Performance Update for Colm Fagan's ARF

[Colm Fagan]

Is it not 11.33%? I agree that one would expect 326% to translate into a higher number.

It's a straightforward compound interest calculation: 3.26^(1/13.5)=1.09148. (I've to disable the portrait orientation lock on my iPhone to get the power calculation, but you can also do it quickly on a spreadsheet.)

Whilst I agree that people with other assets should think of their overall asset profile and consider having an all-equity ARF, you’ve been exceptionally lucky that your investment period started after the Global Financial Crisis. If you’d retired right before the dot.com bubble burst of the GFC kicked in, the picture would be different because of sequence of returns risk etc.

The money for my ARF didn't appear out of thin air on 31 December 2010. It came from a self-administered pension plan, which I started in 1996 and was also invested (almost) entirely in equities - and went through the floor in the GFC, but also experienced the subsequent recovery. I do agree that QE has done wonders for equity returns since then, but I would have happily settled for 3% a year less on average over the period since 2010. That would still have left me with an average return of over 8% a year. BTW, I did experience the "sequence of return" risk: the fund had a negative return in the first year (2011). So what? Of course, it would have been lovely to have kept some of my money in cash at the start of 2011 and then invested it in equities at the end of the year, but I would most likely have kept it in cash (or bonds) for the entire period and would therefore have experienced a lower return overall.
I agree that someone with limited other reserves (or unencumbered equity in their home) would not be well advised to do as I did. One of the main aims of my AE proposal was to give that freedom to pensioners of more modest means. Unfortunately, Minister Humphreys scuppered that ambition.

 

[Duke of Marmalade]

@Gordon Gekko @Colm Fagan Guys, I think you are a tad at cross purposes.
GG is talking about 326% growth, CF is talking about 326% all in
CF is talking about the Mean when he says random selection preserves the average; GG is talking about the Median when he says the blockbusters push the random average down

BTW my global equity ARF is up 12% YTD after 0.9% p.a. AMC

 

[Colm Fagan]

You may not want to reveal how many shares are in your ARF and the percentage weighting? From reading your posts over the years, using my bad memory and my model of your fund, I'd estimate about 7 shares with about fifty percent of value concentrated in two shares.

If you did a money makeover post people would say diversify!

You're right. It's actually 11 but a few of them are small, so there would be only around 7 with a reasonable amount in them. And you're right too that money makeover people would tell me to diversify. I tell myself that, but I haven't had the time to research shares that I would like to add to the portfolio (I may get some time now that my AE idea is dead). Still, I wouldn't be looking to have more than 20 or so reasonable-sized holdings of shares I was comfortable to hold long-term (at whatever the asking price was at the start).

I think the long term expectation of that shape of holding (randomly constructed) is to underperform a passive fund (that tracked the market these are selected from).

My argument was based on simple logic - but it may be faulty.
By definition, a passive fund mimics the entire market. A random selection of stocks should deliver the same return on average, but with a high chance of under- or over-performing.
The managers of passive funds charge fees. They also vary weightings of different stocks over time, as companies are taken over, go bust, have rights issues, etc. Such changes cost money, not a lot, I'm sure, but a cost nevertheless. A random selection of stocks saves the costs of the manager and of switching.

 

[Colm Fagan]

If you're going to go down the past performance / comparison route then it's important to compare like-with-like as accurately as possible.

The YTD figure for the @Gordon Gekko 's family relative on the fund they're invested in (previously dislosed) is 18.92% net of the AMC disclosed and all other costs. The period I'm quoting is 29/12/2023 to 28/06/2024 as those are the dates that the fund prices are available from.

The annualised return for the same fund is 11.3% (net of all charges). The period I'm quoting is 01/01/2011 to 28/06/2024.

But, there are > 400 holdings in the relatives fund. A more concenrated fund on the same platform (with circa 50 holdings) did 11.18%.

