With interest rates stuck at rock bottom and markets close to record highs, coaxing a portfolio into producing a reliable income is a challenge.
Many income investors rely on well known active funds that invest in British shares, such as Woodford Equity Income and Jupiter Income.
However, with low yields across the board the margins are fine, while the fees charged by active managers can significantly eat into your income.
As an alternative, Telegraph Money has examined how to build an income portfolio out of cheap “passive” or “tracker” funds, included exchange-traded funds (ETFs), and outlined the pros and cons of this approach.
In terms of cost, the benefits are clear. The average “ongoing charge figure” for funds in the Investment Association’s UK equity income sector is 0.9pc, with transaction costs on top. In our passive portfolio, the average ongoing charge is two thirds less at 0.29pc.
For a £250,000 Isa portfolio, that’s the difference between an income of £6,500 and an income of £8,025, assuming a 3.5pc yield and ignoring capital growth. The hidden transaction costs will be lower too.
Investing in entire indices also spreads investors’ money across an enormous range of bonds and shares, aiding diversification.
The main drawback with tracker funds as opposed to active managers is that they do not distinguish between companies whose dividends appear secure and those whose payouts look shaky.
A tracker may hold a stock that yields 7pc but doesn’t have the profits to cover its dividend. An active manager is likely to avoid such shares.
As a result, an active fund that yields 3.5pc and a tracker that yields 3.5pc may have very different levels of dividend security. The tracker is also likely to include companies that don’t pay a dividend at all.
Additionally, some indices are massively skewed towards certain companies. For instance, in the FTSE 100 index, which yields 3.8pc, Shell and BP account for 15pc of all dividend income. Relying on that index for income therefore involves a bet on the oil price.
There are more diverse markets, such as the US, where that isn’t a problem – but those markets also tend to offer lower yields.
On the bond side, indices are typically weighted according to the size of firms’ bond issues.
Therefore, investors in a bond tracker fund will have more money in those companies that have the greatest amount of debt.
Of course, larger companies would be expected to have larger debts. But it also means that companies with a massive amount of debt relative to their size will be bought heavily.
Ben Willis of Whitechurch Securities, the wealth manager, produced a tracker income portfolio for Telegraph Money. It consists solely of tracker funds, including some so-called “smart beta” funds, and exchange-traded funds.
It yields 3.6pc overall and is split almost into thirds between bonds, UK shares and global shares.
In terms of risk, it sits in the middle of the road. There is significant exposure to shares out of necessity: Mr Willis highlighted the lack of passive options with which to invest in traditional income-producing assets such as commercial property.
He said: “To get closer to a 4pc yield would require a higher weighting to shares, meaning much more risk. With an actively managed or mixed portfolio, a 4pc income may be achievable with better diversification, and lower risk – but substantially higher charges.”
Bonds – 32pc
- iShares Global High Yield Corporate Bond (12pc) – 4.9pc yield, 0.5pc ongoing annual charge
- L&G Sterling Corporate Bond Index (10pc) – 2.2pc yield, 0.14pc charge
- Vanguard Global Bond Index Hedged (10pc) – 1.6pc yield, 0.15pc charge
Mr Willis said: “The starting point was to use relatively simple index-tracking funds. The Vanguard fund provides exposure to lower-risk government and company bonds, hence its low yield.
“The L&G fund focuses on marginally higher-risk company bonds. Lastly, an ETF was the only way to gain significant exposure to a global high-yield bond index.”
UK shares – 32pc
- L&G UK 100 Index (10pc) – 3.3pc yield, 0.1pc charge
- HSBC FTSE 250 Index (10pc) – 2.5pc yield, 0.18pc charge
- Vanguard FTSE UK Equity Income Index (12pc) – 4.5pc yield, 0.22pc charge
Mr Willis said: “The UK is an established dividend market offering a core source of income for lots of investors – the L&G fund tracks the UK’s 100 biggest companies at a very low cost.
“The Vanguard fund specifically tracks the leading dividend-paying companies, which is why it has a much higher yield.
“The HSBC fund offers exposure to UK medium-sized companies, adding a different income source – valuable as diversification.”
Global shares – 36pc
- WisdomTree Europe Equity Income ETF (12pc) – 5.3pc yield, 0.29pc charge
- Schroder US Equity Income Maximiser (12pc) – 5.1pc yield, 0.4pc charge
- Vanguard Pacific ex Japan Stock Index (6pc) – 3.9pc yield, 0.23pc charge
- iShares Emerging Markets Dividend ETF (6pc) – 4pc yield, 0.65pc charge
Mr Willis said: “The global shares component was more challenging. The US is typically a low-yielding market. The Schroder fund, a new launch, tracks the S&P 500 index but gives up some potential capital growth in return for immediate income, targeting a 5pc yield.
“There is no European equivalent of the Vanguard UK fund, so an ETF was the only option. The WisdomTree fund has low charges and an attractive yield.
“The final two positions – Vanguard Pacific ex Japan Stock Index and iShares Emerging Markets Dividend – are higher risk, and there to further diversify the income sources as well as provide some long-term growth potential.”
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