Join our community of smart investors

Building a passive portfolio for future generations

Our reader wants to build up a portfolio of passive funds to pass on to his children, but needs to reassess his risk appetite
November 4, 2016, James Norrington and Caroline Shaw

Adam Davis is 39 and married with one child aged 19 months. He is self-employed and makes an income of about £250,000 a year, and his wife earns about £75,000 a year. Adam has been investing for 10 years.

Reader Portfolio
Adam Davis 39
Description

Sipp and Isa

Objectives

Accumulate savings cost-efficiently, pass on portfolio to children

"My objective is to accumulate savings with maximum efficiency in relation to tax and costs, which I will not draw on before the age of 75. I anticipate amending my risk profile and equity/bond allocation gradually from around the age of 50.

"I intend to pass on as much of my portfolio as I can after I die. I intend to live frugally when I am older so I do not exhaust the portfolio. I still benefit from similar decisions made by my late father, so I would like to do the same for my children and their children. We will be having a second child next March, and then hopefully at least one more. When they are about 30 we'll try to help them with costs such as deposits for first homes.

"I have a relaxed approach to risk in that I am not concerned by volatility over the medium term. I have seen my self-invested personal pension (Sipp) rise in value by nearly 30 per cent this year, but I would not be surprised or concerned to see it lose 20 to 30 per cent in a year. I want to adopt a buy-and-hold approach, keeping trading to a minimum, as I am not trying to time the market.

"I also want to reduce costs as far as possible while retaining a diverse asset allocation.

"My pension and individual savings account (Isa) are managed on my behalf on a discretionary basis. But I am considering changing this. I want to implement a passive portfolio where practicable - I intend to disengage from 'management' for at least the next 10 years so as to keep costs down.

"I have recently invested £14,000 in Miton Global Opportunities (MIGO). Before that I had been putting my monthly pension contribution into 7IM AAP Adventurous Fund (GB00B2PB2C75), where 90 per cent of my pension was held.

"At the end of the last tax year in March I split my annual contribution between all my Isa holdings with the exception of SG UK & US Step Down Kick Out Plan 13 (UK FOUR).

"And following advice relating to my Sipp in early September I took out 40 per cent of the money invested in 7IM AAP Adventurous Fund and split the amount equally between the four global equity funds in my Sipp.

"I am considering reducing 7IM AAP Adventurous further so the allocation to it is roughly equal to that in the global equity funds. I would then look to invest the money from that in the proposed passive portfolio below. So I would have half in my passive portfolio and the other half in 7IM AAP Adventurous and the four global equity funds.

 

Adam's proposed passive portfolio

Vanguard FTSE Developed World UCITS ETF (VEVE)40
Vanguard Global Value Factor UCITS ETF (VVAL)15
Vanguard Global Small Cap Index Fund  (IE00B3X1NT05)15
Vanguard FTSE Emerging Markets UCITS ETF (VFEM)15
SPDR MSCI Emerging Markets Small Cap UCITS ETF (EMSM)5
BlackRock Global Property Securities Equity Tracker Fund (GB00B5BFJG71)10

 

"My pension contributions are limited to £10,000 a year due to tapered relief, so I would put half of this into the passive portfolio and the other half in the five funds.

"In terms of my Isa contributions, I plan to invest them along the lines of the proposed passive portfolio from now on.

"Part of my reason for wanting to invest in these passive funds are some ideas I got from investment books I recently read, in particular the first two books. I especially liked the approach and ideas in Smarter Investing. The books are:

■ Investing Demystified by Lars Krojier

■ Smarter Investing by Tim Hale

■ FT Guide to ETFs by David Stevenson

■ DIY Investor by Andy Bell."

