Investment trust Isa needs more diversification

JAMES' ISA PORTFOLIO

Chris Dillow, Investors Chronicle's economist, says:

You say you have enough shares to have diversified. This is true in one sense, but not in another.

It's true in that no single share represents more than 6 per cent of your portfolio and the average one accounts for less than 3 per cent. In this sense, you are well protected from idiosyncratic risk - the danger that any one share or investment trust will do badly.

There are, however, two drawbacks with this. One is that a lack of exposure to downside idiosyncratic risk also means a lack of upside - which means that any good stock-pick won't do you much good. The average share accounts for 2.6 per cent of your portfolio. This means that if one were to rise 20 per cent, it would add only 0.5 percentage points to the total value of the portfolio. But this is only the difference between a mildly good day for the market and a slightly bad one. You've diluted away any benefit you might get from stock or fund selection.

There's a second drawback. In reducing idiosyncratic risk, you haven't eliminated all risk, but simply increased your exposure to global market risk - the danger that a fall in world stock markets will drag down all your holdings. This problem is especially acute because in holding investment trusts you are already holding diversified assets.

Take your biggest holding, Finsbury Growth & Income. Looking at annual returns in the last 15 years, this has a correlation coefficient with Scottish Mortgage of 0.79, and one with Temple Bar of 0.92. In other words, a bad 12 months for Finsbury is almost certain to mean a bad 12 months for Temple Bar and Scottish Mortgage. Losses on one stock thus mean losses on others.

This is an unavoidable fact about investing in funds. Funds are simply baskets of stocks and baskets of stocks are correlated because they are exposed to market risk. In holding lots of them, therefore, you have something very much like a global tracker fund.

I suspect there's a reason why you have become over-diversified. Anyone who's been investing for as long as you have is likely to have built up an unwieldy portfolio simply because it's more fun to buy than to sell, with the result that you accumulate superfluous assets.

There's a parallel here with an idea of the late Nobel prize-winning economist Mancur Olson. He argued that countries that had been stable democracies for a long time tended to become dysfunctional because over time they accumulated special interest groups which held back economic performance. Likewise, running a portfolio over time accumulates sub-optimal assets.

This isn't catastrophic; there's nothing much wrong with a global tracker fund. But it does pose a problem. You say you might need the money in 12 months' time. But if global markets fall then, you might need to sell at a bad time. We can, roughly, quantify this risk. Assuming average total returns of 8 per cent a year with 15 per cent standard deviation gives us around a 12 per cent chance of you losing 10 per cent or more in the next 12 months. Now, for some people these odds are tolerable, and for some they're not - it's a matter of taste. If, however, you don't like them, consider switching some stocks or funds into cash. Having one-third of one's portfolio in cash isn't exceptionally high, especially as you have no bond holdings, and might need cash in the near future.

Now, I don't say this to denigrate the principle of holding investment trusts. Quite the opposite. There's something lovely about these. Their discounts to net asset value can be an indicator of investors' sentiment; when they are bearish, discounts are wide and when they are bullish they are narrow. This means that a wide discount - relative to the trust's history - can be a buy signal. You can, occasionally, buy a tenner for £9.

But this works both ways. It also means a narrow discount or high premium is a sell signal.

Over time, a garden can become beautiful. But it can also become full of weeds.

Nick Sketch, senior investment director with Investec Wealth & Investment, says:

This is an interesting portfolio of well-managed funds, but after a few years of strong recoveries in stock markets, it may need to adapt somewhat to meet your aims in the next few years.

You are not a young investor and have little cash. You may also need access in 12 months, but we do not know to what extent you are likely to require income or capital sums from the portfolio at that stage. All of this suggests that you may need to be cautious about assuming that an all-equity portfolio is right for you now. Balancing your core equity exposure with holdings that should be a little more defensive if equity markets have a wobble would be well worth considering. Even if we are not expecting significant cash withdrawals, having 15-30 per cent in holdings that can produce a decent return whether or not stock markets keep rising would make for a slightly steadier performance in what may be slightly trickier times without reducing substantially the return that can be expected from the overall portfolio in the longer term.

