Welcome to the latest instalment of our ongoing Q&A series.
The aim here is to flesh out my thoughts on some questions you may be considering yourself. Hopefully it helps further your thinking as you progress towards financial independence.
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 and consider if you need to reach out to a financial advisor.
If you have a question you’d like answered, post it on the Pearler Exchange or drop it in the comments below.
In this Q&A we discuss:
– LIC question follow-up
– Does tax make investing not worth it?
– High yield funds like VHY
– Does debt recycling trap me?
– Property investing right now
Let’s get started!
LIC follow-up
I enjoy your newsletter, but I think your recent Q&A answer about a listener selling their LICs may not be wise. AFIC and Argo are strong companies with diversified assets that pay fully franked dividends which have risen over the years. Unlike some other single function companies like Woolworths and BHP which have seen their shares and dividends substantially slashed.
Further, LICS pay their dividends in different months to the ETFs and this helps members of the FIRE movement to receive income throughout the year.
A brief search of the internet showed that Motley Fool is recommending AFIC. On another site they’re both listed as shares you could safely own forever. I think the article stated that you could put them in your bottom draw and forget about them as they were safe investments.
Finally, I am disappointed that LICs are under sustained attack which no other company or category on the ASX is subjected to.
Dave:
I think you've misinterpreted what I was saying. I'm well aware of the positive aspects of the old LICs - in fact, I’ve owned several of them over the years.
I’m also aware that they're currently underpriced relative to their history - hence my comments around that
in the answer
(while also defending the returns vs VAS and making sure the reader was looking at the whole picture).
I was also considering the context of the person asking the question. They were pretty clear on the preference to sell and switch and were more interested in the tax outcome and tradeoffs of doing so. It was not a case of "here’s why you should get rid of them” - it's far more nuanced than that.
AFIC and Argo are shares you can own forever - I agree with that. Which is why I compared them to an index and made no comments around the risk of doing so.
If you're an LIC owner, I wouldn't be upset about them falling out of favour. I'd be happy to scoop them up at large discounts to NTA and enjoy the dividend stream that flows your way.
What's the point of investing?
I’m on a path towards generating a passive income through dividends. I’m finding every time my tax return is due I always owe thousands. Makes me question what the point of investing is, when I’m not reaping the rewards but actually the opposite! Is this a regular occurrence for others on the same path?
Dave:
Wow, this one is certainly lacking some perspective.
If you owe thousands in tax every year, it either means one (or a combination) of two things:
1- You’re earning a decent level of dividend income and your portfolio is expanding nicely (likely $10,000 or more of income).
2- You are invested in funds which have high income or high turnover and pay out large amounts of capital gains (could be a fund choice issue).
Keep in mind that you are likely also getting a decent amount of capital growth in your portfolio which remains fully untaxed unless/until you ever sell. So you’re still going to be far ahead overall - especially as the market has been strong in recent times.
Tax and costs can be a frustrating fact of investing. But it’s unfair and wildly inaccurate to say you aren’t reaping any rewards or aren’t better off. To suggest the opposite - that you’re worse off for investing - is absurd.
If it’s a big concern for you though, you may want to look at options which produce lower levels of income and higher growth. US index funds, for example, are like that. And Aussie funds tend to not be that bad due to franking credits, so there’s that too.
There’s no magic way to enjoy a growing passive income stream and a greatly expanding portfolio (in any asset class) while never paying tax. To expect otherwise is frankly, a bit ridiculous.
Adding high yield and active funds
I’m 51 and currently own VGS, VAS and NAB. I was given NAB shares in 2008 and just kept them. I was thinking of adding SOL (LIC) and VHY (ETF). I believe having this mix would add more diversification/ growth (SOL), dividends (VHY) and be tax effective through franking credits. All dividends will be reinvested and I’ll dollar cost average until my early sixties where I could use the dividends.
Dave:
There’s not really a question here, but here’s how I would think about the decision…
VAS and VGS already have a very high level of diversification and a good balance between growth and dividends. So I’m not sure adding SOL (which is an investment conglomerate but is already in VAS) and VHY (which basically concentrates on the biggest dividend payers in VAS) is adding that much of a difference.
That said, if you believe in SOL as a long term investment manager and believe they will continue to outperform the market (as they have for 40+ years), then that is something genuinely different from what you already have. They do invest in private real estate, unlisted businesses, and high yield credit, which is not something people get much exposure to if just holding index funds.
VHY mostly suits someone who really wants to juice the yield of the portfolio (franking credits included) while trading off growth. More on this in a minute. The other option is simply adding more VAS relative to VGS which would boost portfolio yield by itself.
The other thing is how big of your portfolio you make these holdings. If they’re quite big holdings - say 15-25% each - then you’re adding some risk (especially with a single company like SOL, even though it’s diversified). If the holdings are quite small (say 5-10%), then is it really making much difference?
Side note:
I wrote about Soul Patts many years ago
on my blog here
, which gives a bit of history and story behind the company.
None of this is easy to decide on, but hopefully this gives you some things to think about. By themselves, I can see merit and usefulness in both SOL and VHY for various purposes – it’s just deciding whether they make sense for your portfolio and where exactly they fit in.
One thing I’ve learned is you don’t want to complicate things unless you expect a new holding to be highly useful/different/beneficial in some way. But many of us fall into the trap of adding things because they seem interesting, when they aren’t really needed and our boring portfolio is more than sufficient.
What does Dave think of VHY?
Have you ever considered adding a little VHY to your portfolio for some extra dividend income to supplement VAS/VGS?
