ETF income portfolios profit from Brexit

The portfolios were constructed by Alan Miller, founder of SCM Group, and Paul Taylor, chief investment officer of McCarthy Taylor.

Mr Miller's portfolio, which boasts a significant chunk of overseas equities and emerging market bonds, was up almost 12 per cent in capital growth terms between 1 February and 1 July 2016. As it's largely an accumulating portfolio, it has a yield of only about 1.53 per cent. However, the aim with this portfolio is for investors to take income by selling down their holdings rather than receiving dividends from the ETFs. He estimates that the underlying portfolio yield is around 3.6 per cent.

He says: "The current yield to maturity of the underlying bonds within the ETFs is 3.37 per cent and the underlying equities have a dividend yield of 3.72 per cent. Since the portfolio is made up of 70 per cent equities and 30 per cent bonds, the weighted yield is actually 3.6 per cent before all costs and expenses."

The weighted average ongoing charge is 0.29 per cent, resulting in an underlying yield of about 3.3 per cent a year."

The big success stories in his portfolio are emerging market equities and bonds, which have taken off since February due to fundamental factors and the outcome of the Brexit vote. iShares Core Emerging Markets IMI UCITS ETF (EIMI) is up 23.24 per cent between February and July, and SPDR MSCI Emerging Markets Small Cap UCITS ETF (EMSD) returned just under 20 per cent.

In February, Mr Miller scaled down his allocation to emerging market small-caps so that he could put more of his portfolio into emerging market large-caps via iShares Core Emerging Markets IMI UCITS ETF. He thought the outperformance of small-caps against large-caps in the region was coming to an end and appears to have timed that call correctly, at least for now. The larger index - which includes large, small and mid-caps - has outperformed the MSCI Emerging Markets Small Cap index so far in 2016 after underperforming it in the previous year.

Jan Dehn, head of research at Ashmore, says "the big global trade right now is emerging markets". That is partly related to Brexit, but mainly because emerging markets have been out of favour in recent years and that is now starting to change. Despite numerous hurdles, including low oil prices, a rallying dollar and falling commodity prices - all of which should have hurt emerging markets - Mr Dehn says "emerging market fundamentals failed to implode over the past few years despite severe headwinds. This has created a lot of value in emerging markets while there is precious little value left in developed markets".

Mr Miller adds that "valuations on a lot of emerging market stocks were, on virtually every single measure, the lowest in five, six or seven years, and this bounce back is partly because sentiment was so against emerging markets [in the run-up to 2016]".

The fact that emerging markets are largely insulated from Brexit also matters, as does the likelihood that US and UK central bank policy will remain loose.

A weaker pound and dollar, meanwhile, are helping those countries and the returns for UK investors from overseas equities. In local currency terms, iShares Core Emerging Markets IMI UCITS ETF would have returned just over 10 per cent in the year to date, compared with more than double that in sterling returns.

PIMCO Emerging Markets Advantage Local Bond Index Source UCITS ETF (EMLP) is the top performing ETF in Mr Miller's portfolio since February with a return of over 24 per cent. Low interest rates in the developed world mean that the yield on local currency emerging market bonds is now far higher than on those in the developed world. However, the PIMCO Emerging Markets Advantage Local Currency Bond index, which this ETF tracks, has already soared this year and prices on emerging markets bonds are high, meaning they might not be able to keep moving up.

Russia and Brazil feature heavily in this index, accounting for almost 30 per cent, but the ETF tries to reduce the risk of being overly exposed to the most indebted countries by weighting countries by gross domestic product (GDP) and limiting each to a maximum weight of 15 per cent.

Mr Taylor's portfolio has more income-generating ETFs and far larger weightings to UK equities and bonds, so has fared less well, returning just over 5 per cent. However, it has a higher yield of almost 4 per cent.

iShares FTSE 250 UCITS ETF (MIDD) was hit hard by the outcome of the Brexit vote due to the domestic bias of the FTSE 250, and has fallen 2.7 per cent in the year to date. It has recovered the steep losses in the days following the vote, but the ETF's performance remains modest compared with emerging market indices, which are up by more than 20 per cent.

