Exchange traded funds portfolio makeover

IFOR'S PORTFOLIO

Individual savings accounts (Isas): £300,000

Self-invested personal pension (Sipp): £40,000

Taxable investment account: £160,000

Cash within tax wrappers: £130,0000

Cash outside tax wrappers: £105,000

Total portfolio value: £735,000

Chris Dillow, Investors Chronicle's economist, says:

You know what my problem is with this portfolio. And you know how to solve it. So get on and do it. Remember that this portfolio is losing you money, simply because you are paying fees on actively managed funds but are getting tracker fund-type performance (before fees) simply by virtue of holding so many funds - because doing so means there is almost no chance of this portfolio deviating significantly from the market's return.

You say that you don't totally understand exchange traded funds (ETFs). So what? I don't fully understand how cars or computers work. But this doesn't stop me owning them. The same should be true for financial products. (The fact that it isn't is due in part to the criminal stupidity of much of the financial 'services' industry, but let that pass.)

What you need to understand about ETFs is the risks that surround them. One of these risks is counterparty risk, although this is tiny for the more mainstream ones you are interested in. Another is tracking error risk - the risk the ETF will underperform its benchmark index. But the same risk applies to mainstream actively managed funds; many underperform the market.

The biggest risk, though, is simply market risk; if global stock markets fall, so too will the ETFs that track them. This risk, though, is one you are already taking. In holding so many funds you are diversifying away the chance that one or two of them will outperform a falling market; this is why I say that over-diversified portfolios are closet trackers.

There's no guarantee that a bond ETF would fully protect you from such falls. In fact, it's possible that even better quality corporate bond prices could fall as share prices do - if, say, tighter monetary policy causes investors to prefer cash to longer-duration assets.

Are you in a position to take this risk? On the one hand, the fact that your income from other sources is sufficient means you are. But on the other, it could be that stock markets fall at the same time that you want £100,000 for that house, in which case you might find yourself selling at a bad time.

Ultimately, the choice is yours. Just beware that the only way to protect yourself from such dangers is to simply hold cash.

There's another danger here. Your preference for ETFs that track higher-yielding shares in the UK and US exposes you to cyclical risk. Although higher-yielding stocks have tended to outperform over the long term, this performance is a reward for taking on the risk that such shares will do very badly in recessions; in 2008-09, for example, higher-yielding stocks included builders and mortgage lenders which did disastrously. If you don't want to take this risk, consider plain index-tracking ETFs instead.

Another question here is: once you do shift into a simple ETF portfolio, how will you resist the temptation to buy other assets?

The answer, I suspect, is to change your mindset. If you ask simply 'will this share or fund beat the market?' you'll end up with thousands of assets simply because around half will do so. Instead, ask: what does this asset give me that my others don't? What you're looking for here is alpha - that is, for returns which are uncorrelated with the general market.

Now, unlike some efficient market fundamentalists, I'll concede that such alpha is possible. But it is rare for it to be statistically significant from zero. If you begin from this perspective, you'll be reluctant to add assets to your portfolio.

Alan Miller, chief investment officer at SCM Private, says:

It is difficult from the list of holdings to see the actual values in the various investments or ascertain an overall guide to how much as a percentage is invested in each area.

However, it strikes us that your portfolio is made up of 64 different investments and while each may be focused on a particular investment theme, when you add them all together you effectively end up with a giant, expensive index fund. The complexity makes it practically impossible for most individuals (and probably most professionals) to manage. Furthermore, some of these funds, particularly the multi-manager funds, can be very expensive.

Our suggestion is the same to whoever asks. The main goal should always be to keep it simple, understandable, and have something that makes sense and most importantly lets you sleep at night. In my view you have two choices - give it to a professional adviser or fund manager to manage on your behalf so it is their job and responsibility to allocate how much should be in bonds or equities and then how much in each particular region or style.

The alternative, which you seem to prefer, is to do it yourself. Rather than having a particular bias to a particular market or theme which would require deciding when to buy or sell, you appear to be seeking a simple 'default' option made up of a small number of tracker funds. Into these you will then be able to 'automatically' invest any spare cash, or invest when you decide to sell parts/all of the existing portfolio.

Given what you say, to make it simple I would suggest you allocate your new portfolio to a fixed amount in bonds and fixed amount in equities with a very small number of highly diversified, broadly based ETFs. Just from the various names in your list it looks like you prefer investing in equities rather than bonds, so let's start with a high equity weighting of 75 per cent and invest the other 25 per cent in bonds. Fund managers will always tell you they can predict currencies but this is practically impossible and the benefit of not hedging your overseas holdings is that: a) you don't then have to pay for such hedging; and b) when the foreign market (mainly equities) currency falls its market tends to rise so there is a natural hedge anyway.

I suggest the following portfolio:

75 per cent Equities (just 3 ETFs used)

■ 35 per cent UK equities - SPDR FTSE UK All Share ETF (FTAL) as covers UK large, mid and small cap in one ETF.

■ 30 per cent overseas equities - Vanguard FTSE All-World UCITS ETF (VWRL) as covers most developed equity markets in one ETF remembering there is some duplication as currently 8 per cent of this is invested in the UK.

■ 10 per cent emerging markets equities - iShares Core MSCI Emerging Markets ETF (EMIM) covers large, small- and mid-cap stocks in emerging markets in one ETF.

25 per cent Bonds (just four ETFs used)

■ 7.5 per cent iShares £ Corporate Bond 1-5yr UCITS ETF (IS15) as sterling denominated bonds and shorter duration so less exposed to any future rise in interest rates/bond yield.

■ 7.5 per cent SPDR Barclays Capital Sterling Corporate Bond UCITS ETF (UKCO) as this invests in medium/longer-dated sterling corporate bonds.

■ 5 per cent iShares JPMorgan $ Emerging Markets Bond ETF (SEMB) as this invests in US dollar denominated emerging markets bonds (so tends to be less volatile than local currencies).

■ 5 per cent iShares Global Inflation Linked Government Bond ETF (SGIL) as this invests in inflation-linked government bonds across the world (mainly UK and US) so acts as a form of 'protection' against future increases in the inflation rate.

When we invest for clients, we tend to be more opportune and more flexible, investing in a wider range of typically 12-15 ETFs, but this would add to the time and complexity of the portfolio management so we have erred on the side of simplicity and kept to just seven ETFs.

My final point is on DIY investment platform selection. If you are going to do it yourself you should take great care in selecting the platform to buy and hold these ETFs as some just charge a very small fixed price in pounds for buying and selling the ETFs, while others can charge up to 0.35 per cent to 0.45 per cent a year for holding the ETFs - which is actually more than most of these ETFs charge in the first place and a complete waste of money.