Investment Plan Query (Dividend vs Total Return Strategy for Unusual Tax Situation)

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Pyrrho
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Joined: Wed May 16, 2018 7:09 pm

Investment Plan Query (Dividend vs Total Return Strategy for Unusual Tax Situation)

Post by Pyrrho » Wed May 16, 2018 7:27 pm

I have been helping an elderly friend in Ireland with his finances, and we are in the process of investing his savings. His pension income is sufficient to cover his expenditure, which is modest, and the sum in question is not large, but at the moment deposit rates in Ireland are only about 0.5%, and we’d like a shot at preserving the spending power of his money. There are no inflation protected securities like TIPS available, so I am planning the following asset allocation:

50% cash
37.5% bonds: iShares € Aggregate Bond UCITS ETF (IEAG)
12.5% stocks: Vanguard FTSE All-World High Dividend Yield UCITS ETF (VHYL)

I understand that leaving half in cash is very conservative, but we want to avoid the risk of a substantial drawdown.

ETFs are more readily available and much cheaper than mutual funds in Europe, and I believe IEAG is the closest Eurozone equivalent to Vanguard’s total bond market ETF BND in the US.

My reason for wanting to invest in a global high dividend yield ETF instead of a global total stock market ETF like Vanguard FTSE All-World UCITS ETF (VWRL)—basically the equivalent of VT in the US I think—is a little more complicated. I am aware of (and persuaded by) the usual arguments for a total return as opposed to a dividend strategy, and in particular of the argument that dividend stocks may be overvalued right now owing to the reach for yield over the past few years, but a combination of my friend’s individual situation and the peculiarities of Irish tax law seem to me to merit a dividend approach.

Since my friend is elderly and his income is modest, he is exempt from paying income tax, so he would not be subject to tax on any dividends received, as given the likely amounts involved, he would still be below the applicable limit under Irish law. He would be liable to pay capital gains tax at 33% on any realized capital gains, and there is a law in Ireland whereby after eight years, there is an “imputed distribution,” and tax is levied as if one had sold, but that aside, the plan would be to buy and hold.

As of Mar 31, 2018, the VWRL yield was 2.4% and the VHYL yield was 3.7%. Projecting conservative nominal average returns of about 5% on both ETFs over the next several years, and subtracting the tax annually for simplicity, the expected after-tax return on VWRL would then be 2.4% + (2.6% * 0.67) = 4.14%, whereas the expected after-tax return on VHYL would be 3.7% + (1.3% * 0.67) = 4.57%, which is non-negligibly higher.

Of course, I realize that the high dividend ETF might significantly underperform the total stock market ETF, but my basic sense is that even taking into account the superiority of a total stock market approach other things equal, the fact that my friend would pay 33% tax on capital gains but no tax on dividends surely implies that investing in the high dividend ETF would be a worthwhile tradeoff.

I’d be extremely grateful for any feedback that anybody might be able to offer. Again, the sums involved are not very large, and so the potential differences in outcome probably aren’t either, but given the depth of knowledge on this forum, I just thought I’d check to make sure I’m not missing something before we commit my friend’s capital.
Last edited by Pyrrho on Thu May 17, 2018 5:53 pm, edited 1 time in total.

not4me
Posts: 304
Joined: Thu May 25, 2017 3:08 pm

Re: Investment Plan Query

Post by not4me » Thu May 17, 2018 11:08 am

I don't have your answer, but hope this bumps the thread & someone more knowledge in this area than I will chime in. ETFs/taxes/etc in Ireland are not in my area of expertise! But, I would offer a couple of thoughts. First & perhaps most importantly is how this specific individual will emotionally feel about whatever it ends up being. You likely have a good feel for their risk tolerance, view on taxes, etc. Their buy-in is quite important & it doesn't matter if the end result isn't elegant from all perspectives. Depending upon their age, they don't need added stress of paying what they deem as high taxes and/or seeing investment declines that they feel are unacceptable.

