Wednesday, 9 February 2011

ETFs for Income (US, UK)

Although generally the DIY Income Investor approach is based on avoiding paying someone to do what you could do yourself, one exception is Exchange Traded Funds or ETFs. There are now many attractive income-oriented ETFs - both bond and dividend-oriented - on both sides of the Atlantic.

These are a great way to start investing in the stock market, in the asset classes of shares, corporate bonds and government stock (gilts). They spread risk through diversified holding (and so are reasonably safe from defaults and bankrupty) and also have very low management costs compared to actively-managed funds (an asset class that we definitely would not recommend for DIYII).

The problem with most share and bond funds (i.e. not ETFs) lies with the charges and lack of consistent performance over time. Whilst there are clear benefits for investors using the expertise and diversification benefits of a fund, total expense ratios (TERs) of between 1 - 1.5% on traditional managed funds effectively wipe out any advantage this management expertise (if it indeed exists at all!). This is particularly true for fixed income assets in a low interest rate environment where the estimated yield of the underlying assets may only be 3 to 6%.

Charges for ETFs are generally in the region of 0.2%, a reasonable price to pay for the benefit of a structured and diversified portfolio.

US

In the fixed income sector, US investors can choose from a wide range of funds from competing providers covering most of the asset-class sub-sectors one can imagine; Treasury, Municipal, Mortgage Backed, Corporate, Emerging Market etc etc.

As reported recently by Kiplinger (US), ETFs charge low fees, offer instant liquidity (and in the US keep your tax bill down because they rarely distribute short-term capital gains).  ETFs’ low expenses are especially helpful in the low-yield world of government and corporate bonds - although they may not make the same returns as a few of the actively managed funds (with much higher annual charges, of course). See the article for recommendations.

UK

As reported by Fixed Income Investor, the sterling bonds markets are rather less deep and diverse than their US equivalents. This is not surprising given the respective size of the two economies and partly due to this, the choice of fixed income ETFs for sterling-based investors is a little more limited.

However the iShares series of ETFs offers a reasonable line-up with ETF available for gilts, index linked gilts and corporate bonds. In particular:
There are some potential tax issues with some UK ETFs but if you are using an ISA to hold them, there should be no problem.



I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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