As regular readers will be aware, the DIY Income Investor portfolio is steadily increasing its share of income-producing Exchange Traded Funds (ETFs). ETFs provide ready-made, low-cost and diversified funds but are more targeted than simple market tracker funds - and therefore (in my view) more powerful financial tools.
A reader asked whether it might be possible to identify an ETF-only portfolio. This might be attractive for a new investor or someone who does not want to be too involved in the investment process. This seemed like an interesting challenge; so, here goes...
To recap: there are lots and lots of weird and wonderful ETFs - but here we are considering only those that produce an income stream, be it from dividends or from the returns of fixed income securities (such as bonds or preference shares). This is because the key indicator we will be using in selecting what to buy is yield. The reason for this is that the basic assumption underlying the DIY Income Investor portfolio is that high yield is a result of the market being worried about a security - but the market tends to be manic-depressive, and most out-of-favour shares or bonds do seem to manage to recover. In addition, there is a wealth of evidence supporting the effectiveness of investing in (well-selected) dividend shares.Finally, any income-oriented portfolio produces a cash flow, which - together with any newly available cash - can be used to update and reorientate the portfolio.
Income-producing ETFs are usually based on a collection of different securities making up a specifically identified index, managed by a third party. As the ETF mechanically follows the index, the management costs can be held low.
The portfolio will be split into two main parts (based on the experience of the main DIY Income Investor portfolio):
- dividend income ETFs
- fixed-income (bond) ETFs
The reason for this split is to provide stability: if one particular market's share prices tumble, the bond prices usually hold up. And although the two types of security may be somewhat correlated in specific markets, looking at different global markets in dividend shares and fixed-income securities provides even more of an investment airbag again market melt-down.
One of the main advantages of ETFs is diversification: you are effectively buying a collection of different securities of a particular flavour - with being too exposed to the risk of one or two of them failing. This means that the portfolio can be constructed from just a handful of ETFs - because each one is a collection of dozens of individual holdings.
Finally, ETFs quoted locally (in my case, in London) are available for a range of geographical areas around the world. This means we can also follow development around the world as well as diversifying country and currency risk. This international diversity would be impractical to attempt by yourself on the basis of individual securities.
So, to sum up the potential advantages of a portfolio based on income-producing ETFs:
- based on a simple indicator: yield
- inherently well diversified (and therefore minimising individual and currency risks)
- global reach
- easy to manage (only a limited number of ETFs is required)
There is a big disadvantage: you are not going to get rich quickly investing like this. The more you diversify, the less spectacular becomes your performance (although your risks are - hopefully - much reduced). That means this investment style is likely to be quite boring. One option, might be to run the ETF portfolio in tandem with a more risky (and more exciting - if that's what you like) handful of individual income-producing securities: just like the present DIY Income Investor portfolio.
It has been a long time since I have written about the basic mechanics of income investing, so it might be useful to summarise the key points:
- don't think about investing until you have any debt well under control; in this climate of low interest rates it might seem attractive to 'borrow to invest' - but I wouldn't recommend that to anyone
- make sure you have sufficient 'emergency' cash savings to cover unforeseen expenditure; 'fire sales' are never pretty
- don't ignore the possibility of good cash returns (e.g. Ratesetter)
- minimise exposure to taxes (as allowed by the Law): in the UK this means using tax-protected investment accounts suck as ISAs and SIPPs
- use low-cost Internet-based investment brokers; you won't be using them much, so check for any 'inactivity' fees
The World ETF Income Portfolio
As described above, the main characteristics of the ETF Portfolio are:
- 50/50 split between dividend ETFs and fixed-income ETFs
- geographical diversification for each type of ETF
The selection of ETFs will be done based on yield. Therein lies one of the slight difficulties - the most comprehensive source of yield information for the UK-quoted ETFs seems to be the FT and Bloomberg (both of which provides a 'trailing twelve months' yield). However, they never seem to agree on a number! Of course this 'historical' yield is a backward-looking indicator (in terms of the income) but the price and yield trend gives a current view of how market sentiment is evolving (and helps to identify what is 'out of favour' - and therefore of potential interest to us.
In a previous article I summarised the range of suitable ETFs quoted in London. There are alternative ETFs available for most geographical areas.
To start the portfolio, you need to be reasonably well diversified into all the target markets - subject to a minimum yield threshold. To reinvest, you can let yield point you to the (potentially) most lucrative geographic market, whilst maintaining the broad 50/50 dividends/bonds split.
The Lite Version
Because ETFs are now available based on worldwide markets it is possible to create a portfolio based on just two ETFs: one World dividend ETF and one World fixed-income ETF.
The suggestions for this Lite Version of the portfolio are therefore (there are alternatives - see the link above):
- Global Dividend: Vanguard FTSE All-World High Dividend Yield UCITS ETF VHYL - 3.4% (USD version:VHYD) Achieving worldwide diversification with an expense ratio of only 0.29% is quite a feat
- Global Fixed-Income: iShares Global High Yield Corp Bond UCITS ETF IGHY - 4.8% (USD version HYLD) Tracks the performance of the Markit iBoxx USD Liquid
High Yield Capped Index
The Standard Version
This initial selection is based on current (historical) yields, with a minimum yield requirement of 4% There are alternative ETFs for most markets (see link above). New ETFs are being introduced all the time, so it is worth reviewing the market periodically.
- UK Dividend: iShares UK Dividend UCITS ETF IUKD - 4.55%. The 50 highest-yielding FTSE 350 stocks, excluding investment trusts, selected and weighted by one-year forecast dividend yield.
- UK Fixed-Income: none
- US Dividend: none
- US Fixed-Income: iShares $ High Yield Corporate Bond UCITS ETF SHYU - 5.2%
- Euroland Dividend: none [revision]
- Euroland Fixed-Income: iShares Euro High Yield Corporate Bond UCITS ETF SHYG - 5.3% (EUR version IHYG)
- Asia Pacific Dividend: iShares Asia Pacific Dividend UCITS ETF IAPD - 5.7% (USD version: IDAP)
- Asia Pacific Fixed-Income: none
- Emerging Markets Dividend: iShares Emerging Markets Dividend UCITS ETF SEDY - Yield 5.2% (USD version:IEDY)
- Emerging Markets Fixed-Income: iShares Emerging Markets Local Government Bond UCITS ETF SEML - 6.0%
So, there you have it: 6 ETFs providing a World ETF Income Portfolio, with an average yield of over 5%. In the case of four of the potential ETF geographical options there were no ETFs meeting the 4% yield threshold; that may change in the future.
Initially I would aim for a reasonably balanced portfolio: i.e. each holding would be in the range 10% to 20% of the portfolio total, maintaining a broad 50/50 split between dividends and fixed-income. Any new holdings would be selected on the basis of high yield, subtly changing the geographical balance. If the ETF yield dips below the baseline of 4% - and there is a capital gain - it would be an easy decision to sell it and look for something more attractive. Alternatively, you could just take the long view and hold for ever.
For now, this is a virtual portfolio only (unlike the very real DIY Income Investor portfolio). I'll be reporting on virtual progress, starting in the new financial year.
[Slight revision 23/4/15]
I am not a financial adviser 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.