I don't not know what ETFs are available or anything about these specifics. On the cash, that is a high percentage, but perhaps the "sleep well" portion. Is this what is getting 0.5%? Are there other options like Certificates of Deposit or government bonds that might give a small boost & yet be short term & liquid enough to help a bit? Likewise on the bond portion, not knowing the duration of this ETF, is there a shorter duration ETF that might be more suited to time horizon? Perhaps 20% aggregate, 17.5% "short term"? On the stock portion, is there a similar ETF for dividend appreciation? For example, in the US, there are ETFs that focus more on growing dividends over time than having the highest currently.

These may not be useful at all if options aren't available. Best of luck -- they are fortunate to have someone like you helping them

Pyrrho
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Joined: Wed May 16, 2018 7:09 pm

Re: Investment Plan Query

Post by Pyrrho » Thu May 17, 2018 5:05 pm

Thanks so much for your helpful comments! I was beginning to wonder if anybody would reply…

Yes, 50% cash is very conservative, and we may put some of that in a CD or in government bonds, though at the moment, government bond and deposit rates in Ireland—and in Europe more generally—are dreadful. (You have to lock up your money for five years to get even 1%, which hardly seems like a great deal.) I do have a pretty good idea of my friend’s risk tolerance, and of his overall financial situation—which is stable—and I know that he wouldn’t hold me responsible for any losses once he signs off on whatever plan we settle on, but I’m much more nervous about losing other people’s money than I am about losing my own :)

The duration of the bond ETF is 6.67, so it might be worth putting about half in a short-term bond ETF as you suggest, though I’d like to keep things as simple as possible.

As for the stock allocation, there are a couple of other available options, as per your recommendation. There’s an iShares ETF that tracks the MSCI World High Dividend Yield Index, and a SPDR ETF that tracks the S&P Global Dividend Aristocrats Index. Both of those indexes are constructed with a view to the sustainability of the dividend yield, as opposed to the FTSE index that the Vanguard ETF tracks, but the ETFs are a little more expensive (Vanguard: 0.29%, iShares: 0.38%, SPDR: 0.45%), and not as broadly diversified. The FTSE All-World High Dividend Index is constructed by excluding REITS and non-dividend paying stocks from the FTSE All-World Index, and then simply taking the highest yielding stocks from the index until the cumulative market cap reaches 50% of the total market cap of the modified FTSE-All World Index, so the total number of holdings in the Vanguard ETF is 1,292. By contrast, the iShares ETF has only 275 stocks, and the SPDR only 100. (Sorry if I’m telling you what you already know.)

Expenses and number of holdings (and my fondness for Vanguard) aside though, it seems like the MSCI index tracks the corresponding global index somewhat more closely than either the FTSE or the S&P indexes do, so maybe the iShares MSCI ETF would be a good choice:

https://www.msci.com/documents/10199/74 ... 50623fae65

http://www.ftse.com/Analytics/Factsheet ... 7482d7.pdf

https://us.spindices.com/indices/strate ... ristocrats

I believe I have a fairly firm grasp of the intricacies of Irish and EU taxes and regulations etc., so I’m not too worried about getting caught out on those issues. I guess I have two basic questions:

1. Am I right in thinking that, contrary to what would ordinarily be the case (and to the way I have my own money invested), it might make more sense to allocate the stock portion of my friend’s portfolio to high dividend paying stocks than to a total market fund, given that he will owe 33% tax on any capital gains, but 0% tax on dividends?

2. If so, would the iShares MSCI ETF perhaps be a better choice than either the Vanguard FTSE ETF and the SPDR S&P ETF as having the optimal overall balance between fees, quality of dividends, diversification, and closeness of correlation to the corresponding global index? (It’s new, a little small, and quite thinly traded, but the bid-ask spread is only about a penny.)

Once again, I really appreciate your responding to my post. I’ve been lurking on Bogleheads for a few years, and have learned an awful lot, so I finally decided to join up and jump in with a question of my own.

