Core passive funds for your Isa

We have set out 10 passive fund suggestions spanning five categories: equities for growth, equities for income, fixed income, commodities and smart beta.

EQUITIES FOR GROWTH

SPDR MSCI Emerging Markets Small Cap UCITS ETF (EMSM)

With many developed markets looking highly valued, investors seeking growth should consider the potentially higher rewards and risks of emerging market equities. The fastest growth here is likely to come from the smaller end of the market, so Alan Miller, founder of wealth manager SCM Direct, says: "An excellent way to access the growth of emerging market smaller companies is SPDR MSCI Emerging Markets Small Cap UCITS ETF. This charges 0.55 per cent and is invested across 906 companies. This has one of the highest underlying growth rates of earnings for any ETF within our analysis, indicating an underlying growth rate of 14 per cent a year, while the price/earnings ratio is just 13.3 times."

This is the only small-cap emerging market ETF available on the London Stock Exchange. MSCI Emerging Markets Small Cap index is less concentrated in China than its comparable parent index, MSCI Emerging Markets, and over five years has returned 39.7 per cent, compared with 27 per cent for MSCI Emerging Markets. However it has been volatile and investors should not expect a smooth ride.

SPDR MSCI ACWI UCITS ETF (ACWI)

It is important to have a core base of global equities within your portfolio, as well as more targeted allocations to specific countries and asset classes. And SPDR MSCI ACWI UCITS ETF is an easy way to access a large swath of global equities via a single fund.

The index it tracks, MSCI ACWI, is a broad benchmark encompassing large and mid-cap stocks across 23 developed markets and 23 emerging markets, with 2,484 constituents. Unlike some other global indices it includes emerging markets, meaning it is likely to offer exposure to some faster-growth companies and countries.

Oliver Smith, portfolio manager at IG, likes SPDR MSCI ACWI UCITS ETF and says: "This ETF reinvests dividends, saving on dealing costs over time."

The ETF was launched in May 2011 and has an ongoing charge of 0.4 per cent. It has returned 90.8 per cent over five years and 41.5 per cent over one. Financials account for 18.7 per cent of the ETF's assets and IT is the second largest sector weighting at 16.9 per cent.

The US is its largest geographic allocation at just over 55 per cent of assets. This means that you may want to consider what other US exposure you have in your portfolio before investing in it. The UK, however, only accounts for 6 per cent of the ETF's assets.

EQUITIES FOR INCOME

SPDR S&P Euro Dividend Aristocrats UCITS ETF (EUDV)

ETFs that track income-generating shares are becoming increasingly sophisticated, and the SPDR Dividend Aristocrats range is among the most popular of these due to its focus on companies with long-term track records of increasing or maintaining dividends.

S&P Euro Dividend Aristocrats index measures the performance of the 40 highest dividend-yielding Eurozone companies within the S&P Europe Broad Market index which have increased or held their dividends for at least 10 consecutive years. This results in a concentrated portfolio of 39 holdings, but means that SPDR S&P Euro Dividend Aristocrats UCITS ETF has delivered consistent results and generated higher returns than broader European equity ETFs over the long term. SPDR S&P 500 Euro Dividend Aristocrats has returned 25.3 per cent over three years and has a 12-month distribution yield of 3.04 per cent. Its portfolio has a price-to-book ratio of 1.72.

James McManus, analyst at wealth manager Nutmeg, says: "We continue to favour the S&P Dividend Aristocrats indices due to their focus on long-term sustainable dividends and currently hold this ETF in our portfolios."

Vanguard FTSE All-World High Dividend Yield UCITS ETF (VHYD)

This is a broad and well-diversified global equity income ETF that tracks an index comprising more than 1,000 stocks. This index aims to isolate the highest-paying stocks in the year ahead by ranking them according to forecast dividend yield. It screens for stocks from the FTSE All World index with a higher than average dividend yield and then ranks them by 12-month forward dividend yield, until the market capitalisation reaches 50 per cent of the total universe of stocks.