Incidentally, the Actively Managed 100% Global Equity Fund and the Global Index Tracker on the same platform over the period 10/03/2011 (the date that the Index Tracker fund was included on the platform) to 28/02/2024 are identical @ 11.44% pa (net of all charges ie the 0.5% AMC and all OOCs and PTCs)


Gerard

www.prsa.

I never went down the past performance/ comparison route. Others chose to go down that road.
The main point I want to make is that opting for a 100% equity portfolio has served me well. I believe it would serve ordinary workers (active and retired) equally well if the government's AE scheme were structured in the way I proposed.

 

[Sarenco]

By definition, a passive fund mimics the entire market. A random selection of stocks should deliver the same return on average, but with a high chance of under- or over-performing.

I have to confess that the way actuaries think (or at least the way they express themselves) often leaves me scratching my head in puzzlement. So, with that in mind…

It is generally accepted that a handful of stocks account for the bulk of market returns.

Most stocks – in Ireland and beyond – are flops

Just five stocks – CRH, Ryanair, Kerry Group, Flutter, and Kingspan – account for all wealth created on Dublin exchange over 30 years to 2020

www.irishtimes.com

So, logically it follows that the more concentrated an equity portfolio, the higher the probability that an investor will miss out on the small number of “super performers” and will lag the broader market.

Now, you might argue that there is an equal chance that a concentrated portfolio will avoid the turkeys. However, that’s not the case - there are far fewer stars than turkeys.

The managers of passive funds charge fees. They also vary weightings of different stocks over time, as companies are taken over, go bust, have rights issues, etc. Such changes cost money, not a lot, I'm sure, but a cost nevertheless. A random selection of stocks saves the costs of the manager and of switching.

Costs matter, no doubt about it. However, these days passive managers can typically track an index to within around 0.1%.

That’s largely down to stock lending income and the ability to move stocks around to mitigate withholding taxes.

 

[cremeegg]

Regardless of how it feels, I’m really struggling to see how any of the above is right.

I checked a family member’s ARF just there which is in an equity fund. 326% for the same period gross of fees, which are 0.6% pa in total (0.5% headline). Seems like a lot more than 11.2% pa over 13 years.

11.2% compounded over 13 years (11.92^13) is 397%

 

[ronaldo]

My own plan eventually is to hold a portfolio of equities in an ARF and sell Covered Calls to supplement the dividend income. As options trading isn't allowed within a pension wrapper, this would involve a separate account.

The limitations of such an approach is that I'll need sufficient investments outside the pension wrapper to cover the margin requirements to cover what the broker will think is naked calls due to them not having visibility of the ARF holdings.

For example, one holding I have currently trades at €133 and has a 1.36% dividend. Assuming I have enough investments outside the pension to cover margin requirements, I'd purchase 100 shares within my ARF and sell a call option in my Interactive Brokers.

If I were to shoot for >1% options income every 2 months, I would be selling a €150 call option today, for September expiry, and taking in income of €0.85 per share. If the shares close below €150 on September 16th, that income is mine to keep with no additional action. If they close above €150, my Interactive Brokers account would sell short the 100 shares (if I didn't close the option before expiry). However, I'm long the same shares within my ARF so my profit would be the €0.85 options income plus €12 per share (the rise in shares from €133 to €150). This rise would be within my pension wrapper and tax free. I'd suffer a capital loss on the short option outside my pension wrapper, reducing my tax bill.

The biggest problem with this strategy is that you limit your upside potential on the shares that rise dramatically.

 

[Duke of Marmalade]

My own plan eventually is to hold a portfolio of equities in an ARF and sell Covered Calls to supplement the dividend income. As options trading isn't allowed within a pension wrapper, this would involve a separate account.

So the cover is in the ARF and the options are outside it. Sounds messy taxwise.

 

[ronaldo]

So the cover is in the ARF and the options are outside it. Sounds messy taxwise.

From a tax perspective, you can ignore the ARF completely.

Any call options sold that expire worthless will add to your income tax bill (many argue whether options trading is CGT or income but I treat it as income).