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patrick013
Posts: 2167
Joined: Mon Jul 13, 2015 7:49 pm

Re: Investment Plan Query (Dividend vs Total Return Strategy for Unusual Tax Situation)

Post by patrick013 » Thu May 17, 2018 6:25 pm

I wonder why global would be so good. If you stayed with
the EU or just plain Europe or a dividend fund concentrating
on the British isles you should have less currency risk. France
has been having good dividend funds if the exchange rates
stay stable. Check it out.
age in bonds, buy-and-hold, 10 year business cycle

Pyrrho
Posts: 8
Joined: Wed May 16, 2018 7:09 pm

Re: Investment Plan Query (Dividend vs Total Return Strategy for Unusual Tax Situation)

Post by Pyrrho » Thu May 17, 2018 7:17 pm

Thanks for posting! I take your point about currency risk, and can understand your argument for sticking to Europe, though I’m inclined to think that over the long term the effect of exchange rate volatility should diminish to the point that it is outweighed by the benefit of increased global diversification. Here’s my highly oversimplified reasoning:

I realize that there are innumerable other macroeconomic factors apart from the health of the stock market that affect exchange rates, but all else equal—which of course it never is—if the euro appreciates against the dollar, so that euro returns from dollar-denominated stocks are lower, then the European economy—and European stocks—will tend to be doing relatively well, and thus higher gains from the euro-denominated part of the portfolio should at least partly compensate for lower US returns when converted into euros. On the other hand, if the European economy deteriorates and the euro depreciates, then the relatively higher value dollar stocks might make up for poor euro returns, and likewise for other currencies...

I know that people have different opinions about the percentage of their stock allocation that should be assigned to international equities, and I could be completely wrong, but I figure that for an investor in a small country like Ireland—whose economic fortunes are in many ways more closely tied to the US business cycle than to that of Europe (hence the booms and busts in Ireland, since monetary policy largely reflects German and not Irish circumstances)—the least arbitrary stock allocation is simply to own the world.

What do you think? Am I way off?

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patrick013
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Re: Investment Plan Query (Dividend vs Total Return Strategy for Unusual Tax Situation)

Post by patrick013 » Thu May 17, 2018 7:46 pm

Pyrrho wrote:
Thu May 17, 2018 7:17 pm
(hence the booms and busts in Ireland, since monetary policy largely reflects German and not Irish circumstances)—the least arbitrary stock allocation is simply to own the world.

What do you think? Am I way off?
Don't follow Intl that much but I know the US dollar
is trading less than usual. If you can justify investing
in the US or local British companies.....Intl just has too
many variables for me most of the time.

BP, Royal Dutch Shell, Nestle.....some funds that invest
in those ???
age in bonds, buy-and-hold, 10 year business cycle

Pyrrho
Posts: 8
Joined: Wed May 16, 2018 7:09 pm

Re: Investment Plan Query (Dividend vs Total Return Strategy for Unusual Tax Situation)

Post by Pyrrho » Thu May 17, 2018 8:33 pm

I appreciate where you're coming from, and I agree that a broad European or Eurozone fund might well make sense.

But the Irish stock market is so small and so concentrated in a few big companies (the three biggest represent about 41% of the total market cap of publicly traded Irish firms) that to overweight it much in an Irish portfolio would be to succumb to a bad case of home country bias, and even ignoring the Sterling currency risk for an Irish euro investor, I'd be wary of hitching my wagon to the UK's star given all of the uncertainty surrounding Brexit...

not4me
Posts: 304
Joined: Thu May 25, 2017 3:08 pm

Re: Investment Plan Query

Post by not4me » Fri May 18, 2018 11:58 am

Pyrrho wrote:
Thu May 17, 2018 5:05 pm


As for the stock allocation, there are a couple of other available options, as per your recommendation. There’s an iShares ETF that tracks the MSCI World High Dividend Yield Index, and a SPDR ETF that tracks the S&P Global Dividend Aristocrats Index. Both of those indexes are constructed with a view to the sustainability of the dividend yield, as opposed to the FTSE index that the Vanguard ETF tracks, but the ETFs are a little more expensive (Vanguard: 0.29%, iShares: 0.38%, SPDR: 0.45%), and not as broadly diversified. The FTSE All-World High Dividend Index is constructed by excluding REITS and non-dividend paying stocks from the FTSE All-World Index, and then simply taking the highest yielding stocks from the index until the cumulative market cap reaches 50% of the total market cap of the modified FTSE-All World Index, so the total number of holdings in the Vanguard ETF is 1,292. By contrast, the iShares ETF has only 275 stocks, and the SPDR only 100. (Sorry if I’m telling you what you already know.)

