Equity income and passive investing

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1 Equity income and passive investing Todd Schlanger, CFA Investment Strategy Group Vanguard Asset Management, Limited This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

2 Agenda The market environment for passive and equity income The case for indexing and putting performance in perspective Benefits of combining active and passive strategies 2

3 Investors are increasingly investing more in passive equity Net cash flow into equity funds in the UK ( millions) 600, , , , , ,000 0 Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q Active Passive Source: Vanguard calculations, based on data from the Investment Management Association as at 30 June

4 Investors hold about a third of their domestic equity in equity income Rolling 36-month percent of UK equity in equity-income 40% 35% 30% 25% 20% 15% 10% 5% 0% Q Q Q Q Q Q Q Q Source: Vanguard calculations, based on data from the Investment Management Association as at 30 June

5 Yield (%) Yields on dividend paying equities appear attractive Yields over past 10-years Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Hard Currency EM Global High Yield Global Corporates Global Treasuries UK Equity Income Source: Vanguard calculations, using data from Barclays Capital and Thompson Reuters Datastream, 30 September

6 Probability The zero sum game Costs Median post-cost return Benchmark return Return Underperforming benchmark Outperforming benchmark After costs, more than half of all assets underperform Source: The Vanguard Group Inc. 6

7 Global equity U.K. equity European equity Eurozone equity U.S. equity Emerging market equity Global bonds GBP diversified bonds GBP government bonds EUR diversified bonds USD diversified bonds Active managers tend to underperform on average Percentage of active managers underperforming their benchmark, 1999 to 2013 Equity Fixed income 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Surviving funds Surviving + "dead" funds Past performance is no guarantee of future results. Source: Vanguard calculations, using data from Morningstar, Inc. Data runs to 31 December,

8 Performance of active UK equity income funds Percentage of active UK equity income funds underperforming FTSE All Share Index 60% 50% 40% 30% 20% 10% 0% 3YR 5YR 10YR Underperforming Underperforming adj. for survivorship bias Past performance is no guarantee of future results. Source: Vanguard calculations, using data from Morningstar, Inc. and Thompson Reuters Datastream as at 30 September

9 Active equity income funds have tended to favour smaller-cap Top 10 active equity income funds ranked by average market-cap Name Index fund Avg mkt. cap. ( m) Prospectus benchmark Vanguard FTSE UK All Share Index Unit Trust Yes 21, FTSE All Share Vanguard FTSE U.K. Equity Income Index Fund Yes 25, FTSE UK Equity Income Active Equity Income Fund A No 21, FTSE All Share Active Equity Income Fund B No 20, FTSE All Share Active Equity Income Fund C No 19, FTSE All Share Active Equity Income Fund D No 10, FTSE All Share Active Equity Income Fund E No 9, FTSE All Share Active Equity Income Fund F No 8, FTSE All Share Active Equity Income Fund G No 8, FTSE All Share Active Equity Income Fund H No 7, FTSE All Share Active Equity Income Fund I No 5, FTSE All Share Active Equity Income Fund J No FTSE All Share Notes: Top 10 active equity income funds are based on net cash flows over past 12-months. Source: Morningstar, Inc. Data as of 30 September,

10 Small-cap has outperformed in recent periods Rolling 36-month excess returns 15% Small outperforms 10% 5% 0% -5% -10% Small underperforms -15% Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Past performance is no guarantee of future results. Source: Vanguard calculations, using data from Thompson Reuters Datastream. Data to 30 September, Notes: Performance FTSE Small-Cap Index relative to the FTSE All-Share Index. 10

11 Persistence of equity income funds over past 10-years Performance for 5-years ending 30 September 2014 of funds from top half from 5-years ending 30 September % 50% 40% 30% 20% 10% 0% Stayed in top half Fell to bottom half Merged/liquidated Past performance is no guarantee of future results. Source: Vanguard calculations, using data from Morningstar, Inc. Data runs to 30 September, Notes: Performance relative to FTSE All Share Index. 11

12 Client pulls all assets Client pulls most assets Client pulls some assets Client asks questions Client pulls all assets Client pulls most assets Client pulls some assets Client asks questions Adding passive can help reduce risk Active portfolio Market return Portfolio s periodic return Adding passive Market return Source: Vanguard. Portfolio s periodic return 12

13 Passive can help capture the performance of equity income and lower volatility Rolling 36-month excess return relative to FTSE All Share Index 7% 5% 3% 1% -1% -3% -5% -7% Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr % Median Active Fund 100% Equity Income Index 50% Median Active Fund / 50% Equity Income Index Past performance is no guarantee of future results. Source: Vanguard calculations, using data from Thompson Reuters Datastream and Morningstar, Inc. Data to 30 September,

14 Financials Consumer Goods Oil & Gas Basic Materials Health Care Consumer Services Telecommunications Utilities Industrials Technology Sector positioning of equity income (in percent) 4% 3% 2% 1% 0% -1% -2% -3% -4% vs. FTSE All Share Index vs. FTSE All World Index Source: Vanguard. Data to 30 September, Notes: Sector positioning is represented by FTSE UK Equity Income Index. 14

