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Worried about inflation and sovereign defaults

Our reader who works in the City has an enviable track record of investing but our experts think he can do better
February 7, 2013 & Gavin Haynes

Barney Black is 42 and has been investing for 16 years. Having worked in the City for over 20 years he believes his job, though well-paid, is not particularly safe. However, after having three children, his wife has recently gone back to work part-time.

His average annual return over the 16-year period has been 11.7 per cent a year. His investment goals are to preserve capital, maximise returns after tax and derive an inflation protected and growing income stream.

While he rates Troy Asset Management's Sebastian Lyon, he is sceptical about other actively managed funds: "I believe that investors paying annual fees of 1.5 per cent and above are being ripped off - this management cost should be expressed as 25 per cent of the likely annual return rather than 1.5 per cent of capital."

He has strong concerns about inflation, too: "I do not hold any conventional bonds (either corporate or sovereign) as I believe that fixed-income prices are currently in a QE-driven bubble and that buying long duration bonds at current prices will prove disastrous," he says. "I do not believe that central banks will be able to accurately control the inflation they are currently seeking to engineer and that further sovereign defaults are likely.

"As a result I am weighted towards 'real' assets (ie, directly-owned defensive equities) rather than financial assets. I have recently been buying physical gold as quasi-cash that provides tail-risk insurance."

He holds his shares via TD Waterhouse and Hargreaves Lansdown and uses self-invested personal pensions (Sipps) and individual savings accounts (Isa) wrappers for his holdings. "I hope these companies are both conservatively managed and using safe custodians."

Reader Portfolio
Barney Black 42
Description

Shares and funds

Objectives

Preserve capital, maximise returns and grow income

BARNEY BLACK'S PORTFOLIO

HoldingNo of shares or unitsCurrent value (£)
Heineken Holding NV2608,672
Centrica4,04813,561
GlaxoSmithKline1,59222,001
National Grid1,70011,679
SSE1,43920,866
Coca Cola69816,092
Johnson & Johnson1908,586
Proctor &Gamble1195,145
3i5711,382
BP1,9148,824
Diageo67111,997
Ladbrokes1,9563,971
London Stock Exchange2112,439
Morrison4,52711,408
Pennon7885,114
Unilever82519,668
Vodafone6,39810,557
WH Smith1,71110,694
Colgate302,007
Mondelez International2253,854
BAE Systems1,8236,362
British American Tobacco1033,241
Dee Valley voting ordinary3754,969
Imperial Tobacco1373,354
Microsoft97016,256
Nestlé2008,333
Pearson6057,254
Reckitt Benckiser62625,015
Reed6003,960
Sage6842,141
Tesco6,00921,212
Greggs7073,196
G4S1,3643,601
Total individual equities£307,409

BlackRock World (excluding UK) Equity Index Tracker

158,629

Personal Assets Trust13446,310
Troy Trojan Fund - income units12,17324,711
Cash46,365
Index linked bonds213,196
ETFS Physical Gold Exchange Traded Fund19,934
Physical gold (coins)16,200
GRAND TOTAL

£832,755

Note: Price and value as at 13 January 2013

Source: Barney Black

 

LAST THREE BUY TRADES:

Pennon (UK)

Heineken (UK)

Mondelez International (US)

LAST THREE SELL TRADES:

BHP Billiton (UK)

Hershey (US)

Shell (UK)

SHARES OR FUNDS ON WATCHLIST:

Microsoft

SABMiller

Danone

Fundsmith Equity Fund

Ruffer Absolute Return

 

Chris Dillow, the Investors Chronicle's economist says:

This portfolio raises a nice question: how can we protect ourselves against two nasty but perhaps incompatible risks. You fear that central banks won't be able to control inflation and that more sovereign defaults are possible. But, to some extent, these are mutually exclusive. A world in which governments are defaulting is one in which banks are suffering big losses, in which case investors should worry about recession and deflation; remember that break-even inflation rates fell sharply during the banking crisis of 2008-09.

Worries about these twin risks rule out a lot of assets. Ordinarily, I'd suggest investors worrying about sovereign defaults should hold the cash or bonds of safe-haven countries; I'd put the UK and US (for now) into these categories, along with Germany and Switzerland. But your worries about inflation rule out most of these. This leaves gold as perhaps the only obvious insurance - along, perhaps, with Swiss francs.

Note here that gold - like all insurance - comes at a price. If tail risks or uncertainty fade - or if markets believe they are fading, which is not the same thing - the gold would fall, perhaps a lot given its usual volatility.