Expenses and number of holdings (and my fondness for Vanguard) aside though, it seems like the MSCI index tracks the corresponding global index somewhat more closely than either the FTSE or the S&P indexes do, so maybe the iShares MSCI ETF would be a good choice:

https://www.msci.com/documents/10199/74 ... 50623fae65

http://www.ftse.com/Analytics/Factsheet ... 7482d7.pdf

https://us.spindices.com/indices/strate ... ristocrats

I believe I have a fairly firm grasp of the intricacies of Irish and EU taxes and regulations etc., so I’m not too worried about getting caught out on those issues. I guess I have two basic questions:

1. Am I right in thinking that, contrary to what would ordinarily be the case (and to the way I have my own money invested), it might make more sense to allocate the stock portion of my friend’s portfolio to high dividend paying stocks than to a total market fund, given that he will owe 33% tax on any capital gains, but 0% tax on dividends?

2. If so, would the iShares MSCI ETF perhaps be a better choice than either the Vanguard FTSE ETF and the SPDR S&P ETF as having the optimal overall balance between fees, quality of dividends, diversification, and closeness of correlation to the corresponding global index? (It’s new, a little small, and quite thinly traded, but the bid-ask spread is only about a penny.)
I think you've got a good handle on what needs to be considered. I'll try to be more specific in my reply, so in regards to question #1: I would agree that in this case it is a better approach. I assume that dividends will NOT be reinvested, but rather spent. If that "withdrawal" isn't sufficient then shares can be sold (leaving the main downside being a less diversified holding; still with almost 1300 holdings....). For some the "sell decision" is hard to pull the trigger on, especially if that results in more tax.

For question #2, with my limited knowledge of these, I'd go with Vanguard due to breadth of holdings & expense ratio. Whether you dollar cost average in or make one big leap, it doesn't sound as if bid/ask spread would be a big concern. Given any time period, these may move back & forth, but hopefully not enough to be a concern. Have you charted the actual products to see about past performance & see if any sizable difference?

Along those lines, does the overall allocation seem to generate appropriate income for the need? Another consideration not mentioned yet is whether there is a desire to leave any estate.

I think you've got this!

Pyrrho
Posts: 8
Joined: Wed May 16, 2018 7:09 pm

Re: Investment Plan Query (Dividend vs Total Return Strategy for Unusual Tax Situation)

Post by Pyrrho » Fri May 18, 2018 9:28 pm

Yes, the plan would be to spend, not reinvest, the dividends; hopefully there’ll be no need to sell any shares. As you say, it can be hard for some people to pull that trigger. And though I know it doesn’t make sense from a strictly rational perspective, behavioral factors such as mental accounting make it easier to deal with a falling market when the portfolio is throwing off a little income, since the dividends can be reckoned as real, and the drawdowns dismissed as mere paper losses. Or at least that's how I'll try to explain it to my friend when the time arrives 😊

Maybe I’ll go with the Vanguard ETF... I have looked back at the historical returns of each of the ETFs, and the differences between them aren’t huge. I don’t want to engage in performance chasing, but I do like the fact that the MSCI high dividend index on which the iShares ETF is based tracks the broader market index from which it’s constructed more closely than does the corresponding Vanguard FTSE index; on the downside, the MSCI index covers only 23 developed markets, whereas the FTSE index is much more comprehensive. In the end, I'd say either decision could probably be justified, and the difference in outcome is unlikely to be great. I’ll sit down, run some estimates, make a choice, and stick to it.

I do think the asset allocation, though very conservative, should generate enough supplementary income for my friend. The estate planning, such as it is, has been done. His wife passed away a couple of years ago, and his most valuable asset, his home, will simply be divided between his adult children. I understand that in certain cases where the intention is to pass on one’s wealth, the time horizon used to determine the asset allocation should be fixed with reference to the heirs as opposed to the investor, but in this instance stability of principle and peace of mind probably count for more.

Thanks so much for taking the time to offer your feedback! I’m extremely grateful. It’s reassuring to hear that I’m not altogether on the wrong track, and I feel that I’ve just about done my due diligence and am ready to implement the plan.

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