Investing is a broad topic with lots of potential rabbit holes to go down.

To help simplify tricky questions and clear away confusion, we’re running an ongoing Q&A series. We hope these little discussions provide you with helpful insights to further your thinking as you progress towards your goals.

Just so you know, in many cases there’s often not a ‘right’ answer, so be sure to think carefully how to adapt any information to your own circumstances.

If you have a burning question you’d like answered, feel free to leave it in the comments below, or post it on the Pearler Exchange.

Alright, this time we’re tackling:

• How do dividends work with my ETF?
• Savings account / term deposit as a defensive asset?
• Can index funds cause a crash?
• How does VGS compare to VTS?
• How do I smooth out a downturn?

Interesting topics, so let’s get started!

How do dividends work with my ETF?

Some people begin investing in ETFs from the start. Others, like myself, try their hand at stock picking first, and only later come to add diversified funds to their portfolio.

And because an ETF is a basket of companies in one parcel, it can be confusing for new investors to grasp how dividend payments work. An individual company is simple - we hear how much profit they made, what dividend they'll pay and when.

But with an index fund, we hear nothing about the companies inside the fund. Rest assured, you absolutely still get paid dividends from the underlying companies!

Let’s take the popular Aussie index fund VAS as an example. The fund holds shares in the top 300 Aussie companies on the ASX, collects the dividends and then passes these on to VAS shareholders.

VAS is set up to pay its cash distributions every three months. These payments will amount to whatever cash dividends the underlying companies happened to pay during that quarter. Sometimes this is a large amount, other times it’s not. It depends on the timing of when each company pays its dividends and which quarter that falls into.

You can see from this page on Vanguard’s website (way down the page under Distribution History) that these payments are generally made in Mid January, Mid April, Mid July, Mid October, based on the number of shares/units investors held at the end previous month (the ‘ex-dividend’ date).

For other funds, you’ll usually find plenty of information on the ‘product/fund page’ around the dividend yield, frequency, previous distributions paid, and so on. Each ETF will pay different levels of dividends depending on which companies are in the portfolio, and also how much turnover is in the fund. ETFs that buy and sell more frequently end up creating capital gains events and these must be paid out to shareholders as part of the regular distributions.

After the ‘ex-dividend’ date, the share price of the ETF will typically go down. This is because investors who purchase after this date are not entitled to the upcoming dividend. This is a mechanical function with ETFs, as cash is leaving the fund and because units (shares in the fund) trade at their net asset value (NAV) every day. Shares in individual companies are a little different, since people can continue to pay any price they want on any particular day, and opinions change regularly on what a company is ‘worth’.

It’s also worth noting that some ETFs may not pay dividends at all, if the companies inside the fund themselves do not yet pay dividends.

Should I use a savings account or term deposit as a defensive part of my portfolio?

Alongside this question is usually the comment around interest rates. At the time of writing, it’s now possible to earn rates of around 4% on savings accounts and term deposits.

That’s causing a few investors to think “maybe I should keep more of my money in cash since the return ain’t so bad.”

Returns on cash have definitely improved, that’s for sure. Much better than we’ve experienced for all of the last decade! But there are some things worth remembering.

Earning 4% is still a decent bit lower than the long term average for share market returns (7-10%). Any interest earned is completely taxable. Whereas share returns are more tax-friendly thanks to franking credits on Aussie dividends and no tax on capital gains until sold.

The exception here is using an offset account attached to your home loan, instead of a savings account. Or simply paying down the home loan itself. Both options offer a guaranteed tax-free return which is pretty appealing given where rates are.

Another thing to remember is that there’s no growth component to cash. So the income and value won’t grow over time, like it generally does with shares. Plus interest rates may come back down from these levels. In fact, many astute observers are expecting just that in the next year or two as the economy slows.

But it’s more than just returns - what about risk? Cash offers essentially no risk, provided it’s parked at an authorised deposit taking institution (ADI) covered by the government guarantee (list here). So this boosts the attractiveness of keeping money in cash as a type of defensive asset which will hold its value.

Ultimately, it also depends what function you see the cash serving. Is it for quick access to money in case of opportunities? A larger than normal emergency fund in case of job loss? Decent return in the short term with little risk? Or to reduce the volatility of your overall net worth?

Can index funds cause a big crash in the future?

Over the last few years, there have been countless articles suggesting that the popularity of index funds is about to cause a problem.

More specifically, these thought-pieces say that "people piling into index funds” will lead to a big bubble which will eventually burst. It sounds scary. And much of it even sounds intelligent, because there’s always a kernel of truth in these things. But here’s why you can safely ignore such hysterical stories…

1- Investors have steadily adopted index funds over the last (almost) 50 years since their invention. So it’s hardly a new phenomenon of people “piling in” on some random new investment. This trend sometimes accelerates during a downturn since investors in active funds usually don't do any better, so people think “what's the point - I may as well just own the index.”