Vanguard FTSE All-World High Dividend Yield UCITS ETF has a high weighting of over 40 per cent to the US, and it is also overweight the technology sector, which increases its risk. And it does not screen for dividend sustainability, meaning stocks with unsustainable yields could be included in its portfolio.

However Mr Smith says: "This ETF has a value tilt, with a 26 per cent allocation to financials, which should provide an opportunity if rates start to rise globally."

The ETF also has an attractive yield of about 3.1 per cent. It excludes real estate investment trusts (Reits), and stocks forecast to pay no dividend in the next 12 months or which have no dividend information available. Vanguard FTSE All-World High Dividend Yield has an ongoing charge of 0.29 per cent, and is fairly large and liquid with a size of about $500m.

FIXED INCOME

Lyxor FTSE Actuaries UK Gilts 0-5 Y UCITS ETF (GIL5)

The number of ETFs that track bond indices has grown, meaning it is possible to be far more targeted about the point on the yield curve you are exposed to. This is particularly important at a time when rising inflation and interest rates are undermining the value of longer-dated bonds. Fixed income remains an important way to diversify portfolios and get income, but investors should be careful about how much interest rate risk they are taking.

Mr McManus says: "Lyxor FTSE Actuaries UK Gilts 0-5 Y UCITS ETF is our core pick for fixed income. It is the market leader in terms of management fees and total cost of ownership, and the lower duration of the underlying bonds reduces the sensitivity to interest rate changes."

The ETF tracks an index of 14 gilts, which it has succeeded in doing closely.

Gilts are not a cheap area to invest in just now, and this market could struggle if interest rates rise and yields increase elsewhere. However for a core exposure this is a low-cost way to access the shorter end of the gilt yield curve - the ETF has an ongoing charge of just 0.07 per cent.

iShares £ Corporate Bond 0-5yr UCITS ETF (IS15)

Corporate bonds offer a higher yield than UK gilts due to their slightly higher risk - iShares £ Corporate Bond 0-5yr UCITS ETF has a yield of 2.55 per cent. However 53 per cent of its assets are in investment-grade bonds rated BBB or above, meaning their default risk is low.

And the ETF has low exposure to interest rate risk as the majority of its bonds mature in between one and three years. "I would advocate taking shorter duration positions in bonds at the moment," says Ben Seager-Scott, director of investment strategy and research at Tilney Group. "Long-dated gilts look unattractive and although they have come off their Brexit lows, they still seem to have greater downside risk than upside potential."

Of the 253 bonds in iShares £ Corporate Bond 0-5yr UCITS ETF's portfolio, Barclays Bank and UBS bonds account for the largest two allocations - 2.68 per cent and 1.03 per cent of assets, respectively.

The ETF has an ongoing charge of just 0.2 per cent and has tracked its benchmark, Markit iBoxx GBP Corporates 0-5 Index, closely. It is also large at £1.3bn in size.

SMART-BETA STRATEGIES

PowerShares FTSE RAFI US 1000 UCITS ETF (PRUS)

The US is a good place to use passive funds as active managers struggle to outperform this market due to the number of analysts covering each stock. This ETF tracks an alternatively-weighted index that uses a number of factors to weight stocks: book value, income, sales and dividends. The ETF also tends to be weighted towards value stocks, but should be able to capture financially sound businesses as well.

Value investing has been out of favour for a number of years, while quality and growth strategies have outperformed. However, if economic growth continues to improve in the US and interest rates rise, value is likely to be the better style to back due to its focus on well-priced businesses with the potential for a re-rating. PowerShares FTSE RAFI US 1000 UCITS ETF also has one-fifth of its assets in financials stocks, which should do well in the event of an interest rate hike.