 

Adam Davis' portfolio

HoldingValue (£)% of portfolio
71M AAP Adventurous (GB00B2PB2C75)175,141.5540.91
Scottish Mortgage Investment Trust (SMT)30,348.267.09
Fundsmith Equity (GB00B41YBW71)29,123.806.8
Rathbone Global Opportunities (GB00B7FQLN12)28,519.996.66
Lindsell Train Global Equity (IE00B3NS4D25)28,992.246.77
SG UK & US Step Down Kick Out Plan 16 (UK Four)20,4524.78
Alliance Trust (ATST)19,848.584.64
Miton Global Opportunities (MIGO)16,263.653.8
SG UK & US Step Down Kick Out Plan 13 (UK FOUR)15,856.503.7
AVIVA Investors Multi-Strategy Target Return (GB00BMJ6DT26)7,651.761.79
Newton Global Income (GB00B7S9KM94)14,361.703.35
Invesco Perpetual Global Targeted Return (GB00BJ04HL49)12,436.562.9
Vanguard LifeStrategy 100% Equity (GB00B41XG308)29,148.706.81
Total428,145.29

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

I applaud your plan to adopt a low-cost long-run passive strategy, and I'll highlight two great reasons for doing this. One is that over the next few decades creative destruction will cause even some of our largest companies to do badly or even collapse, while new big companies will emerge from unexpected directions. We can't predict which those will be, so our best approach is to back the field rather than particular horses - and this means tracker funds.

Secondly, it's insufficiently appreciated just how horribly management charges compound over time. For example, take a £400,000 portfolio and assume real returns after charges of 5 per cent, which is reasonable based on historic returns. Now assume charges take an additional 0.5 percentage points a year so your total returns are only 4.5 per cent a year. After 40 years of investing you would have £489,000 less.

If you're surprised by this, it's because your snap judgment is prone to an anchoring effect. Your estimate is anchored by the fact that 0.5 per cent doesn't seem much. So you underestimate just how it compounds over time.

The power of compounding is immense. But it can work against you. Which is why fund managers are so rich.

A few might add enough value to justify such fees. But whether you can spot them is uncertain, while the fees are certain. Your general strategy, therefore, is spot on.

But are your choices time-consistent? I ask because of two things you say.

One is that you intend to live frugally when you're older. But are you living frugally now? If yes, then fine. If no, you might well be underestimating your future outgoings because it's hard to change our habits in later life.

Secondly, you say you wouldn't be concerned by a loss of 20 or 30 per cent. Is this really true? Some people say this, only to discover they are concerned when the loss hits. Granted, these are a minority: as Christoph Merkle has shown most investors are not greatly surprised when they are hurt by losses. But the minority who are can make a big mistake: their heightened risk aversion can lead them to sell when prices are temporarily depressed.

So think about whether your future self really will be the person you expect.

 

James Norrington, specialist writer at Investors Chronicle, says:

At this point in your life when your family is expanding, your mortgage costs, childcare and general living expenses are probably high. Although you are a high earner, as you are self-employed it is worth taking some precautions in case you have to take a lower salary from the business in future. As well as keeping a sizeable cash buffer and some investments in liquid money market instruments, you should talk to your financial adviser about ways to protect your income in case of illness.

As you point out your tax-free annual allowance will be reduced to £10,000 going forward. So check whether you have any annual pension allowance that you can carry over from the previous three years. Fortunately, the decision to expand Isa allowances to £20,000 from April 2017 will provide you and your wife with the opportunity to save some more of your money tax-free. If one of your goals is saving for your child, you can also use the annual Junior Isa allowance, which is £4,080 per child in 2016-17 tax year.

 

Caroline Shaw, head of fund and asset management, COURTIERS Investment Services

Distribution of capital when your children reach age 30 requires careful planning, but it seems sensible to target the Isa for the bulk of the withdrawals, as they will be tax-free if taken from here.

Leaving your pension mostly intact so it can keep growing is one of the most efficient tax planning strategies, because if you die before age 75 all withdrawals are free from tax until the money runs out. In cases of death after 75, withdrawals are taxed as income on the recipient.

