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Income at a lower cost via ETFs

Many UK equity income investment trusts trade at premiums but a number of low-cost income ETFs are coming to market. However, when seeking dividends an active manager might still have the edge
December 12, 2012

With many of the best UK equity income investment trusts trading at premiums to net asset value (NAV), investors wanting a reasonably priced alternative are struggling for options. However, a number of equity income-focused exchange traded funds (ETFs) have come to market providing further options, although at present the range is still limited. There are four UK funds investors could consider.

iShares FTSE UK Dividend Plus (IUKD) is one of the first of its kind available to UK investors, having launched in 2005, and tracks the FTSE UK Dividend+ Index. It uses physical replication so buys the shares in the index. The fund offers an attractive distribution yield of 5.05 per cent, boosted by stock lending, and a low charge of 0.4 per cent. Tracking has been reasonable with the fund returning 9.07 per cent since launch, in contrast to 10.48 per cent for its index.

It is also one of the larger equity income ETFs with more than £468m in assets, while others in this space have less than £100m.

The FTSE UK Dividend+ Index offers exposure to the 50 highest-yielding UK stocks within the universe of the FTSE 350 Index, excluding investment trusts. Stocks are selected and weighted by one-year forecast dividend yield.

A more recent addition to the market is SPDR S&P UK Dividend Aristocrats ETF (UKDV) which also uses physical replication. Because this fund was only launched in February this year, a dividend yield is not yet available; however, the weighted average gross dividend yield of stocks in the fund is currently 4.32 per cent, so the fund's yield is likely to be a bit lower because of costs. These are low though, with a total expense ratio (TER) of only 0.3 per cent.

So far the fund has tracked its index closely.

The S&P UK High Yield Dividend Aristocrats Index follows the 30 highest dividend-yielding UK companies within the S&P Europe Broad Market Index, which have followed a managed dividends policy of increasing or stable dividends for at least 10 consecutive years.

Although it is not marketed as a dividend index, PowerShares FTSE RAFI UK 100 Fund (PSRU) tracks the performance of the largest UK equities. These are selected on four fundamental measures of firm size: book value, income, sales and dividends. The 100 equities with the highest fundamental strength are weighted by their fundamental scores.

This fund yields around 3.77 per cent, although this is not much higher than a FTSE 100 ETF offers. However, in terms of growth performance the FTSE RAFI UK 100 Index consistently outperforms the FTSE All-Share. PowerShares FTSE RAFI UK 100 Fund has a TER of 0.5 per cent and uses physical replication.

Amundi ETF FTSE UK Dividend Plus ETF (AUKD) tracks a dividend-focused index but reinvests the dividends. However, it could be worth considering if you want to reinvest, as this has been proven to be a substantial way to boost growth. It uses synthetic replication so gets its returns via a swap. It charges 0.29 per cent.

The fact that income ETFs track rather than select can be problematic, however. For example, because they sought out the highest dividend payers approaching the financial crisis, they built up a very high exposure to banks and so had a terrible 2008, with iShares FTSE UK Dividend Plus losing -43.89 per cent in that discrete year.

"This is because they owned the banks all the way down which only got thrown out of the index when they cut the dividends," says Edward Allen, portfolio manager at Thurleigh Investment Managers. "With a passive fund you lose a manager's ability to be pragmatic when cutting holdings. For this reason I think that for short-term exposure (up to two years) equity income ETFs are fine, and they certainly keep pace with some of the larger active funds in terms of performance, but don't hold them for the long-term without observing what is in them."

Brian Dennehy, managing director at independent financial adviser Dennehy Weller & Co, says that they use equity income ETFs focused on UK and Asia, but only as part of a wider equity income portfolio. "If we're looking for income growth the guiding hand of an outstanding manager is worth a premium in charges," he says. "You must keep a close eye on these ETFs. For example, if you weren't paying attention in 2008 you remained invested in a dividend-focused UK ETF with a horrible weighting in banks. There is always a price to be paid for low cost."

For our pick of active equity income funds, see the IC Top 100 Funds.