NHS consultant is attracted to Venture Capital Trusts

JOHN'S PORTFOLIO

Source: Investors Chronicle. Price and value as at 12 September 2014.

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

Imagine two shares with identical expected returns. Call them A and B. The government then imposes a tax on A but not on B. What would happen? Clearly, investors would sell the taxed stock A and shift into B. The price of A would then fall and B would rise. This process would stop when the post-tax returns on the two stocks were the same. If you wanted the tax advantage in stock B, you'd have to pay for it in terms of a higher price and lower expected returns.

The logic here is simple and straightforward. And it sends a powerful warning. Do not buy anything simply because it carries tax advantages. You pay for those advantages; this is one reason why Aim stocks have underperformed for years.

The case for buying venture capital trusts (VCTs) is not that they carry tax breaks, therefore. If there is a case for them, it's that their pre-tax returns are better than those on ordinary shares.

Recent history, though, does not suggest this is the case. In the last five years only 28 of the 75 VCTs in Trustnet's database have outperformed the (albeit high) returns on the All-Share index - although there is massive variation across funds. Granted, the last five years might not be a representative sample. But this is consistent with what we know about corporate performance - that growth is largely random and independent of size so tiny companies have no higher odds of booming than big ones; and that the death rate for small young companies is high.

For these reasons, I would caution against big investments in VCTs.

I would also warn against investing in China on the grounds of its growth prospects, and for a similar reason; expected growth, like expected tax advantages, should be embedded into prices. History shows that equity returns across countries aren't strongly related to GDP growth. The case for investing in China - and other emerging markets - would be that they should carry risk premia to reflect their extra risks, and that you are happy to take those risks.

You say that you are thinking of moving away from individual stocks to funds. As regular readers might guess, I'd recommend a tracker fund or exchange traded fund (ETF); if we're being purist, one that tracks global markets but an All-Share tracker is a decent alternative. You can think of these as a low-cost fund of funds.

In fact, your portfolio draws attention to a reason why trackers are a good thing. You've contrived to end up with a big cash holding, even though you say you're happy to take risk.

This seems to be because you haven't found good stocks to buy. Now, this would be an excellent case for being cash-rich if you had researched hundreds of stocks on the market and concluded that all were unattractive and that the market was therefore expensive.

What is not a good case for holding cash is if you happen to have sold stocks and haven't yet got around to reinvesting the money. Doing so means you're taking on reinvestment risk. If shares rise while you're underinvested, you'll end up buying when prices are higher and expected returns are lower. What we have here, I fear, is a case of the tail wagging the dog. Your asset allocation is being determined by your stock selection. It should be the other way round.

And herein lies a case for trackers. If you want to be in the market but haven't yet found good stocks - because there are all those darned patients who demand your time - you should be in a tracker fund. Think of a tracker as a default option. If you can't find good stocks, but aren't pessimistic about the general market, just hold the tracker. And if or when an attractive stock does turn up, just shift a little from the tracker.

Alan Steel, chairman at Alan Steel Asset Management, says:

On first glance you are doing rather well. Then you dig deeper and concerns emerge.

You're high risk alright. You've done rather well over the last five years it seems, although I don't know how long your funds/stocks have been held, what you did during the crisis six years ago, or how you react to heavy falls in asset prices. I'd say you are not diversified enough and have too heavy exposure to Asia/emerging markets. Aberdeen Asian Smaller Companies Investment Trust was a great call but reversion to mean suggests the next five years will not be so hot.

Your biggest strategy call now revolves around your pension/future income position. By my calculation you have about £340,000 in the Sipp with 60 per cent in Asian Smaller Companies. Ouch. Then there's the Scottish Widows Stakeholder Pension pot not mentioned in the dialogue, but worth just shy of £400,000, in three Scottish Widows funds that may look cheap but are well below average performers. Odd that, when you see your attraction to high-risk high performers like Jonathan Asante, the manager of First State Global Emerging Market Leaders Fund. You should consider transferring into the Sipp to engage better funds. I would.

You say you have stopped contributing to the Sipp (presumably the Scottish Widows plan too), to restrict exposure to the 55 per cent tax. The problem is you are probably still contributing to the NHS pension scheme, and should continue to do so. I wonder if you have considered Individual Protection 2014 from HMRC which will give you a protected lifetime allowance equal to the value of your pension rights on 5 April 2014 - up to an overall maximum of £1.5m? You can't go for Fixed Protection 2014 because you are probably still contributing (who said Pension Law's been simplified?). The details of both can be found here. But you should take advice. If on 5 April 2014 your total perceived pension fund value was £1.25m or over you ought to go for Individual Protection 2014. It protects you against any future restrictions. I don't know your salary or current NHS entitlement but I'd be surprised if the total is below £1.25m.

As to your fears about the 55 per cent tax, with changes afoot next April that may reduce the charge substantially when you withdraw income, and not knowing what the law will be 11 years and beyond from now, I'd say to ignore the tax and let the funds grow on a medium-risk basis. John, if you were 55 today, you wouldn't have to crystallise all the pensions in one go anyway. You could take the benefits from the NHS and leave the rest for a while. But I stress this whole area is fraught with danger so go see an independent financial adviser who specialises in pensions.

VCTs? I'd go canny, as they say up here in Scotland. I have come across a tiny minority that delivered the tax relief and made money. Buy them on a tax discount long-haul tax-free income basis for life and beyond but not as a brilliant investment. Otherwise you'll be very disappointed.

I note your worries about individual stocks and need for diversification. I agree. But I'd ask you to consider how the best fund managers go about it. They do heavy research, keep disciplined and buy into deep-value stocks, then hold them for the long haul. Think of investors such as Warren Buffett, Joel Greenblatt, Anthony Bolton and Neil Woodford. None of them are traders. And I'd advise ignoring headlines, and if this highly predicted (for months) correction comes, I'd buy on that basis. Our research suggests we could be in for a long-term secular bull market for world equities where stock-pickers come into their own.

There are plenty of great stock-pickers around, so I’d fill my boots with them on an asset mix basis. The team at Standard Life Unconstrained is a good place to start, and folks like Angus Tulloch, Gervais Williams, Tim Steer, Paul Ehrlichman, Terry Smith and not forgetting Felix Wintle who picks well in the world's biggest most dynamic market - the US. There are others in my fantasy team.

Why you haven't put more away (split between husband and wife) over the last 18 years in Isas mystifies me. Isas are a perfect foil for pension plans, allowing you to produce low taxed income and capital later on. So I'd concentrate on building Isas at the maximum in decent funds from now. Investors seem not to see that, in retirement or part retirement a clutch of well run equity income funds are ideal income providers. For the kids you should carry on as you are doing, although I'd be tempted to stick a smaller company fund in, perhaps one managed by Gervais Williams.