Dave: I’ve been asked about this fund lots of times in the last 12 months or so.
Interestingly enough, it was the very first share I ever owned. I liked the idea in theory, especially when I was aiming to maximise cashflow and leave work. But in practice, I didn’t like it as much.
What happened? Well, some of the major VHY holdings at the time were mining companies - bought for their high expected yield. The problem was, it became increasingly obvious that the dividends were unsustainable at the time (2015) due to the mining downturn, prices fell and large dividend cuts were expected.
The rules-based approach of VHY simply bought and held them as major holdings based on dividend yield at the time - and held them until dividends were (massively) cut later.
After that, I moved to LICs like the ones mentioned above, which focused on sustainably growing dividends, not just high yield. That made more sense. And then later, I
I moved towards index funds
after learning more about how brutally hard it is to keep up with the market given the 80/20 rule of stock returns.
Personally, I’m not against looking at high yield options if you don’t mind the tradeoffs. But given we don't need the extra yield, I won't be adding it. I wrote a bit about
high yield options here
back in 2019.
Am I trapped after debt recycling?
If you debt recycle your home loan, does that mean that you’ll have to stick with the same bank for the life of the home loan? Say I’ve started debt recycling with Bank A, but down the track Bank B has a more attractive mortgage rate - I won’t be able to refinance to bank B?
Dave:
No, from what I can tell, you can switch banks, and there shouldn’t be an issue with deductibility. Reason being, when you switch banks, the purpose or your loan has not changed - that same amount that you borrowed has still been put into investments.
You can always reach out to confirm this with them if you want to be totally certain. And if you want to switch to Bank B, make sure they keep your debt recycled loan split separate. This will give you the clearest ongoing link between the borrowed funds and your investments to show the ATO if they ever asked about it.
Say you had a $600k home loan, $500k was your normal mortgage, and $100k had been
debt recycled.
Make sure the new lender creates the same loan splits for you. If you don’t tell them, the bank will just do the easy thing and give you a new $600k loan, making it a bit more grey and tricky for accounting purposes.
Property investing advice from ChatGPT
I currently have $350k in equity in an investment property and I’m looking at withdrawing $200k to buy ETFs. I asked ChatGPT to run some comparisons against investing those funds in property instead of ETFs.
It looks like property is much better because you’re earning 8% on $400k (assuming I get another $200k home loan) whereas I’d only be earning 8% on $200k if I bought ETFs.
This is based on investing in a region like Rockhampton, which is currently growing by more than 8% (just using this figure to be conservative). I’ve also factored in rental income and all expenses as well as dividend returns, and property seems to be coming out on top significantly.
Obviously, ETFs are far more liquid and far less of a hassle, but from a financial perspective, property looks like it outperforms because it’s leveraging a larger asset. Am I missing something here? Would love to hear your thoughts
Dave:
First, careful listening to AI religiously for investing advice! It’s fine for getting information, but it often isn’t able to think through scenarios very well unless you know what to ask.
A few things are worth fleshing out here:
1- Expenses
Holdings costs on rental properties are always under-estimated. This will eat into a good 40% of the rent, so a 4% yield will become 2-2.5%. Leveraging more than 100% by using equity + a new loan for purchase on a $400k asset might be:
$10k net rent, $20-25k interest (assuming $400k asset + all borrowings). You'll get back some tax, but likely still out of pocket $7-10k pa. So you need the property to grow 2% pa just to breakeven.
2- Growth
Long term growth rate will absolutely not be 8% per annum. That’s a wildly unsustainable capital growth rate for property in the modern era. You are hopefully thinking of 8% as the ‘total return’ rather than just pure capital growth.
Sometimes prices will grow 50% over 3 years, other times they’ll creep up slowly or go nowhere (or fall) for 4-5 years. This happens in every city. I would assume 4% long term growth as reasonable and conservative these days. By the way, I never assume high returns from shares either. You’ll never see me quoting anything over like 8% as an expected average (including growth and income), even though historic returns have been 10-11% pa.
3- Lumpy costs and return dilution
Large up front costs like stamp duty, ongoing negative cashflow, and flat markets (which are inevitable), then selling costs and CGT at the end, all dilute the returns and need to be factored in. This assumes you’d be selling later to add to your ETFs, which is likely what you’re thinking of.
I spoke about some overlooked property lessons I've learned in Episode 39 of the Aussie FIRE podcast . It expands on the above points. To be clear, I’m not saying it's not a good idea or it won’t work out better. Just be fully aware and totally realistic before assuming it's a no brainer based on a simple answer from ChatGPT.
You could make a ton of money in property if you catch a good growth wave. And yes, the higher borrowing capacity can create more gains. But you may also find yourself out of pocket or nowhere after holding a property that has barely moved in 5+ years. That’s the nature of investing with large amounts of debt.
Assuming you go ahead, it's worth considering to invest in the cities that have had the worst performance over the last decade - as counterintuitive as that may sound. Because eventually, they simply get too cheap relative to the rest, and inevitably have a strong growth wave.
We’ve seen that over the last 5-6 years in Brisbane, Perth and Adelaide (and it looks like Darwin is booming now for similar reasons), after languishing while Melbourne and Sydney boomed.
The people who called them ‘second tier’ and not worth investing in have simply been proven wrong as Melbourne and Sydney have lagged behind in the last half-decade. It’ll eventually be Melbourne and Sydney’s turn again, and the smaller capitals will probably flatline for a while.
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’s best-selling book Strong Money Australia is available on
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or
Audible.