Any call options that go deep in the money will cost you more to repurchase, thus suffering a loss (more than offset by the ARF). This would reduce your overall income tax bill.

The strategy, assuming you aim for 1% in options premium every 2 months, allows you to take an income of 6% annualized. On average, it works well on a falling market, a market thats going sideways or one that's increasing slowly. In selling options on each underlying once every 2 months, I'd alternate a selection of half of my positions every month to limit losses, or maximize gains, incurred in sudden market movements.

In a rapidly rising market, you'll have to buy back your options at a loss or else go short the shares (offset within the ARF). I'm not familiar with rules on whether short selling in this manner would be applicable to CGT or Income Tax but, if CGT, the decision on whether to buy back the option or go short the shares would depend on your tax situation at the time (if you're in net profit on your options trades for the year, you'd buy the option back at a loss and reduce your tax bill). You'd then decide whether you hold, or sell, the shares in your ARF that have rose significantly.

 

[Duke of Marmalade]

I have to confess that the way actuaries think (or at least the way they express themselves) often leaves me scratching my head in puzzlement.

Me too

So, logically it follows that the more concentrated an equity portfolio, the higher the probability that an investor will miss out on the small number of “super performers” and will lag the broader market.

Now, you might argue that there is an equal chance that a concentrated portfolio will avoid the turkeys. However, that’s not the case - there are far fewer stars than turkeys.

Actuaries love wild examples so let us assume that the market consisted of 10 stocks, costing 1 each. One stock returns 9 another returns 1 and the rest return 0.
As a Duke I go for the market, investing 0.1 in every stock, My return is 1, i.e. my money back.
Imagine 10 Colms, who each just pick one of the stocks and invest their whole 1 in that stock.
One lucky Colm finished with 9, another with 1 and the rest bombed out but between them they got 10, their money back same as me.
But for sure, as Colm says, riskier.
And referring to the earlier nerdish point, the Colms got a Mean average of 1 but a Median average 0.

 

[Colm Fagan]

11.2% compounded over 13 years (11.92^13) is 397%

I don't want this to become a self-help lesson in compound interest, but you're right (forgetting about the bit in brackets, which should be 1.112^13).
For what it's worth, I calculated the average 11.2% a year for 13.5 years by looking at each year's cash flows, assuming they were paid out half-way through the year, and seeing what constant annualised rate of return would give the same fund as I actually have after 13.5 years, remembering of course that the interest earned in half a year is a bit less than half a full year's rate, e.g., 11.2% in half a year is 5.45%, not 5.6% (showing that I meet @Duke of Marmalade's description of a nerdish actuary!) To prove my nerdiness, the calculation changes for the last half-year! BTW, Duke, your nerdish answer to @Sarenco's question might qualify you for honorary actuaryship, to add to your Dukedom!

 

[Colm Fagan]

My own plan eventually is to hold a portfolio of equities in an ARF and sell Covered Calls to supplement the dividend income. As options trading isn't allowed within a pension wrapper, this would involve a separate account.

Hi @ronaldo. Your plan of having options outside the pension fund reminds me of a brilliant wheeze I thought of a few years ago, but which came badly unstuck - because I thought I knew better than the market.
Around 2015 or so, I realised that I had heavy exposure to the UK market. I liked the companies I was invested in, but didn't like the currency. I decided to hedge my sterling exposure, but the options had to be outside the pension fund. Everything was going swimmingly until I decided, after the Labour MP Jo Cox was murdered, that the UK electorate would be so revolted by her murder that they were certain to vote to stay in the EU, so I cashed most of my options. The rest is history!

 

[ronaldo]

Hi @ronaldo. Your plan of having options outside the pension fund reminds me of a brilliant wheeze I thought of a few years ago, but which came badly unstuck - because I thought I knew better than the market.
Around 2015 or so, I realised that I had heavy exposure to the UK market. I liked the companies I was invested in, but didn't like the currency. I decided to hedge my sterling exposure, but the options had to be outside the pension fund. Everything was going swimmingly until I decided, after the Labour MP Jo Cox was murdered, that the UK electorate would be so revolted by her murder that they were certain to vote to stay in the EU, so I cashed most of my options. The rest is history!

