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Investment trusts and ETFs for drawdown

Our pick of the best investment trusts and exchange traded funds for your DIY income drawdown portfolio
February 19, 2014

Annuities, the insurance product that gives you pension income for the rest of your life, hit the headlines last week for being a "broken market" which gives most pensioners a poor deal, according to a report from the Financial Conduct Authority. For those willing to keep some risk on the table, then income drawdown could be a better option.

Drawdown lets you keep your pension invested in the stock market while taking an income from it. But getting the underlying investment strategy right can be tricky. There are two things you need to get right if you're going to become a successful drawdown investor. The first is getting enough income to give you a good quality of life - without stripping too much meat from your pot too quickly and leaving yourself to survive off skin and bones during the last years of your life.

The second is picking the right investments for your portfolio. Earlier this month we hand-picked some actively managed open-ended funds that could work well for your portfolio, and this week we've looked at some investment trusts and exchange traded funds (ETFs) that could also be a good fit for you.

Constructing a drawdown portfolio

Your pension fund needs to service you for the remainder of your life, which thanks to improving life expectancy could be more than 20 years from the point of retirement.

Because of this, most advisers say the majority of your portfolio needs to be held in riskier assets to give you growth - rather than lower volatility ones. The right mix of investments should be tailored depending on your age and health, which are good indicators of how long you have left to live.

But analysts are mixed on how you should proportion the assets in your portfolio. Some prefer a 100 per cent equity portfolio with equity income funds dominating the allocation. Others say too many equities are a mistake, as even the most defensive equities and funds can fall by around a fifth in a bear market. And if a market drop occurs at the start of your drawdown period, it could be difficult to recoup.

That's why some investment advisers say you should hold a larger chunk of bonds in your drawdown portfolio, and then split the rest of the portfolio between absolute return and equities.

A moderate risk-balanced asset allocation might be 50 per cent equities, 25 per cent bonds, 10 per cent property, 10 per cent absolute return funds and the remaining 5 per cent in commodities.

Most advisers agree that having a mix of around five or six funds, investment trusts or ETFs is about the right number for a drawdown portfolio. Fewer than this might not be diverse enough, but many more could be too many to keep on top of. And reviewing your portfolio every year is also a good idea - so you can rebalance it if you need to.

How much income should you take?

A flat rate annuity would probably give you a rate of about 3 to 3.5 per cent in return for your pot - but you can safely do better than this if you're in drawdown. There is a maximum limit placed on how much income can be withdrawn each year, though. The most you can take is 120 per cent of the Government Actuary's Department (GAD) rate. When you first start using capped drawdown, your pension provider will work out the maximum allowable income by using a special set of tables provided to HM Revenue & Customs by the GAD. These tables take into account your age and gender as well as the prevailing 15-year gilt yields.

The GAD rate for a 65-year-old man is currently 6.1 per cent, meaning he could take a maximum £7,320 income from a £100,000 pension, using capped drawdown.

A 60-year-old retiring could sensibly take 4 per cent of their pot as income, but as they get older they could draw more - up to about 6.5 per cent - although unless you have a short life expectancy, that level would be likely to deplete the fund quickly.

What investments should you put in your portfolio?

Equity income investment trusts are ideal for drawdown portfolios because they give you the level of risk you need to get to grow your pot, and they also provide vital yield to support your income. Jason Hollands, head of business development at Bestinvest, says you need a combination of UK and Global equity income funds to spread the risk as much as possible. He says as much as half the equity portfolio could go to UK equity, though.

Standard Life's Equity Income Investment Trust (SLET) has a large concentration in small- and mid-cap companies. It's beaten its benchmark (FTSE All-Share) consistently for five years in terms of both net asset value (NAV) and share price, and it's on a tiny 0.28 per cent premium - which is small enough not to have to worry about. It is yielding 3.2 per cent. The manager, Thomas Moore, has a good track record and Ben Yearsley, head of funds research at Charles Stanley, thinks it could make a good long-term holding for a drawdown portfolio.

A cheaper way to get UK equity income is through an ETF. Like mutual funds, ETFs pool investor assets and buy stocks or bonds according to an index-style strategy. But ETFs trade like stocks, and you can buy or sell at any time. Many of them have very cheap TERs, which can make them good investments if you're looking to keep costs down. Becuase of this it can be a smart move to use ETFs to get exposure to areas of the market where actively managed funds struggle to beat the market.

We like iShares UK Dividend UCITS ETF (IUKD) which yields 4.18 per cent and has a TER of 0.4 per cent - a snip of the fees charged by most investment trusts. It follows the 50 highest yielding stocks of the 350 biggest companies (excluding investment trusts) on the London Stock Exchange. It's a sensible option for savers looking for an income as it tracks the firms with the lowest share price relative to the dividend they pay. It has a TER of 0.4 per cent. A more recent (and smaller) addition to the market is SPDR S&P UK Dividend Aristocrats ETF (UKDV) which also uses physical replication. It's yield is 4.02 per cent, according to its latest factsheet, and its TER is 0.3 per cent.

