Isa portfolio needs more capital protection

John Cartmell's Isa portfolio

JOHN CARTMELL'S OTHER ASSETS

Source: John Cartmell and Investors Chronicle, *Rounded to nearest full percentage.

LAST THREE TRADES:

Marlborough Nano Cap (Buy), Fidelity Far East Asia (Sell), Somerset Global Emerging Markets (Buy).

WATCHLIST:

Neptune Russia and Greater Russia (possible increase), European smaller companies, commercial property fund, Marlborough Nano Cap (possible increase), Jupiter India (possible sell).

Chris Dillow, Investors Chronicle's economist, says:

You ask whether it's worth persevering with your Indian and Russian funds. There's one thing here we know for sure. It's that the mere fact you've lost on these is no reason whatsoever to hold onto them. Instead, the case for clinging on is that next year's likely bad news - that the Fed will begin to reduce its quantitative easing - is already discounted. If so, you should benefit from these markets reaping the risk premia that are a reward for their extra risk.

If markets were rational, this would be the case. But markets might not be rational. And there's a worrying precedent here. In 1994 the Fed began to tighten policy after responding to a financial crisis. Although the move was universally expected, bonds, shares and - especially - emerging markets all suffered. This warns us that emerging markets might be more vulnerable to changes in US monetary policy and less forward-looking than we might think.

However, you're betting quite heavily upon the rational market hypothesis. In holding several emerging market funds as well as Russian and Indian ones, you're making some correlated bets that emerging markets can withstand the Fed's tapering; almost one-third of your non-cash, non-pension wealth is in emerging markets. This bet might pay off, but it's risky.

Think of this another way. Why might we be surprised by the Fed next year? One possibility is that it will keep monetary policy loose. But this is most likely to happen if global growth looks like being weaker than expected. But in this case, emerging markets might suffer because weaker growth would reduce investors' appetite for risk. Another possibility is that the Fed will tighten more than expected. In this case, though, US equities would probably do well because of the positive growth surprise - in which case you're better off with developed markets than emerging ones. Either way, emerging markets look risky. The best outcome for them would be if the Fed keeps policy loose despite good growth - that is, if it's more dovish than investors expect. Do you really want to bet on that?

I would, therefore, consider trimming your exposure to emerging markets - perhaps by shifting into UK ones.

As for your general portfolio position, there's one thing I sympathise with, and one thing I don't. I share your belief that bonds might well do badly. But I would remind you that they do have value as a hedge against worse than expected economic activity or an increase in risk aversion. Holding none of them is an extreme position.

I have less sympathy with your aim to "make hay while the sun shines" before scaling back on risk. The fact is that we just cannot predict when the sun will go in. Yes, the best predictor of returns we have - foreign buying of US equities - points to stock markets rising in the next 12 months. But this is a decent probability, not a certainty.

Do you need to take so much risk? Put it this way. Taking £30,000 a year out of your pension and portfolio wealth means running it down by 6.8 per cent, based on current values. It would be a close call whether the portfolio will return this much. Which means you would be eating slightly into capital. Personally, I don't think this is a big deal; older folk should run down their wealth - that's what it's for. But if you're keen to leave a big bequest, you might not want to do this.

Barring a strong bequest motive, I suspect you can afford to start taking more conservative positions while still meeting your main investment objectives. Just don't think that you can make the shift at precisely the right time. You can't.

Patrick Connolly, a certified financial planner with Chase de Vere, says:

You have taken a sensible approach to your retirement planning, combining tax-efficient pension, Isa, cash and National Savings holdings.

Your target of achieving an income of £30,000 a year seems easily achievable from age 65 when you will receive your defined benefit pension and state pension. However, you might have to accept a lower income beforehand unless you are prepared to put your underlying pension and Isa investments or cash savings at greater risk.

My concerns are that you have a large proportion of your money in high-risk investments and seem to think you can predict when to move from high-risk to lower-risk holdings. You want to benefit while you consider "the global economy is on the rebound". This is a very dangerous strategy. Many equity markets have already risen significantly in the past couple of years, supported by loose fiscal policies and the expectation of an improving economic picture. You are considering European Smaller Companies "for the rebound", but the average open-ended fund in this sector has already risen by nearly 60 per cent in the past two years. It is entirely possible the market is due a correction, which would be bad timing for you with only one year until retirement.

You need to get more of a balance between capital growth and capital protection.

You seem to have spent a great deal of care and attention with your Isa portfolio although this is worth significantly less than your pensions. You are concerned about an India fund in which you have £1,378, yet you have £255,843 in just two pension funds. It is likely to be your pension holdings which determine whether you will achieve your retirement goals more than your Isa funds.

Your pension investments are mainly in equities, with your two biggest holdings the Scottish Widows Pension Portfolio Three and Standard Life Managed Pension Fund having about 70 per cent and 80 per cent in equities respectively.

You point out the current risks of fixed interest and I agree, but the potential downside on equities is still likely to be greater. Even though you are planning for your pension money to stay invested you can reduce the risk you are taking by diversifying more away from the equity markets.

When taking pension benefits, you should be able to access 25 per cent as a tax-free lump sum. This should be nearly £80,000 and can be used to generate income to supplement your pension income. You can look to move this money year by year into Isas using both your and your wife's annual allowances.

The remaining pension fund can provide you with an annual income of about £15,000 a year through drawdown, although taking the maximum amount will put his underlying capital at more risk.

You hold lots of good-quality Isa funds, although most are quite risky, with a particular focus on smaller companies and emerging markets. Also, 25 holdings is too many for an Isa portfolio of £128,500. You seem to have built a collection of individual funds rather than an overall portfolio.

You will need this Isa money in the future and so need to get better control. To start I would get rid of some of the specialist funds. Nobody knows whether Russia or India will outperform in the future and so why hold funds investing specifically in these countries, or China for that matter? I would amalgamate them in broad-based emerging markets funds, which will have exposure to these countries and many more.

I would reduce exposure to smaller companies. They are likely to outperform in the longer term although with more volatility, and in your position there is a risk of bigger capital losses at what could be the wrong time.

I suggest moving money into larger companies and diversifying further with fixed-interest exposure, using strategic bond funds where managers have flexibility and so can avoid the most expensive areas, and 'bricks and mortar' commercial property which can be a great diversifier. I would also get rid of all the small holdings in individual shares as these add very little to the overall portfolio.