Portfolio too slanted to high-yield shares

Richard Holden's Isa portfolio

Richard Holden's Sipp portfolio

Source: Investors Chronicle

Price and value as at 7 November 2012

Chris Dillow, Investors Chronicle's economist says:

There are two things I like here: your aim to take up your full Isa allowance and make Sipp contributions; and your desire to hold for the long term. In both respects, you're observing one of the key rules of investing - to minimise costs and taxes. This is slightly negated by holding a few expense-charging funds, but you can probably justify this on the grounds that these give you access to bundles of assets that are otherwise awkward to get.

What's more questionable is your preference for higher-yielding shares. Insofar as this is a way of avoiding the temptation to buy glamorous 'growth' stocks, it's a good idea. History shows that, on average, such growth stocks rarely deliver the returns investors expect.

However, efficient market theory and common sense tell us that we don't get owt for nowt. A decent yield comes at a price. That price is often slower capital growth. One reason why utilities and insurers yield so much is that the market just doesn't expect them to grow as much as other shares. The question for your portfolio, then, is: is the market's pessimism justified or not?

History suggests it is often not: value and defensives have, on average, done better than they should. However, while it's worth betting something on history continuing, I'm not sure we should bet much. There's always a danger in financial markets that investors have wised up to their past errors. Indeed, given that sentiment towards equities generally is quite depressed now, it could be that defensives are overpriced relative to the general market.

This possibility raises the question: where will the growth in your portfolio come from? The obvious candidate is your speculative Aim holdings. These make sense as a play upon the possibility that sentiment will improve, which would disproportionately benefit Aim.

But there's a danger here. Aim stocks carry lots of idiosyncratic risk, which means there's a chance they could do badly even if Aim generally does well. For example, in the past two years, the correlation between monthly changes in Polo Resources and Aim has been just 0.26, and that between KSK Power Ventures and Aim has been 0.15. This means they'll probably rise if Aim rises - but no more than probably. And the sort of circumstances in which Aim does very well would be those in which your utilities and insurers underperform - because they'll be conditions in which investors' sentiment improves.

In this sense, your portfolio carries relatively little market risk. It's quite possible that it would underperform if the general market does well - because your defensives should underperform a rising market and because your more speculative plays might suffer idiosyncratic losses.

Instead, you've got a nice behavioural finance portfolio here. You're making several bets: that the defensive anomaly will continue; that value stocks are underpriced; that improving investor sentiment will lift Aim; and that some Aim stocks (your holdings) are mispriced.

These are reasonable bets. But remember, you're betting against orthodox economic theory here. This says that, on average, returns come only because you take market risk.

The obvious way to hedge your bets would be to switch towards a tracker fund, which gives you more market risk, more exposure to the possibility that orthodox theory is right.

I don't say this to recommend that you do so. Just be aware that if you don't, you're taking some very interesting positions.

Lee Robertson, chartered wealth manager and chief executive officer at Investment Quorum, says:

This portfolio broadly mirrors the approach we take with many of our clients. Indeed, two of your fund choices, Newton Global Higher Income and Henderson Strategic Bond, feature in our own client portfolios.

Your portfolio aims to deliver a secure and growing income from companies with good track records of paying dividends, with a secure capital value underpinning the strategy. Over the past 25 years you have built a very tax-efficient portfolio, utilising both your Isa and pension allowances. This will allow you to tailor tax-efficient withdrawals upon your retirement, as and when required, from two sources, thereby maximising any allowances to which you are entitled.

The portfolio constituents are all good quality firms, and many have done well of late and delivered the income that you have sought - but the potential for them to do less well is growing with the potential for recovery in world economies. Investors with concentrated portfolios comprised of defensive stocks are very often wrongfooted when pursuing income without due care and attention to the potential capital value implications for the stocks held. That said, you do state that you are a long-term investor, and that you do not churn the portfolio unnecessarily, so it may be that you are comfortable with this prospective scenario over the short to medium term.

However, there are some further points we believe to be worth raising given the current composition of the portfolio. It appears to be largely slanted towards high-yield stocks and there is currently some concern over the capital values of these stocks, particularly in defensive sectors, as there has been a huge interest in high yield over the past three or four years. This has led the prices of these stocks to inflate, with an attendant potential for a substantial price drop should investors switch to growth and recovery stocks. With your concentrated portfolio of around 30 stocks the risks of capital retracements are therefore greatly amplified.

I would illustrate another concern, that of securing income at the expense of capital, by turning to a particular stock in the portfolio, although I note that you have it on watch - Vodafone. Over the past five years the stock has traded as a very poor investment for growth and income investors, with only the dividend supporting it as a portfolio constituent. Over the past three years you have actually lost capital value, so you are securing an income reinvested to the detriment of your capital. This loss is in the ballpark of 11 per cent, which negates two years of dividends.

It is possible that you could achieve a better level of diversification by exchanging some of your stocks for funds, such as Cazenove UK Income and BlackRock UK Income - thereby moving to a position which is slightly less concentrated. I do, however, understand that you are already holding some funds and that this may not be a route you wish to pursue.

The availability of dividends on a global basis is also a very real opportunity for you. It would diversify you from a single market and open up the opportunity of investing in countries in different stages of the economic cycle. While it would be easier to buy into global equity income via funds it is possible to buy direct equities in some overseas markets, assuming you can cope with the paperwork.

The only final points I would make would be to ensure that your Sipp and Isa charges are still competitive and to congratulate you on your proactive approach to securing your financial future.