How do I reduce the 90 holdings in my Isa?

READER'S ISA PORTFOLIO

Chris Dillow, the Investors Chronicle's economist, says:

Here's an idea. Why don't you buy a brand new Mercedes, drive it to a fund manager's office and give it to him as a gift?

If you think I've lost my mind, that's the point. This is what you're doing. You've got over £300,000 in funds, mostly in actively managed ones charging high fees. And these fees add up over time. Over a 10-year period, an extra one percentage point per year in charges could easily add up to £50,000. You're handing over a top quality Merc.

And for what? Your equity holdings alone are a pretty well-diversified portfolio, especially as they contain some global investment trusts. Your ETFs add to that diversification. But I don't see what most of your funds are contributing. It's mathematically unlikely that the 42 will, on average, beat the market by much. You're gaining charges without performance or diversification benefits.

I fear you've lost sight of first principles here. Think of the investment process as comprising two steps.

First, decide how much risk you want to take. This determines your split between safe assets (cash or bonds - but that's another story) and risky ones, which are equities. The latter should comprise a low-cost tracker - either an ETF or ordinary fund. If we're being purist, this should be a global tracker, but an All-Share tracker is a close substitute given the correlation between the UK and the global market.

Secondly, ask: why might this simple two-asset portfolio not be enough?

One reason could be that it doesn't sufficiently protect you from some risks that you worry about. For example, your gold and oil ETFs are justifiable because they offer protection against a possible surge in oil prices - although their contribution to your portfolio is diluted away by the many other assets.

Or you might want to hold extra emerging markets shares because UK and global trackers could suffer if the eurozone suffers a lost decade of Japan-style stagnation. Or you might also want to spread your trackers across one or two providers to protect against fund manager risk - the danger that one would underperform the index or get into financial trouble.

Another reason might be simply that you want some spice in your portfolio - a bet on a few interesting stocks or a specific country or sector fund.

Your current portfolio certainly has lots of spice. But there are drawbacks with it. If you hold over 90 different assets, then great performance by one or two will be diluted away; even if one doubles in price over 12 months, it would add only just over half a percentage point to your total return, which is just one day's volatility. And don't think that many of your assets would outperform. Even if we concede that the stock market is informationally inefficient so that it's possible to beat it by picking good stocks or funds, it is not so inefficient that very many assets are underpriced. Still less is it likely that you could spot those that are. Everyone's knowledge, remember, is limited. The typical professional fund manager has only a handful of good ideas - whose impact he dilutes by holding worse quality stocks. Why believe that you can do better?

All this is getting around to advising you what you already know. You say you're happy to grow rich by using tracker funds. So why don't you? I appreciate that selling is painful, not least because you might kick yourself if the fund subsequently rises. One way to start is to ditch funds with high fees that operate in the same asset class as your ETFs or investment trust holdings. For example, you have Asian exposure through Witan Pacific and some ETFs, what are your Asian funds adding to these? Every gardener knows that weeding and pruning are essential. The same's true of investing.

Patrick Murphy, a chartered financial planner at Zen Wealth, says:

You have built a large portfolio over the years, but it lacks the essential ingredients for an efficient portfolio - structure, diversification and discipline.

In order to construct an efficient, passive portfolio, you should adopt an investment process that targets market-beating performance by implementing a structured exposure to dimensions of higher expected return.

You should then use a method of portfolio construction and implementation that enhances your performance, relative to the average investor.

I will now explain how you can do that.

Following the whole market or sections of it through index-tracking funds is a worthwhile low-cost way to gain exposure to markets, but academic research has identified two particular areas of the market that have reliably rewarded investors over time. These are:

a) Smaller companies; and

b) Low-priced companies (that is, companies whose book value of assets is high relative to their market price) known as 'value' companies.

It has been found that these two sectors perform better than the market average, over time.

However, because risk and return are related, the higher expected return comes at a price and, as a consequence, investing in these companies is riskier than investing in the whole market. There are periods when these groups of shares underperform the market, but over time the academic research indicates that these risk premiums have been worth paying for.

Having identified these dimensions of higher expected return, you should aim to keep your exposure to them as high as possible, by investing in funds managed with the specific aim of maintaining the highest possible exposure to the dimension of higher expected return.

You then should follow these three steps to building a structured portfolio.

Step 1. Determine the basic equity/fixed income split to be adopted.

Although you are a high-risk investor, I would not necessarily advocate a 100 per cent exposure to equities, as the greater the proportion of equity in a portfolio, the more risk that portfolio will be exposed to. You therefore need to consider how much of the portfolio to allocate to 'non equity' funds.

Step 2. Determine the international equity dimension.

The equity component of the portfolios should be split proportionally across the developed world. I would recommend that you do this according to the market capitalisation of each country. This will help to ensure a well-diversified portfolio and will avoid an overweight or bias in any one particular country.

There should also be an appropriate allocation to emerging markets within the equity component of the portfolios. Emerging markets equities have higher levels of risk than developed market equities and the expected returns of these equities are, as a consequence, higher.

Step 3. Determine the small cap and value equity dimension.

The last stage is to consider how much to allocate to the two areas of higher return (small cap and value companies). When deciding on this, there are two factors to consider:

Risk/return: increasing allocation to small and/or value stocks may increase risk, expected return and tracking error but may not increase volatility;

Sensitivity to tracking error: increased sensitivity to prolonged periods of underperformance to the market.

Diversification

I believe that diversification is essential, so where possible you should look for funds with a large number of holdings compared with their peer group. This means that you will be spreading the risk within the portfolio across a wide range of underlying investments. This reduces the reliance on the performance of a small number of stocks (which is more traditional within a pure actively managed portfolio). The number of stocks is dependent on the asset class. For an equity-based fund I would recommend funds that have no fewer than 500 stocks. For fixed-interest funds this limit should be around 20.

Management fees, taxes, expenses and transaction costs incurred in the management of a portfolio have a direct impact on returns, so managing costs is as important as managing investments. Good investment performance can be wiped out by high costs or a failure to seek tax efficiency. All other things beings equal and wherever possible, you should seek the most cost-efficient route to market returns.

Passive investments generally cost less than the average actively managed investment by minimising trading costs and eliminating the costs of researching stocks.

Discipline

Staying invested through thick and thin is usually the best strategy for investors, as timing exit and entry points is as unreliable as any other prediction of market movement. You should therefore aim to remain in the market all the time it remains appropriate to do so.

Investing is often likened to a ride on an emotional rollercoaster. If you consider the typical behaviour of the vast majority of investors, you can understand why. When an upward trend emerges, investors follow the trend but only buy-in once they are convinced that it is for real. Unfortunately, this can be close to the point that all the gains have been made and the trend reverses. Too often, it is emotions that drive investors and the result is that they can buy high and sell low.

The solution is to invest without emotion. This can be achieved by the use of a portfolio of globally diversified index funds, tempered with a fixed-income component to reduce volatility. This allows an investor to stay invested at a risk level they feel comfortable with and minimise the urge to move.