Currently, the portfolio (including cash) has about 40 per cent in UK equities, although only about half of that is in FTSE 100 stocks, so there is a strong bias away from the largest companies compared with an index. This has been very beneficial in the last few years, but there may well be room for some profit-taking at these levels, particularly among mainstream mid-cap exposure.

Overseas equities represent about 25 per cent, with a strong bias to emerging markets (mostly Asia). This is a sensible long-term stance, and these markets now look good value again, although there may be some more pain in the short term. However, a case can be made for increasing the investments in the US, Europe and Japan, as well as taking advantage of recent weakness in emerging markets. On the other hand, there are also a few holdings that have done so well that some profit-taking looks sensible here, too.

Sectorally, the portfolio has strong biases to consumer services and technology, and away from healthcare and (to a lesser extent) resources, telecoms, utilities and financials. Increasing the investment in the healthcare sector, in particular, may be worth considering, as would increasing the 'look-through' exposure to more defensive equities with a decent yield.

The portfolio has almost no exposure to diversifying assets, such as infrastructure, structured products, hedge funds, commercial property, and (most obvious of all) fixed interest. While high-grade bonds offer poor value, there are opportunities in all these areas that can provide good returns and yet do not rely on stock markets rising to perform soundly.

All of that gives us quite a few changes to consider. Assuming for a moment that you do not expect to take capital sums from the Isa in the next two or three years and thus do not need to hold a significant cash balance, the list of potential new investments that could do a useful job for this portfolio is long.

In UK equities, possible additions would include topping up Edinburgh Investment Trust (EDIN), plus the ever-green choices of Artemis Income (GB0032567926), Threadneedle UK Equity Income (GB00B60SM090) and Diverse Income Trust (DIVI). A large-cap growth fund such as Old Mutual UK Alpha (GB0032544065) is also worth considering, as well as some holdings that have had a tougher time in recent years - Artemis Alpha Trust (ATS) springs to mind or even the currently much-criticised M&G Recovery Fund (GB00B7759Y38). These additions could perhaps be paid for by partial or complete sales of Value & Income Trust and the existing smaller company funds (all of which have high mid-cap exposure in reality).

In overseas equities, profits could be taken in Scottish Mortgage after its phenomenal run, while top-ups to BlackRock World Mining (BRWM) and Templeton Emerging Markets (TEM) look timely. Possible additions include sector specialist in healthcare and financials such as Polar Capital Global Healthcare Growth & Income (PCGH) or Polar Capital Global Financials (PCFT).

In the US, compelling large-cap investments are hard to find, but there is little wrong with considering low-cost passive options such as exchange traded funds (ETFs) or well-designed structured products.

In Europe, The European Trust (EUT) and Henderson Euro Trust (HNE) would complement the existing holdings well. Japan is trickier, as most of us expect the currency to weaken further in the medium term. As a result, hedged unit trusts such as Polar Capital Japan Fund (IE00B3NMNC60) or JOHCM Japan (IE00B5LD7P60) might be good complements for the current holding.

Favouring Asian emerging markets looks sensible, too, provided one can stand the short-term risks. However, it may be wise to move from Aberdeen New Thai to a more diversified holding such as Edinburgh Dragon Trust (EFM) or Pacific Assets Trust (PAC).

Away from equities, smaller and nimbler fixed-interest investments look more attractive for now. That suggests investments very different in behaviour from government bonds, such as CVC European Credit Opportunities (CCPG) or Jupiter Strategic Bond (GB00B2RBCS16).

In the 'alternative' sector, quoted hedge funds such as BH Macro (BHMG) or BlueCrest AllBlue (BABS) have a place, despite a couple of weak years. The infrastructure and property sectors also offer some defensive qualities, as well as attractive income yields. Finally, well-designed, good value and tradable structured products can offer returns of 7 per cent - 10 per cent a year in all but the most disastrous equity environments, and could provide a slightly more defensive element to the portfolio without weakening the overall expected return.