The RAFI process has a relatively long track record compared with many other smart-beta ETF strategies, but has had periods of underperformance against the S&P 500 index when its style is not in favour. The ETF has an ongoing charge of 0.39 per cent and a long track record of 10 years.

iShares Edge MSCI Emerging Markets Minimum Volatility UCITS ETF (EMV)

Minimum volatility ETFs are one of the more established ways of using themes or factors in a passive portfolio, and can help to protect against losses in turbulent markets. This means iShares Edge MSCI Emerging Markets Minimum Volatility UCITS ETF could be a good way for cautious investors to track emerging market equities.

"iShares MSCI Emerging Markets Minimum Volatility helps dampen down some of the volatility associated with this high-risk region," says Mr Seager-Scott. "Although this also tends to mean lower returns in rising markets, over the long term these strategies can still perform thanks to a more attractive risk-adjusted return profile through the cycle."

The index the ETF tracks is composed of emerging market equities with a lower volatility than the wider MSCI Emerging Markets index, and it has slightly lower weightings to China and the financial sector alongside a higher weighting to consumer staples stocks. In 2011, when MSCI Emerging Markets index lost 17.8 per cent, MSCI Emerging Markets Minimum Volatility only fell by 5.5 per cent.

iShares Edge MSCI Emerging Markets Minimum Volatility UCITS ETF has 258 holdings and an ongoing charge of 0.4 per cent.

Mr McManus says: "We have recently added this fund to our portfolios on the basis that the outlook for emerging markets has improved somewhat, but performance is likely to remain volatile. The strategy provides upside exposure to emerging markets while offering a degree of protection against market volatility."

COMMODITIES

Source Physical Gold P-ETC (SGLD)

Exchange traded commodities (ETCs) are one of the best ways to get direct exposure to commodities because they deliver the return of the spot price, rather than that of the shares of commodity-related companies.

Jason Hollands, managing director at Tilney Group, says: "A little bit of physical gold in a portfolio could be considered an insurance policy against a loss of confidence in the financial system."

Mr Smith adds: "Gold is an event-risk hedge at a time when volatility remains low despite the policy and political risks on the horizon. We like Source Physical Gold P-ETC, which provides exposure to the spot Gold price, ample liquidity and a competitive total cost of ownership."

This ETC is physically backed by gold bullion held in JPMorgan Chase's London vaults and delivers investors the return of the London Bullion Market Association (LBMA) gold price, the recognised benchmark for the precious metal. It has an ongoing charge of 0.29 per cent, and is large and liquid with a size of $3.7bn. It also has a relatively long track record having been launched in June 2009.

Mr Seager-Scott says: "A combination of low correlation with traditional asset classes and its use as a store of wealth, particularly when fiat money has been subject to conventional and aggressive monetary policy, means it could be an effective form of insurance if recent market exuberance reverses."

Source Bloomberg Commodity UCITS ETF (CMOD)

This ETF only launched in January, but is already being recommended by several wealth managers due to its competitive ongoing charge and breadth of coverage. The ETF tracks Bloomberg Commodities Index, comprised of 24 commodities in areas including energy, grains, industrial metals, precious metals, softs and livestock.

Like many commodity ETFs, Source Bloomberg Commodity UCITS ETF does not physically hold the assets it invests in but pays a counterparty to deliver the return of those assets in exchange for a fee, and holds a basket of Treasury bills as collateral.

"This ETF weights the commodities two-thirds by liquidity and one-third by global production, with caps on individual group weightings to ensure diversification," says Mr Miller.

Lynn Hutchinson, assistant director at Charles Stanley Pan Asset, adds: "This is the cheapest available commodity ETF in Europe with a management fee of 19 per cent and a derivative swap fee of 21 per cent. Since its recent launch the ETF has already attracted incredibly high inflows of over $1bn."

Commodities are likely to prove volatile in the coming months, but the recent rally could continue due to factors such as a better supply/demand balance for oil and industrial metals, as well as a potential boost to infrastructure spending in the US and UK.

Performance of ETFs and relative indices (cumulative total return, %)

Source: FE Analytics, as at 24.02.17 **Index information not available

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