My strategy will, basically, limit upside potential if the shares rise sharply - much less of an issue when using your pension for an income versus earlier decades when you were in the accumulation phase.

If the shares rise too sharply (more than about 9% in 2 months in the sample above), you have a decision to make and may end up selling the shares in your ARF having locked in that 9% gain but not participated in any gains beyond that.

In a market where all your ARF positions are dropping in value, going sideways or even rising very slowly, it offers a ~6% income on your ARF without having to touch the positions within it.

The biggest problem comes if there is a massive divergence in the performance of your shares in the ARF. For example, if holding 10 shares where 9 drop by 10% and one doubles in value, you'll limit your participation in the one that doubles whilst incurring full losses (less the options premiums you take in) in the 9 that drop.

As with a standard buy and hold strategy, the more positions you hold, the less likely your performance is to veer TOO far off the market as a whole.

 

[Duke of Marmalade]

Any call options sold that expire worthless will add to your income tax bill (many argue whether options trading is CGT or income but I treat it as income).

Any call options that go deep in the money will cost you more to repurchase, thus suffering a loss (more than offset by the ARF).

Hmmm! If they were in the same tax net, in theory you would sell the shares to fund the option losses. But in this case you would pay income tax plus USC on transferring the cash out of the ARF. Of course if the amounts involved are small and you have sufficient liquidity outside the ARF you could just ride it out, meaning you increase your overall equity percentage.
I note in another post the rationale for the strategy, chopping off the peaks in your equity portfolio for an income, but I think I have seen somewhere that in fact the bulk of equity returns comes from the peaks. There is no free lunch!

 

[Colm Fagan]

@ronaldo I too would be wary of your strategy. I believe in keeping things as simple as possible and to have the minimum number of snouts in the trough. Your strategy offends against both principles. In my experience, option providers are in it for one thing, to make as much money as possible for themselves. Someone has to pay.

 

[RMGC11]

By definition, a passive fund mimics the entire market. A random selection of stocks should deliver the same return on average, but with a high chance of under- or over-performing.

This point has been touched on (refuted) by other people, I do believe it's worth discussing further however.

The vast majority of returns in the market come from a very small percentage of stocks (4-5%).
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4541122 (Underperformance of Concentrated Stock Positions)

The market pricing things fairly is also a big assumption - though that is debated at the highest levels. It's enough to track a stock like GME to dissuade one of that opinion.

The most recent example: Nvidia alone accounts for more than a third of the S&P 500’s gains this year! That's one stock out of 500, driving 30%+ of gains.

 

[ronaldo]

@ronaldo I too would be wary of your strategy. I believe in keeping things as simple as possible and to have the minimum number of snouts in the trough. Your strategy offends against both principles. In my experience, option providers are in it for one thing, to make as much money as possible for themselves. Someone has to pay.

Who is the option provider? In my case, I'm the provider as I'm selling the options short. I've been using this strategy for years - just not in a separate pension account.

The reason for not using the strategy within a pension wrapper yet is that I'm a cross border worker with a workplace pension where my AMC for the fund platform is 0.19% and it capped at £475 annually (basically, zero additional annual management charge for the fund platform for any pension funds beyond £250,000).

I'm not willing to move from a platform with such charges to one of the Irish platforms; given the fees they charge.

 

[ronaldo]

The most recent example: Nvidia alone accounts for more than a third of the S&P 500’s gains this year! That's one stock out of 500, driving 30%+ of gains.

It's unusual times for sure. Most stock-pickers who passed on the magnificent 7 are vastly under-performing the market.

In normal times, we would expect a lot more breadth to the market rises. It'd still be a small number of significant out-performers - but not to the extent it's been in recent times.

