Two ETF portfolios for income in retirement

Choosing the right equity ETF

Mr Miller suggests a balanced portfolio of ETFs tracking UK and global equities indices and bond markets, with equities making up the biggest chunk of that. He recommends db X-trackers FTSE All-Share ETF (XASX) as a straightforward ETF which tracks the performance yield of the FTSE All-Share index. The fund currently pays dividends of 2.86 per cent.

He also recommends the iShares Core Japan IMI UCITS (SJPA) and iShares Core Emerging Markets IMI UCITS (EMIM) because they are some of the cheapest products available and both carry the appeal of being physically replicating products, making them more transparent.

When looking at ETFs tracking equities, it is important to decide whether to opt for a straightforward product replicating the whole of the market or select an ETF which targets only the largest or highest-yielding stocks within the index.

For US equities, Mr Miller suggests the Powershares RAFI US 1000 ETF (PSRF) fund as it focuses on the cheaper US stocks with potentially more appealing valuations. He says: "In the US you don't want to buy a conventional index, you want to buy something more tilted to the cheaper stocks."

The FTSE Rafi index was launched in 2005 and tries to reduce the exposure to overvalued stocks. It has less exposure to companies that have seen large increases in price compared to their earnings, setting it apart from other indices weighted by market cap.

Mr Mill also likes WisdomTree's ETF range, which targets stocks offering the best income growth over time rather than focusing purely on dividend yield, which can be deceptive.

WisdomTree products are weighted by annual cash dividends paid, meaning there is more chance of tracking larger, more sustainable businesses rather than smaller ones offering high yields. The WisdomTree Europe Small Cap Dividend (DFE) fund selects the companies comprising the bottom 25 per cent of the WisdomTree Europe Dividend Index based on market capitalisation after taking out the largest 300 companies.

It has an expense ratio of 0.388 per cent and in the last quarter of 2014 offered a strong dividend yield of 3.88 per cent.

Dividends vs accumulating funds

If you want to live off the returns from your portfolio, dividends may seem like the necessary option, in which case you need a fund with a distributing share class. However, in order to build up a solid pot which will not run dry in a matter of years, Mr Miller says growth and accumulation is also important. If you choose funds focused on high growth rather than high yield, you can sell units when necessary, giving you an income, and potentially secure a stronger pot in the long term.

"I think the more you invest in income, the less you get in capital, so in a way you should try to aim for return over dividends," says Mr Miller.

Several dividend-paying equity ETFs are also more expensive than their accumulating peers. "The [accumulating] iShare core ETFs have both large and small cap exposure," says Mr Miller. "You get something very well diversified without paying the charges of most similar funds charge."

"If you go through a low cost dealer it could be better to buy the cheaper ETF and sell down your units," he adds.

Alan Miller's portfolio

Focus on dividends and commercial property

The majority of Paul Taylor's portfolio is made up of distributing funds. He suggests channelling a healthy 40-60 per cent into a ETF such as the iShares UK Dividend UCITS (IUKD). This ETF is selective, tracking the performance of the FTSE UK Dividend+ Index as closely as possible. The index offers exposure to the 50 highest-yielding stocks within the FTSE 350 and weighted by one-year forecast dividend yields.

The fund does pay dividends, boasting a current dividend yield of 4.34 and is reasonably priced at 0.40 per cent. It also has the benefit of physically tracking its holdings, meaning there are no extra third-party fees or risks of price distortion through futures contracts.

The fund has closely tracked its benchmark over a five-year period too. In 2014 it returned 7 per cent compared with 7.69 for the benchmark and in 2013 returned 23.54 per cent against 24.25 per cent for the FTSE UK Dividend+ Index.

Mr Taylor says: "I would keep to the UK to avoid exchange rate issues for the bulk of portfolio and have FTSE UK Dividend Plus as a core holding if you can tolerate some volatility. I would suggest inflation proofing, as I believe inflation will return. Avoid high yield as the risk of default is greater and the yield is not high enough to justify the risk. With bonds so highly priced you are better off with good quality shares with high dividends."

He recommends channelling the rest of the portfolio into index-linked, corporate bond ETFs and also recommends investing in real estate investment trusts (Reits) as a way of building up value in your portfolio. He argues that in order to grow the pot, it is sensible to have a mixture of distributing and accumulating assets.

"We don't see a rise in value coming from gilt bond funds in the current environment so it makes sense to have income generating assets there. We get underlying growth from the UK Equity and the property funds as well as good yields."

He likes Tritax Big Box REIT (BBOX) and recommends it as a small chunk of the portfolio. The commercial property fund manager became the first listed pure 'big box' real estate investment fund back in 2013 and set out to capitalise on the growing demand for vast warehouse space from online retail giants like Amazon and Ocado.

The yield on the fund is 3.9 per cent and the fund's shares have consistently traded at a premium to NAV. Mr Taylor says: "While the fund is already a reasonable size, the manager and board clearly have aspirations to grow it further.

"The fund's prospective dividend yield is attractive and its blue chip tenant base provides a very good level of income security, which should provide comfort over its targeted gearing level."

Investing in bond ETFs

When it comes to index-linked ETFs, iShares £ Index-Linked Gilts (INXG) is a good option for gaining exposure to a broad basket of UK government bonds while taking an income from the dividends, which are paid out on a semi-annual basis. The fund is cheap, with a total expense ratio of 0.25 per cent, and gives exposure to sterling-denominated, investment-grade government bonds.

Mr Taylor also recommends iShares £ Corporate Bond Ex Financials (ISXF). This fund has an ongoing charge of 0.20 per cent but also occupies the less risky end of the corporate bond market by excluding financials, which tend to carry higher risk than industrial or utility companies. It is included in both Mr Taylor and Mr Miller's portfolios.

However, according to Morningstar analyst Kenneth Lamont, investors should be aware of the risks with this fund connected to inflation and currency. GBP-denominated corporate bonds tend to have longer maturities than euro-denominated funds, connected to higher demand from pension funds. This means that the ETF tracks an index with a longer maturity (in this case ~14 years) and duration metrics (modified duration of ~8.5) and will be more vulnerable to higher losses when interest rates start to rise.

Paul Taylor's portfolio

Notes: *Annual management reduces to 0.9 per cent above £500m up to and including £750m, 0.8 per cent above £750m up to and including £1bn and 0.7 per cent above £1bn.

• After rounding up Mr Miller and Mr Taylor's recommendations, we will be keeping an eye on the performance of the portfolios and posting updates.