Our little systems have their day;
They have their day and cease to be

Tennyson, In Memoriam A.H.H.

This is my forty-fourth portfolio update. I complete this update monthly to check my progress against my goal.

Portfolio goal

My objective is to reach a portfolio of $2 180 000 by 1 July 2021. This would produce a real annual income of about $87 000 (in 2020 dollars).

This portfolio objective is based on an expected average real return of 3.99 per cent, or a nominal return of 6.49 per cent.

Portfolio summary

Vanguard Lifestrategy High Growth Fund	$716 680
Vanguard Lifestrategy Growth Fund	$41 103
Vanguard Lifestrategy Balanced Fund	$77 788
Vanguard Diversified Bonds Fund	$111 667
Vanguard Australian Shares ETF (VAS)	$202 336
Vanguard International Shares ETF (VGS)	$54 872
Betashares Australia 200 ETF (A200)	$230 058
Telstra shares (TLS)	$1 785
Insurance Australia Group shares (IAG)	$6 449
NIB Holdings shares (NHF)	$5 316
Gold ETF (GOLD.ASX)	$124 756
Secured physical gold	$20 070
Ratesetter (P2P lending)	$9 881
Bitcoin	$173 010
Raiz app (Aggressive portfolio)	$17 258
Spaceship Voyager app (Index portfolio)	$2 619
BrickX (P2P rental real estate)	$4 471
Total portfolio value	$1 800 119 (+$34 376 or 1.9%)

Asset allocation

Australian shares	41.1%
Global shares	22.2%
Emerging market shares	2.2%
International small companies	2.9%
Total international shares	27.3%
Total shares	68.4% (6.6% under)
Total property securities	0.2% (0.2% over)
Australian bonds	4.5%
International bonds	9.1%
Total bonds	13.6% (1.4% under)
Gold	8.0%
Bitcoin	9.6%
Gold and alternatives	17.7% (7.7% over)

Presented visually, below is a high-level view of the current asset allocation of the portfolio.

Comments

The portfolio has substantially increased this month, continuing the recovery in portfolio value since March.

The strong portfolio growth of over $34 000, or 1.9 per cent, returns the value of the portfolio close to that achieved at the end of February this year.

This month there was minimal movement in the value of Australian and global equity holdings, There was, however, a significant lift of around 6 per cent in the value of gold exchange traded fund units, as well as a rise in the value of Bitcoin holdings.

These movements have pushed the value of gold holdings to their highest level so far on the entire journey. Their total value has approximately doubled since the original major purchases across 2009 to 2015.

For most of the past year gold has functioned as a portfolio stabiliser, having a negative correlation to movements in Australian equities (of around -0.3 to -0.4). As low and negative bond rates spread across the world, however, the opportunity cost of holding gold is reduced, and its potential diversification benefits loom larger.

The fixed income holdings of the portfolio also continued to fall beneath the target allocation, making this question of what represents a defensive (or negatively correlated to equity) asset far from academic.

This steady fall is a function of the slow maturing of Ratesetter loans, which were largely made between 2015 and 2017. Ratesetter has recently advised of important changes to its market operation, and placed a fixed maximum cap on new loan rates. By replacing market set rates with maximum rates, the peer-to-peer lending platform appears to be shifting to more of a ‘intermediated’ role in which higher past returns (of around 8 to 9 per cent) will now no longer be possible.

The expanding value of gold and Bitcoin holdings since January last year have actually had the practical effect of driving new investments into equities, since effectively for each dollar of appreciation, for example, my target allocation to equities rises by seven dollars.

Consistent with this, investments this month have been in the Vanguard international  shares exchange-traded fund (VGS). This has been directed to bring my actual asset allocation more closely in line with the target split between Australian and global shares.

Fathoming out: franking credits and portfolio distributions 

Earlier last month I released a summary of portfolio income over the past half year. This, like all before it, noted that the summary was prepared on a purely ‘cash’ basis, reflecting dividends actually paid into a bank account, and excluding consideration of franking credits.

Franking credits are credits for company tax paid at the company level, which can be passed to individual shareholders, reducing their personal tax liability. They are not cash, but for a personal investor with tax liabilities they can have equivalent value. This means that comparing equity returns to other investments without factoring these credits can produce a distorted picture of an investor’s final after-tax return.

In past portfolio summaries I have noted an estimate for franking credits in footnotes, but updating the value for this recently resulted in a curiosity about the overall significance of this neglected element of my equity returns.

This neglect resulted from my perception earlier in the journey that they represented a marginal and abstract factor, which could effectively be assumed away for the sake of simplicity in reporting.

This is not a wholly unfair view, in the sense that income physically received and able to be spent is something definably different in kind than a notional ‘pre-payment’ credit for future tax costs. Yet, as the saying goes, because the prospect of personal tax is as certain as extinction from this world, in some senses a credit of this kind can be as valuable as a cash distribution.

Restoring the record: trends and drivers of franking credits

To collect a more accurate picture of the trends and drivers of franking credits I relied on a few sources – tax statements, records and the automatic franking credit estimates that the portfolio tracking site Sharesight generates.