You should consider funding pensions for your children. This tax-efficient saving won't be accessible until your children are 55 but may allow them as young adults to focus their own savings on house deposits, as they already have some pension provision. And for this you should also choose a buy-and-hold portfolio of low-cost passive investments.

You and your wife should fully use your Isa allowances each year. Considering both your assets is important when planning to help your children on to the housing ladder, and your wife's Isa allowance could also be used to support this objective.

You should also ensure that you and your wife have wills in place that deal clearly with the guardianship of your children in the event of your deaths. Insurance provision, while the children are still entirely dependent, should also be considered.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

This portfolio has a massive equity weighting. Granted, history suggests this is warranted because over long periods equities usually outperform other assets. However, history - or at least UK and US history - might be misleading. We got lucky in the 20th century because the risks that investors worried about - such as political turmoil or depression - did not generally materialise. But can we stay lucky? I'm not so sure.

Certainly, I'd question your intention to become more cautious past the age of 50. If you intend to pass on a big bequest, the time horizon that matters is your children's lifespan and their children's. At 50, therefore, you would be still a very young man for investing purposes. So why plan on cutting equity exposure then? Could it be that you are worried by long-term risks? If so, you should consider reducing risk exposure now.

 

James Norrington says:

The decision to diversify your holdings is sensible and, going forward, your proposed asset allocation will give a balance of international exposures. It also nicely blends passive exchange traded funds (ETFs) and actively managed funds.

You plan to have a high allocation to equities which entails accepting more risk, so while you have a long-term investment horizon and demonstrate a realistic attitude to risk and return, you should consider how you would really feel about your portfolio falling 54 per cent from its peak value as happened to MSCI World Index in 2008-09.

The funds you hold give a high degree of exposure to the US, which is reflective of the global economy, and also other developed markets such as Japan and the UK. It may be the case that several of of your funds have sizeable holdings in the same stocks, such as Apple (AAPL:NSQ), Johnson & Johnson (JNJ:NYQ) and Microsoft (MSFT:NSQ). This may not be a problem, but a level of duplication across funds is something you should be aware of.

Large quality US stocks are expensive right now, so your decision to add some exposure to value stocks via Vanguard Global Value Factor UCITS ETF (VVAL) offers diversification benefits, even if the value style continues to underperform in the short term.

I like that you are considering emerging markets as a way to enhance returns over the longer term. Your proposed ETF holdings give you the opportunity to benefit from the expansion of huge economies like China and India, as well as some dynamic smaller companies in countries such as South Korea and Taiwan that fall in-between definitions of developed and developing markets.

You could consider broadening your asset exposure away from equities. The property securities fund you are considering would help diversification, but as its underlying assets are listed on stock exchanges they could experience volatility in periods of stress.

The use of ETFs also makes it easy to track other assets, such as gold, that are weakly correlated with equities and can help spread your risk. However, as gold doesn't pay an income it shouldn't account for more than a small portion of your portfolio.

 

Caroline Shaw says:

Moving to a passive portfolio will reduce overall costs and this will have a positive effect over the lifetime of the portfolio. 71M AAP Adventurous Fund has had disappointing risk-adjusted returns over the past one, three and five years, and the other funds used have all performed well within their peer groups.

The risk profile of the suggested passive portfolio seems sensible because of its focus on equities. For an 11-year time horizon, investing solely in equities is sensible given your objectives. And in view of your conviction, why not shift the portfolio to being 100 per cent passive? This approach discourages fiddling and incurring trading costs, and removes the need for you to closely monitor newsflow with respect to your active holdings, which will allow you to focus on your increasingly busy family life.

Holding absolute return funds seems out of kilter with your objectives and risk profile, so I suggest the entire Isa and Sipp portfolios are switched to your passive portfolio model, with future contributions directed to the passive choices.

But holding global property securities seems unnecessary. The chosen fund is largely US focused and incurs equity risk and currency risk, rather than property risk, so offers little risk diversification. I would allocate that proportion to global developed world equities instead.