What's more, I'm not sure that such risks are compatible with an equity weighting of over 50 per cent. Yes, shares could benefit if QE does finally ignite stronger economic activity and hence demand-driven inflation. But many types of inflation are bad for shares - remember the 1970s - and sovereign defaults would be horrible for them.

A further issue here is that although you're sceptical of long-duration bonds, a quarter of your portfolio is in index-linked gilts. This seems odd, as the deflating of a QE bubble could well cause index-linked prices to fall along with those of conventional gilts; traditionally, the two assets have been surprisingly highly correlated. Sure, it's possible that break-even inflation rates would soar as the bond bubble bursts, causing linkers to do well. But I wouldn't bet on this.

The justification for holding so many index-linked gilts is that you plan on holding them to maturity, and so shorter-term price risk just doesn't matter to you.

Which brings me to a risk nearer to home. You say your job is "not particularly safe". Your wife now works part-time, so your household is diversifying its human capital. But is this sufficient protection? An especial danger here is not just that you'll lose your job, but that you'll do so at a time when share prices are falling - say, because of a default-induced financial crisis.

Granted, you have some cash to protect you from this. But a cash weighting of less than 6 per cent is rather low, given it must protect you not only from job loss but also normal market fluctuations. And this raises the nasty possibility that you might have to sell some of your shares at low prices simply to make ends meet - thus breaking one of the first rules of investment, that one must never, ever, be a forced seller.

I stress this not just because I'm a pessimist, but to raise a point that is often overlooked in economic commentary. Risks are not just big geopolitical things such as inflation or sovereign debt crises, but local idiosyncratic things such as whether Barney Black will lose his job, or whether house prices in a particular village will fall. We should build our portfolios not just to manage big risks, but local ones, too.

All of this makes me seem very critical of this portfolio. But I'm not. I wholly applaud your scepticism about active fund management, and your use of trackers to get global equity exposure. Such intelligence deserves to be rewarded.

 

Gavin Haynes, managing director at Whitechurch Securities, says:

I would agree that the long-term risks to your portfolio should be focused upon avoiding erosion of capital from inflation, rather than concern over the short-term volatility associated with having a large proportion of the portfolio invested in equities.

Given your time horizon and willingness to accept risk, I believe the asset allocation makes perfect sense: 60 per cent invested in equities, broadly split between UK and overseas exposure, with the balance invested in index-linked bonds and gold to add diversification and provide inflation proofing for the portfolio.

You are well-equipped to take your own decisions and invest directly in the equity markets. Your long-term record is something most professional fund managers would be proud of, given that the annualised total return from the FTSE All-Share index is around 5 per cent over the same period.

You have a very jaundiced view of active management. It is possible to gain exposure to good-quality managed funds at a significantly lower annual management charge than the 1.5 per cent that you quote.

As a stockpicker yourself, you can see the benefit of good active managers beating a passive approach. Therefore I am surprised to see all your global equity fund exposure in a tracker fund. You could consider low-cost active funds such as the Fundsmith Equity Fund (GB00B4LPDJ14) already on your watchlist, which invests in a focused portfolio of global leading companies, or Scottish Mortgage Investment Trust (SMT), a global stockpicking investment trust with a strong track record.

For long-term investors the global shift in economic power towards emerging markets and Asia should have a greater weighting than is represented in global equity benchmarks. It is hard to research these markets and even an experienced private investor such as yourself could look to invest with experts such as First State and Aberdeen if increasing exposure to these regions.

Away from equities, while a potential inflation hedge, it is dangerous to view gold as a form of 'quasi-cash', due to its speculative nature. Index-linked government bonds do look historically expensive, but the QE policies that are being viewed as 'the greatest financial experiment in history' may well justify this price for insuring your portfolio over the long term.

As you hold your investments in nominee accounts you remain the owner, providing a high degree of safeguard from corporate failure. Hargreaves Lansdown is a FTSE 100-listed company with a strong balance sheet and covered by the FSCS. TD Waterhouse is covered by the Dutch financial compensation scheme. You can request information from them regarding the custodians they use.

Amanda Tovey, head of equities at Whitechurch Securities, adds:

The direct equity content of the portfolio currently comprises 33 stocks with some small holdings in percentage terms in relation to the overall portfolio. These smaller holdings are adding little to the overall portfolio performance and it would be worth considering either adding to them if they are stocks in which you have a strong conviction or consolidating.

The portfolio is skewed towards defensive sectors with a high concentration in utilities, beverages and pharmaceuticals; probably a product of the investment process but you should be aware that the portfolio could underperform in a cyclical upturn.

The sector concentration should also be considered from a risk perspective. You hold several large utility companies and water companies. While they provide a solid yield, any major regulatory changes could be detrimental to around 18 per cent of the portfolio.