Sail past inflation with top UK dividends

Another way to safeguard yourself in this environment is to spread your risk across many companies, and a quick and easy way to do this, particularly if your portfolio is on the small side, is via a fund. However, due to low interest rates equity income investment trusts are in high demand and tend to trade at a premium to net asset value (NAV).

But another reasonably priced fund option is the iShares FTSE UK Dividend Plus exchange-traded fund (ETF). This ETF tracks the FTSE UK Dividend+ Index, which comprises the 50 highest-yielding stocks in the FTSE 350, excluding investment trusts index. At present, the ETF has a generous 5.52 per cent distribution yield which, before tax, outpaces both the Consumer Prices Index (CPI) and Retail Prices Index (RPI) inflation. The fund has also tracked its index well since the launch nearly six years ago, with a tracking error of less than 1 per cent.

But, instead of paying a premium for this, the total expense ratio (TER) on this fund is a very acceptable 0.4 per cent.

The ETF pays its dividends four times a year.

iShares FTSE UK Dividend Plus buys the shares it tracks rather than entering into a derivative swap with a counter party like some ETFs, which eliminates a potential risk. You are not reliant on the swap counter party, usually a bank or insurance company remaining solvent, or the basket of collateral which some synthetic ETFs hold as insurance, but which sometimes bears little resemblance to the assets the ETF is suppose to be tracking.

This means that iShares FTSE UK Dividend Plus is more transparent because you know exactly what assets it holds.

iShares funds are managed by BlackRock, one of the world's largest asset managers. To date, iShares ETFs, most of which invest in the assets they track rather than entering into swaps, have not encountered problems.

Although iShares FTSE UK Dividend Plus is domiciled in Dublin, it can be held within an individual savings account (Isa) and self-invested personal pension (Sipp), qualifying for the tax benefits these wrappers offer. It also has UK distributor status, so when you sell the shares you incur capital gains tax, which you can offset against your £10,600 yearly allowance, rather than income tax.

The 50 shares in the FTSE UK Dividend+ Index are selected by their one-year dividend yield forecast, and their weighting in the index is determined by their dividend yield rather than market cap. The index aims to capture the long-term effect of higher compounding returns and it benefits from lower correlations to traditional market cap weighted indices. The stocks in FTSE UK Dividend+ Index also have to be liquid: if they prevent the index from trading £75m within half a trading day, they are excluded.

The downside to an ETF is that is can never outperform its index, and is likely to always underperform it slightly because of running expenses and fees. Also, the holdings are selected just because of their yields and liquidity - there is not a fund manager to do due diligence on the company to assess if it has any positive attributes beyond a high yield. An ETF makes no judgement about whether a company's high yield is a good investment.

Taking the top 10 holdings, Aviva, Resolution, Catlin and Amlin are Investors Chronicle's buy tips, while Tui Travel , Halfords, Legal & General, Hays and RSA are sells.

However, on balance, this fund still offers a generous yield and decent growth prospects and is a good solution for investors who want instant diversification. BUY.

IC TIP RATING

Tip style: Income

Risk rating: Medium

Timescale: Medium to long term

Source: iShares.

Performance data as at 3 October 2011.

TOP 10 HOLDINGS as at 30 September 2011

SECTOR BREAKDOWN