The chart below sets out both the level and major different sources of franking credits received over the past eleven years.

From this chart some observations can be made.

• The level of franking credits has grown substantially over the past ten years – from a total of under $1 000 per year to around $8 000 annually.
• Recent years have seen a particularly high accrual of franking credits – such that by value, over half of the total value of franking credits has been received over the past three financial years.
• These credits now constitute a significant element in total realised returns – in the last financial year the value of franking credits represented a 12 per cent boost to the total level of cash distributions, and over the past two years they have contributed around $8 000 each year to the total level of after-tax returns. This is the equivalent of the portfolio paying nearly $700 per month in tax liabilities.

The key reason for the rapid growth over the recent decade has been the increased investment holdings in Australian equities. As part of the deliberate rebalancing towards Australian shares across the past two years, these holdings have expanded.

The chart below sets out the total value of Australian shares held over the comparable period. 

As an example, at the beginning of this record Australian equities valued at around $276 000 were held. Three years later, the holding were nearly three times larger.

The phase of consistently increasing the Australian equities holding to meet its allocated weighting is largely complete. This means that the period of rapid growth seen in the past few years is unlikely to repeat. Rather, growth will revert to be in proportion to total portfolio growth.

Close to cross-over: the credit card records

One of the most powerful initial motivators to reach financial independence was the concept of the ‘cross over’ point in Vicki Robins and Joe Dominguez’s Your Money or Your Life. This was the point at which monthly expenses are exceeded by investment income.

One of the metrics I have traced is this ‘cross-over’ point in relation to recorded credit card expenses. And this point is now close indeed.

Expenditures on the credit card have continued their downward trajectory across the past month. The three year rolling average of monthly credit card spending remains at its lowest point over the period of the journey. Distributions on the same basis now meet over 99 per cent of card expenses – with the gap now the equivalent of less than $50 per month.

The period since April of the achievement of a notional and contingent form of financial independence has continued.

The below chart illustrates this temporary state, setting out the extent to which portfolio distributions (red) cover estimated total expenses (green), measured month to month.

An alternative way to view the same data is to examine the degree to which total expenses (i.e. fixed payments not made on credit card added to monthly credit card expenses) are met by distributions received.

An updated version of this is seen in the chart below.

Interestingly, on a trend basis, this currently identifies a ‘crossing over’  point of trend distributions fully meeting total expenditure from around November 2019. This is not conclusive, however, as the trend curve is sensitive to the unusual COVID-19 related observations of the first half of this year, and could easily shift further downward if normal expense patterns resume.

One issue this analysis raises is what to do with the ‘credit card purchases‘ measure reported below. This measure is designed to provide a stylised benchmark of how close the current portfolio is to a target of generating the income required to meet an annual average credit card expenditure of $71 000.

The problem with this is that continued falling credit card spending means that average credit card spending is lower than that benchmark for all time horizons – measured as three and four year averages, or in fact taken as a whole since 2013. So the set benchmark may, if anything, be understating actual progress compared the graphs and data above by not reflecting changing spending levels.

In the past I have addressed this trend by reducing the benchmark. Over coming months, or perhaps at the end of the year, I will need to revisit both the meaning, and method, of setting this measure.

Progress

Progress against the objective, and the additional measures I have reached is set out below.

Measure	Portfolio	All Assets
Portfolio objective – $2 180 000 (or $87 000 pa)	82.6%	111.5%
Credit card purchases – $71 000 pa	100.7%	136.0%
Total expenses – $89 000 pa	80.7%	109.0%

Summary

One of the most challenging aspects of closing in on a fixed numerical target for financial independence with risk assets still in place is that the updrafts and downdrafts of market movements can push the goal further away, or surprisingly close.

There have been long period of the journey where the total value of portfolio has barely grown, despite regular investments being made. As an example, the portfolio ended 2018 lower than it started the year. The past six months have been another such period. This can create a sense of treading water.

Yet amidst the economic devastation affecting real lives and businesses, this is an extremely fortunate position to be in. Australia and the globe are set to experience an economic contraction far more severe than the Global Financial Crisis, with a lesser capacity than previously for interest rates to cushion the impact. Despite similar measures being adopted by governments to address the downturn, it is not clear whether these are fit for purpose.

Asset allocation in this environment – of being almost suspended between two realities – is a difficult problem. The history of markets can tell us that just when assets seem most ‘broken’, they can produce outsized returns. Yet the problem remains that far from being surrounded by broken markets, the proliferation appears to be in bubble-like conditions.

This recent podcast discussion with the founder of Grant’s Interest Rate Observer provided a useful historical context to current financial conditions this month. One of the themes of the conversation was ‘thinking the unthinkable’, such as a return of inflation. Similar, this Hoover Institute video discussion, with a ‘Back from the future’ premise, provides some entertaining, informed and insightful views on the surprising and contingent nature of what we know to be true.

Some of our little systems may well have had their day, but what could replace them remains obscured to any observer.