Best income ETFs

Mr Taylor's best ETFs for growth are concentrated in his bond portfolio, but his highest-yielding ETF by some margin is iShares UK Dividend UCITS ETF (IUKD). This ETF offers exposure to the highest-yielding subset of the FTSE 350 and has a yield of over 6 per cent - higher than when we checked the portfolio in February.

However, that yield could be a signal of unsustainable dividends in the FTSE 350. According to The Share Centre, the UK's largest stocks are paying out more in dividends than they are making in profits - a phenomenon last seen in the financial crisis. Dividend cover is below 1.0 times after falling 38 per cent in the past year. Banks, miners and oil producers are the hardest hit, and the FTSE 100 is home to the worst affected stocks.

But in the short term, the dramatic slide in sterling post-Brexit is flattering the payouts of those stocks for UK investors. According to Capita, sterling's devaluation will boost dividends by £4.3bn this year. Two-fifths of the dividends paid by UK-listed companies are declared in dollars or euros, meaning that a weaker exchange rate has resulted in a boon for UK investors in those stocks. "Even though steep cuts are still coming through from a number of large mining concerns, banks and others, overall they are being largely offset by the much weaker pound," says Capita.

Mr Taylor says: "I think some dividends in the FTSE 350 could be difficult to sustain, but the rise in the oil price should start to feed through soon and we have got an increase in demand for commodities, which will benefit the miners, who we thought could struggle to maintain their yields."

According to Trustnet, over three years iShares UK Dividend UCITs ETF would have earned an investor income of £15.19 on an initial investment of £100 and over one year paid out £5. It pays quarterly dividends and in total paid 50p a share in its last financial year.

Its top 10 holdings include Royal Dutch Shell (RDSA), BP (BP), HSBC (HSBA) and Weir Group (WEIR).

Other good equity payers include Wisdomtree Europe SmallCap Dividend UCITS ETF (DFE), which aims to isolate dividend-paying smaller companies in Europe with the best chance of offering growth and sustainable yields. It selects companies using annual cash dividends paid rather than looking at yield alone, and would have paid out £7.69 on an initial investment of £100 over three years, according to Trustnet. It has also performed well in capital growth terms despite Brexit headwinds.

Bonds and the Brexit effect

The top income-payers across both portfolios were bond ETFs. Bonds are a controversial area due to their steep prices, with many investors questioning whether they have further to run. But both Mr Miller and Mr Taylor have a sizeable chunk of their portfolios in bond ETFs which have paid out consistent incomes.

The iShares £ Corporate Bond ex Financials UCITS ETF (ISXF) has been a particularly good income-payer, having already paid out £1.40 this year. Over three years, an investment of £100 would have generated an income of £10.11, making it one of the best payers in the portfolios. The ETF is made up of sterling-denominated investment-grade corporate bonds issued by non-financial institutions. In the four months since February, it has generated impressive capital growth as well as a healthy income stream, having risen 10.17 per cent between 1 February and 1 July 2016. However, it is expensive and its 1.84 per cent yield partly reflects that. The risk is that those prices cannot continue heading upwards.

Corporate bonds were buoyed immediately after the UK referendum as markets believed further easing by the Bank of England (BoE) could relax borrowing costs for UK corporates. But the BoE's decision to leave rates at 0.5 per cent could cause a reaction in those markets.

"The risk in relation to corporate bonds is that they are overpriced," says Mr Taylor. "But I don't think there is a default risk. At some point the prices have to come down, but we take the view that the spread is still right and the ETF has done the job very well.

"With bank base rates staying at 0.5 per cent where can you go for income? It has got to be corporate bonds. The main risk is that they are expensive and that there will be capital loss when the market returns to a more normal trend, but it's hard to say when that will be."

Mr Taylor's top-performing bond ETF is iShares Global Inflation Linked Government Bond UCITS (SGIL), which has risen by 14.6 per cent since February. It offers exposure to inflation-linked bonds issued by major developed economies and is dollar-denominated. Over three years it would have generated an income of £6.44 on £100 invested.

iShares Global High Yield Corporate Bond GBP Hedged UCITs ETF (GHYS) was a new introduction to the portfolio in February and over three years would have generated £14.18 income on £100 invested, and £5.03 over one year. In the year to date, it has already paid out dividends of £2.47. That is far higher than most bonds and it yields 5.27 per cent, reflecting the higher-risk nature of the high-yield market.

