LICs
The fees of different LICs vary wildly and usually depends on their strategy and turnover. The older style LICs such Argo, Milton, BKI and AFIC are very ‘index’ like – being weighted towards larger companies.
They tend to be very long term holders of their investments, so do very little selling. Their fees are very low – around 0.16% or less per annum. Check out my LIC reviews page where I look at these companies in detail. And make sure you’re using a very low-cost stockbroker like SelfWealth or CMC Markets.
Higher fee LICs
Something to remember here is, all LICs are not equal. Many of the more active LICs charge high fees, so this puts them at an instant disadvantage when trying to deliver out-performance for shareholders.
Some LIC portfolio managers have still managed to deliver good out-performance, over time, despite charging higher fees and/or performance fees.
This is true more-so in the LICs that focus on the small-mid sized companies, where the companies tend to be less researched and there is a greater chance to outperform the market. These LICs tend to be much more active. Fees for this type of LIC tend to be around 1% per annum. Some (not all) charge performance fees too.
Many high fee LICs are rubbish, so it pays to be careful and only invest with a LIC or manager who has proven themselves by delivering good performance over the longer term. There are still quite a few good ones out there. So it can pay to find the good fund managers by doing some research.
A couple of LICs I like in this space (small-mid cap shares) are QV Equities, which is managed by Investors Mutual (approx. 1% fee), and Mirrabooka Investments, which is managed by the same guys as AFIC for around 0.6% fee.
These two managers have both proven themselves by delivering out-performance in the small/mid cap space for around 20 years, despite their higher fees. Like anything though, there is no guarantee this will continue.
I’m obviously a big fan of Listed Investment Companies and clearly biased, but not without reason. Don’t get me wrong, index funds are great too!
I just feel that in Australia, the index is a bit too concentrated in one or two sectors to rely on indexing alone. So here’s my answer to the question “which is better?”…
I would say in the US, indexing is the best option for long term returns, low fees and low fuss. But it’s my view, that in Australia, investing in good quality and proven LICs, are often a better fit for income focused investors. That also doesn’t mean you can’t own both. Each have their pros and cons.
My preferred LICs are the older ones with very low fees. But I do own other LICs which focus on small and mid-sized companies to help diversify away from the top heavy nature of our sharemarket.
By using LICs, we can build a more well balanced dividend-paying portfolio, without sacrificing that all important income we need for financial independence!
If you want to learn more about implementing the Aussie Dividend Strategy, download my free PDF guide: “Your Simple Step-by-Step Guide for Passive Income” – Get your copy here to read at your leisure.