If you're looking for global equity income, Murray International (MYI) is an investment trust that could make an excellent long-term addition to your portfolio. Although the performance has suffered in recent months (it's heavy in emerging markets which have fallen heavily), and it's trading on a 6.14 per cent premium, it has still earned a place in our Top 100 Funds list for 2013. It is managed by Bruce Stout, a fund manger with a strong track record and a particular interest in conservatively managed companies. The trust also has a strong yield of 4.29 per cent - adding to its appeal.

An ETF alternative for global equity exposure is HSBC's MSCI World UCITS ETF (HMWD), which tracks the MSCI World index. It has a 1.9 per cent yield and is super cheap with a TER of 0.35 per cent.

For European Equity Income, Mr Yearsley likes Henderson's Eurotrust (HNE). It yields 2.18 per cent and is managed by John Bennett, who Mr Yearsley describes as a "quality manager". It is also relatively focused with about 50 holdings among larger companies.

A cheaper alternative for Europe exposure could be Man GLG Europe Plus Source ETF (MPFE). Its composition is dictated not by market capitalisations of its consituents, but by broker recommendations. Share tips from 65 brokers are fed into a computer programme, which filters them down to around 200 stocks. The screen filters only include stocks from 17 eligible European countries and removes those that are not easy to buy and sell. Its TER is 0.75 per cent.

Absolute Return

Designed to remain strong and steady - even in a bear market - these funds could be good to preserve capital and protect you from downside risk. On average absolute return funds are delivering yields of about 4 per cent, but if you're looking for an investment trust, you might have to sacrifice some yield for sustainable growth. We like Personal Assets Trust (PNL), which is managed by Sebastian Lyon. It earned a place in our Top 100 Funds list for 2013 and is a solid long-term core holding that will soldier on, regardless of the market. It has an ongoing charge of 0.95 per cent.

Bonds

If you want fixed income for your portfolio, investment trusts aren't the most popular way to invest, but we like Henderson Diversified Income (HDIV), which earned a place in our IC Top 100 Funds list for 2013. It aims to provide shareholders with a high level of income and capital growth over the long term by investing selectively across fixed income asset classes, including secured loans, high-yield and investment-grade corporate bonds. It has performed strongly in recent years as investor appetite for yield has resulted in a recovery in loan prices. The fund is managed by John Pattullo and Jenna Barnard, who run a number of successful open-ended bond funds at Henderson.

Also in our Top 100 Funds list is New City High Yield Fund (NCYF) - one of the longest established trusts focusing on debt. It aims to provide investors with a high gross dividend yield and the potential for capital growth by investing in high-yielding fixed-interest securities.

There are also some ETFs you can buy to get cheap bond exposure. We like iShares' Global Inflation-Linked Government Bond (IGIL), which has a TER of 0.25 per cent. It is good way to get a diversified exposure to bonds with inflation protection built in as it aims to track the performance of the Barclays World Government Inflation-Linked Bond Index, investing in physical index securities. It offers exposure to developed world government inflation-linked bonds issued in the domestic currency of each included country. If you're looking for a higher risk/return option, have a look at iShares JPMorgan $ Emerging Markets Bond UCITs ETF (SEMB). It has a 0.45 per cent TER, and the base currency is also in dollars.

Performance of recommended investment trusts

Investment trustTickerInception date1-yr return (%)3-yr return (cumulative%)5-yr return (cumulative%)Net expense ratio (%)12-month yield (%)*
Standard Life Equity Income ordSLET15/11/9125.8246.68138.520.973.31
Murray International ordMYI18/12/07-8.2818.29105.440.714.65
Henderson EuroTrust ordHNE6/07/9221.7644.84109.700.942.13
Personal Assets ordPNL22/07/83-4.7114.7055.910.891.73
Henderson Diversified Income ordHDIV18/07/0711.2527.11141.25na5.83
New City High Yield ord**NCYF9/12/043.9132.11121.901.206.84

Performance of recommended ETFs

ETFTickerInception date1-yr return (%)3-yr return (cumulative %)5-yr return (cumulative %)Net expense ratio (%)
iShares UK DividendIUKD4/11/0516.0931.44119.290.40
iShares JPMorgan USD Emerg Markets BondEMB17/12/07-11.6714.5944.990.60
SPDR S&P UK Div Aristocrats ETFUKDV28/02/1220.87nana0.30
HSBC ETFs PLC HSBC MSCI World ETFHMWO10/12/10nanana0.35
Source Man GLG Europe Plus ETFMPFE27/01/11nanana0.75
iShares Global Inflation Linked Govt Bd*IGIL1/08/08-9.549.3517.260.25

Source: Morningstar. Returns are shown as at 17 February 2014. *12-month yield as at 31 January 2014. **Returns as at 14 February 2014.