15 Passive can help capture the performance of equity income and lower volatility Rolling 36-month excess return relative to FTSE All Share Index 20% 15% 10% 5% 0% -5% -10% Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec % Equity Income Index 100% Median Active Fund 50% Median Active Fund / 50% Equity Income Index Past performance is no guarantee of future results. Source: Vanguard calculations, using data from Thompson Reuters Datastream and Morningstar, Inc. Data to 30 September,

16 Dividend paying equities are not a substitute for bonds Median 3-month return during the worst quartile of global equity market performance % 2.0% 1.6% 2.5% 2.7% 3.4% 0.0% -0.1% -2.0% -4.0% -3.8% -3.7% -6.0% -5.0% -8.0% -6.5% Global Equities UK Dividend Equities Commodities UK REITs EM Bonds Global Corporates Diversified Global Bonds Global Government Bonds UK Gilts Past performance is no guarantee of future results. Sources: Vanguard, based on data from Barclays, Citigroup, JP Morgan, S&P, and FTSE. Notes: Displays the median monthly return of each asset class during the worst quartile of global equity market returns. UK Dividend Stocks as the FTSE 350 High Yield index, UK REITs defined as the FTSE/EPRA NAREIT Index, Commodities defined as the S&P GSCI index, EM Bonds defined as the JP Morgan Emerging Markets Bond Index, Global Corporate Bonds defined as the Barclays Global Corporate Index (hedged to GBP), Diversified global fixed income is defined as the Barclays Global Aggregate index (hedged to GBP), Global Government Bonds defined as the Barclays Global Treasury Index (hedged to GBP), and UK Gilts defined as the Citigroup World Government Bond index. All returns are in sterling terms with income reinvested, Figure covers the period Jan.1994-Dec

17 Key takeaways Investors in the UK have increasingly recognized the benefits of adding passive strategies to their portfolios. Indexing provides a simple, efficient investment strategy to access the markets, or segment of the market, at low cost. The theoretical implications of the zero sum game hold across a broad range of asset and sub-asset classes There are risk control benefits to adding passive funds to an active portfolio. Income producing equities should not be considered a substitute for bonds. A key advantage of tracker funds are their lower relative costs. 17

18 Appendix 18

19 No wealth is created through the payment of a dividend An equity pays a dividend Initial wealth Final wealth 3 Dividend Ex-dividend price A bond pays a coupon Initial wealth Final wealth 3 Coupon Principle Source: Vanguard. 19

20 Annual return Dividend payments are a capital budgeting decision Performance of FTSE All-Share constituents by dividend yield 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Highest dividend (1) 2 3 Lowest dividend (4) Income Return Price Return Past performance is no guarantee of future results. Source: Vanguard calculations, using data from Thompson Reuters Datastream. Notes: Performance represents 20-years to 31 December

21 The advantages of a total return approach Total return approach Pros: Maintains asset allocation Provides broader diversification No factor, duration, or credit overweight's Increases the longevity of the portfolio Lowers rebalancing events Income-only approach Pros: May be less complicated to implement Cons: More complicated to implement Cons: May shift asset allocation May shift sub-asset allocation Increases factor, duration, and credit risks Increases concentration risks Reduces longevity and future income generation Higher rebalancing events 21

22 Important information This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. This document is designed for use by, and is directed only at persons resident in the UK. The opinions expressed in this presentation are those of the individual speakers and may not be representative of Vanguard Asset Management, Limited. The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information on this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future performance. ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing. This fund invests in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall. Investments in smaller companies may be more volatile than investments in well-established blue chip companies. All rights in the FTSE All Share Index and FTSE UK Equity Income Index (the Indices ) vest in FTSE International Limited ( FTSE ). FTSE is a trademark of London Stock Exchange Group companies and is used by FTSE under licence. The Vanguard FTSE All Share Index Fund and Vanguard FTSE UK Equity Income Index Fund (the Products ) have been developed solely by Vanguard. The Index is calculated by FTSE or its agent. FTSE and its licensors are not connected to and do not sponsor, advise, recommend, endorse or promote the Products and do not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Indices or (b) investment in or operation of the Products. FTSE makes no claim, prediction, warranty or representation either as to the results to be obtained from the Products or the suitability of the Index for the purpose to which it is being put by Vanguard. The Authorised Corporate Director for Vanguard Investment Funds ICVC is Vanguard Investments UK, Limited. Vanguard Asset Management, Limited is a distributor of Vanguard Investment Funds ICVC. The Manager of Vanguard FTSE U.K. All Share Index Unit Trust ( Trust ) is Vanguard Investments UK, Limited. Vanguard Asset Management, Limited is a distributor of Vanguard FTSE U.K. All Share Index Unit Trust. Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority Vanguard Asset Management, Limited. All rights reserved. VAM

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