 

[Colm Fagan]

Hi @ronaldo Teaching granny to suck eggs! That's how I feel. If you can negotiate those sorts of charges, I take my hat off to you. I wish I could get anything close to that. I also hear you about your experience with options. I doubt if anyone is going to take you for a ride. It's all way past my pay grade.
@RMGC11 Again, you seem to know your onions. My long-held argument against investing in "hot stocks" was that you might hit gold the odd time, but you could lose your shirt backing lots of losers. My preference was to stick to shares that I was reasonably confident would deliver good but not spectacular returns in the long-term. My ambition was and still is to earn around 4% to 5% a year more than I could earn on "safe" bonds. I've more than achieved that up to now. The return over the last 13.5 years was closer to 8% more than I could have got from bonds. That outcome was fortuitous, and can be attributable largely to QE (or so the experts tell me). I'm not banking on it in future. My spreadsheet expects the average return to revert to close to 4% over bonds for the rest of my life. (I also have the comfort of knowing that the current fund value exceeds the "smoothed" value which I use for planning purposes, but that's another story!)
Of possible interest in this regard is an article I wrote many years ago, when I had a regular column entitled "Diary of a Private Investor". My very first column was on this very topic. Here is the link https://www.colmfagan.ie/documents/25_Document.pdf?d=July 23 2019 14:06:38.

 

[AAAContributor]

Any call options that go deep in the money will cost you more to repurchase, thus suffering a loss (more than offset by the ARF). This would reduce your overall income tax bill.

In a rapidly rising market, you'll have to buy back your options at a loss

I'm interested in the tax side of the transaction but I'm trying to get my head straight on your proposal and strategy.

A big assumption is that the option side of the trade carries income tax treatment, but as you are assuming that, let's run with it for the sake of an example.

Let's assume a simple example - there are just 2 accounts: ARF A/C & OPTION A/C - and all we are seeking to do is understand the interaction of the accounts based on price movements and the tax implications following on from the price movements. Other trade iterations can be brought in later, but the strategy needs to stand up in its simplest form first.

Assumptions:
At time 'T':
Option position and type: Short an out-of-the-money (OTM) Call Option
S (share price): 100
X (exercise price): 110
P (option price): 1

Tax Rate of the individual: 25% (income tax plus USC)

Account Status at time T:
ARF A/C: Long one share valued @ 100
OPTION A/C: Short an OTM call option on the share with an exercise price of 110 and maturity T+1. Option seller receives the premium of 1.

At time 'T+1':
S: 150 (increase in price of the share of 50%)
X: 110
P: 40 (S-X)

Account Status at time T+1:
ARF A/C: Share is worth 150. Gross gain of 50.
OPTION A/C: Short option position is closed out by going long a call with same strike and maturity. Realised trading loss of 39 (premium received of 1 less 40 cost of offsetting option position).

Monies have to come across from ARF A/C to fund the cash shortfall in OPTION A/C. The share is sold in the ARF A/C. ARF A/C is long cash of 150.

To fund the OPTION A/C, 52 (39/(1-0.25)) needs to be taken from the ARF A/C. 39 is transferred to the OPTION A/C and 13 is paid in tax.

Is your net worth now in negative territory? +50 on the share, -39 option trading, -13 in tax, resulting in a net position of -2 (and worse if subject to a higher tax rate)?

Perhaps the strategy is to use the 39 loss ("trading loss") against your PAYE (income tax and USC) of 13 to put your net worth back in positive territory?

If you are using a trading loss against other income (a Section 381 loss), the full loss has to be used. 13 of the 39 loss can't be used against the PAYE tax of 13 with the balance carried forward to use in future years against the same trade (the trade of option trading). You would need to have scope to use the full 39 in the same year. The trading loss also can only offset income tax and not USC. In addition, if the trade is carried out in a non-active capacity, loss relief is not prevented, but it is limited (Section 381B), further crimping the potential utilisation (in a particular tax year).

Does the above broadly match what you have in mind? Have you gotten tax advice on the strategy?