But Mr Miller is uneasy about this ETF following the steep rise in high-yield bond prices, especially when you can get comparable yields on what he feels are less risky emerging market bonds.

"Global high yield generally makes me nervous and following the recovery in the oil price a lot of those bonds have bounced back," he explains. "The yields on many sovereign emerging market debt ETFs are similar to this high-yield corporate bond ETF, and if you were to ask me which I would rather lend to - sovereign governments or riskier companies - I know which I would choose."

Mr Miller argues that "there is an anomaly in yields" between emerging and developed market economies due to the fact that emerging market bonds yield two to three times the amount that developed market ones do without a much greater default risk. "They also tend to be shorter dated so you would be better off in the case of an interest rate rise," he adds.

Portfolio changes

Mr Miller plans to switch his allocation to iShares Global High Yield Corporate Bond GBP Hedged UCITS ETF (GHYS) into the new UBS ETF - Barclays USD Emerging Markets Sovereign UCITS ETF (Hedged to GBP) (SBEG).

"This UBS fund is a 'smart-beta' ETF without the bias to overpriced stocks or bonds that is common in many smart-beta ETFs," he says. "It offers broadly diversified access to the sovereign debt of more than 60 emerging market countries, but with a single country issuer cap of 3 per cent determined by the amount of debt outstanding rather than simply market value. The UBS sovereign emerging markets bond fund is better diversified than traditional funds, which are normally based on the JPMorgan Sovereign Emerging Market Bond Index. The UBS fund also has a higher yield to maturity (4.9 per cent versus 4.8 per cent) and shorter average bond maturities (10.3 years against 11.6 years)."

He wants to switch his Japanese exposure from iShares Core MSCI Japan IMI UCITS ETF (SJPA) into Lyxor JPX-NIKKEI 400 UCITS ETF Daily Hedged C-GBP (JPXX), which tracks a relatively new shareholder-friendly index of companies that meet corporate governance standards and are more focused on dividend payouts.

"The Nikkei 400 index is composed of Japanese companies that meet various efficient use of capital and investor-focused management benchmarks," says Mr Miller. "The companies are scored by their three-year average return on equity (ROE), three-year cumulative operating profit and market value, together with qualitative factors regarding corporate governance and disclosure."

With the re-election of prime minister Shinzo Abe this month, who won a decisive victory, markets are anticipating further weakening of the yen against sterling. That means now could be a good time to take advantage of hedged share classes.

Mr Taylor, meanwhile, is concerned about the property section of his portfolio. "We know that the property sector has struggled to perform and we've had property funds halting redemptions," he says. "When the big property funds start unloading property it could have a downward effect on commercial property prices. So if I was going to sell anything it would be iShares MSCI Target UK Real Estate UCITS ETF (UKRE)."

In recent weeks several high-profile property funds, including Aviva Investors Property Trust (GB00B7RBQM86) and M&G Property Portfolio (GB00B89X8P64), halted redemptions from their funds amid a mass of withdrawals. Aberdeen last week chose to reopen its fund, but imposed a 17 per cent dilution levy on investors wanting to withdraw money.

Unlike open-ended funds, real-estate investment trusts (REITs) and ETFs do not have to sell their underlying assets in order to pay back investors, but they have been affected too. iShares MSCI Target UK Real Estate UCITS ETF is down 4.43 per cent over the past four months and Mr Taylor now wants to move his money out of this and put it into Tritax Big Box REIT (BBOX).

Alan Miller's portfolio, performance and yield

Source: FE Analytics as at 14.07.16, yield data: Morningstar, as at 14.07.16

*As of 1 October 2015 iShares £ Corporate Bond 1-5yr UCITS ETF changed its name to the iShares £ Corporate Bond 0-5yr UCITS ETF.

Paul Taylor's portfolio, performance and yield

Source: FE Analytics, yield data: Morningstar, as at 14.07.16

Income earned by ETFs

Source: FE Analytics, as at 14.07.16

Total dividend payments (financial year) of income-paying ETFs

Source: ETF fact sheets and financial reports

Source: ETF fact sheets and financial reports