Two of the best exchange-traded funds (ETFs) for those interested in low-cost passive investing are: the Vanguard FTSE All World UCITS ETF (VWRD) and the iShares Global Government Bond UCITS ETF (IGLO). They are cheap, globally diversified and domiciled in Ireland, which is particularly important for expatriates looking to avoiding US estate tax upon death.
You could literally invest your money in just these two funds every month until you retire and you would likely have a very happy and prosperous retirement.
However, they have one small drawback that stops them from being perfect. They distribute their dividends. Now there are two new funds, VWRA and IGLA, that accumulate the dividends instead. I'll explain the jargon and why these new funds are useful.
The joy of dividends
Dividends are an important part of investing. They make a difference. If someone points at a particularly miserable part of a stock performance chart and says: "If you invested here you would not make any money for years", well they'd be wrong. You would be receiving dividends all that time, to ease the pain a bit.
Every three months, a publicly listed company will declare its profit for that quarter. Some of the profit will be ploughed back into the business, to make it even more awesome. But some of it will be distributed as cash back to the shareholders, as a thank you for taking a risk on the company.
Different companies pay different dividend rates, with those in more mature industries generating lots of cash paying more than fast-growing businesses. Some might not pay a dividend at all.
On average, you can expect about a 2 per cent return on a global index tracker to come from dividends. This is important, because studies have shown you can take out up to 4 per cent of your stock and bond portfolio every year to cover your living expenses in retirement. If you are following the 4 per cent rule, then half of your annual living expenses can be covered by dividends. You don't have to sell as many of your stocks and bonds every year.
VWRD holds 3,354 stocks across 47 countries and aggregates their dividends, paying out cash to your brokerage account every quarter (you can find all this by googling VWRD fact sheet). Currently it is paying out 2.1 per cent of your investment per year, so if your portfolio is $100,000, you get $2,100 in dividends as cash.
IGLO does the same, aggregating interest payments from its 731 bonds and paying out dividends twice per year at an annual rate of 1.2 per cent.
This is useful in retirement, as you can simply withdraw the cash to live on. But if you are in your accumulation phase before retirement, then you will want to reinvest the dividends as soon as possible.
Some brokers, such as Interactive Brokers, give you the option to allow them to reinvest the dividends for you, but they are going to charge you a trading fee each time. The fee could be a decent chunk of the dividend itself, so it is not really worth it. Better to wait until you have some monthly or quarterly income coming in and investing your dividend cash with that.
The even greater joy of accumulating ETFs
The accumulating funds VWRA and IGLA save you even this minor hassle by automatically reinvesting the dividends for you, at no extra charge. This is much more efficient, as the dividends are reinvested while you sleep so there is one less thing to worry about. It can also be more tax efficient, sparing you income tax on dividend distributions, though this varies from country to country.
What's the next step?
In general, you are better off investing in VWRA and IGLA until you retire and then switching into VWRD and IGLA to receive the dividends. If you are already in VWRD and/or IGLO, it's fairly cheap and fast to sell your distributing ETFs and reinvest into accumulating ones.
Depending on your broker, it might take one minute, or up to three days if they wait for cash from the sale to be settled in your account before allowing the next trade. I think it's worth the switch rather than having a mixed portfolio of distributing and accumulating funds, which would make rebalancing a pain.
Steve Cronin is the founder of DeadSimpleSaving.com. On November 1 and 2, he is running a 10-hour Expat Saving and Investing workshop in Abu Dhabi