2- The idea that indexing will lead to a crash, or make a crash much worse when it does occur, is silly. It's a cleverly designed story to evoke fear. The last few crashes - 2020, 2008 - have not been worse than prior crashes - 2000, 1987, 1974 - even though there is now far more money invested in index funds than ever before. So this statement really hasn’t proven to have any merit.

3- Crashes are nothing new. Whether people are invested in index funds or other funds, or individual stocks, it doesn't matter. If a lot of people pull their money out at once and want to sell, then yes, prices fall. That's been the case since the beginning of markets. It doesn't magically become a problem because more people are invested in index funds. Why? Because, collectively, everyone owns all the shares. So if a large pool of people desperately want to sell, it puts downward pressure on the whole market.

4- Index funds may be at the 'forefront' of the next crash simply because they’d be the most invested asset. Just like active funds were at the 'forefront' of previous crashes. Again, no different. Active funds didn’t cause previous crashes. Huge selling pressure and everyone wanting to get out of the market is what caused it.

So where’s this kernel of truth?

If we end up with the amount of money invested being overwhelmingly dominated by index funds, the market could become less efficient at pricing companies correctly.

But that then leaves greater opportunity for active investors to outperform, so the number of active investors in the market would likely increase. That in itself would bring back some balance, as we slide back down the spectrum to a healthy split between active and passive investors.

The truth is, as I always say, nobody can say with certainty what will play out. But these two related ideas - that active investors will basically disappear, and that the market will crash because of index funds - both seem highly unrealistic to me.

Be wary of anyone confidently predicting anything with certainty. Especially negative future events. That’s usually done solely for clicks and attention. Fear sells, after all.

With international shares, how does VGS compare to VTS? Why do people choose one over the other?

These two investments get thrown around among the most popular options for Aussies wanting to invest in overseas shares.

On one hand, they’re similar to each other. Both give a large exposure to international companies. But there are some differences:

VTS owns and tracks the total US stock market of approximately 4,000 companies. It invests in the US only, which some may perceive as the ‘best’ market given its dominance and historic performance. VTS also has a lower management fee at 0.03% per annum.

On the other hand, VGS owns shares in almost 1,500 international companies. About 70% of this is US firms, with the remainder being spread all over the place, including Japan, UK, Canada and Europe. The management fee is higher at 0.18% per annum.

So VGS has fewer companies, higher fees, and less US exposure. That sounds bad to many people. But the main benefit with VGS is diversification. It’s possible the US loses its dominance/importance over time, and other developed countries do better. In this way, VGS is less susceptible to that risk.

VTS is also domiciled in the US. What this means is the fund is essentially run from the US, whereas VGS is operated locally. This, unfortunately, means Aussie investors could be liable for US estate taxes if they end up with a large enough shareholding (more info here).

So there’s a few ways that VGS can offer more peace of mind for investors. That said, there are many people who simply wish to invest only in the US alongside their Aussie shares. And fair enough - there’s no right answer for everyone.

Of course, investors may also wish to invest in emerging markets as a smaller part of their portfolio. But VGS and VTS are often the competing ‘building blocks’ of a portfolio that investors debate about, so we’ll leave that topic for another day!

How do I smooth out a downturn?

What a lot of investors want to know is this: if I have to invest through the ups and downs, how can I make those down periods a bit smoother or easier to handle.

Sometimes people ask this from the position of living off their portfolio. Other times, it’s those in the accumulation stage wondering how to best manage the volatility and smooth out the bumps. Let’s tackle both.

When in a stage of early/semi-retirement, you can use a combination of the following things to smooth things out and plug the potential gap between your investment income and personal expenses: cash buffer, flexible spending, and a little part-time work.

If you are still working towards FI, then you don't want to smooth out a downturn! You should genuinely hope for a nasty crash and a long slow recovery.

This kind of scenario - although painful to live through - will allow you to invest a lot of money over many years while share prices are low, dividend yields are higher, and nobody wants to invest.

When the market finally recovers, your cheaply bought shares will be showing some impressive capital gains. It sounds counter-intuitive, but shares going up in a straight line is actually not what you want early on in your journey.

You want shares to go up a lot, but only after you’ve bought a lot!

Final thoughts

I hope you enjoyed this Q&A session, and these answers gave you food for thought.

Remember, if you have a question on a topic you’d like some more information on, feel free to post it on the Pearler Exchange. They’ll be answered by fellow investors in the community - like myself, someone more knowledgeable, or one of the Pearler team.

You can also post a question down in the comments selection and we’ll cover it in a future Q&A article.

Until next time, happy long term investing!

Dave