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Broaden your overseas exposure to balance your portfolio

Our reader wants to generate a return of 4 to 5 per cent a year, but should consider adding some overseas exposure to help balance his portfolio
November 24, 2016, Ian Forrest and James Norrington

Alaster is 67 and has been investing for 44 years. He and his wife have two children who are no longer financially dependent on them.

Reader Portfolio
Alaster Chalmers 67
Description

Shares and funds

Objectives

Income & capital growth of 4 per cent to 5 per cent

"Our goals are providing a growing income and capital growth on our investments of 4 to 5 per cent," says Alaster. "We have cash individual savings accounts (Isas) worth approximately £55,000 and premium bonds worth £40,000, and own our home. My wife also has half-shares in two other houses valued at between £400,000 and £500,000.

"My attitude to risk has always been to ride out the highs and lows in the market. Losses in a market crash might be high, but reinvesting during these times increases portfolio value in the long run.

"As the market is in continuous movement it pays to keep cash available for unexpected outgoings and keep the portfolio growing by reinvesting dividends.

"I have reduced my holding in WM Morrison Supermarkets (MRW) and switched the proceeds into Royal Dutch Shell (RDSA).

"I have been reinvesting dividends from BP (BP.) and InterContinental Hotels (IHG), and also plan to start doing this with Standard Life (SL.).

"I am thinking of adding some investment trusts, such as Scottish Mortgage Investment Trust (SMT), and will add to my current holdings by reinvesting dividends, mainly in holdings with dividend cover of between one and two times."

 

Alaster's portfolio

HoldingValue (£)% of portfolio
Aviva (AV.)2,8021.85
BAE Systems (BA.)1,6711.11
Banco Santander (BNC)7140.47
Barclays (BARC)2,9031.92
Royal Dutch Shell (RDSA)14,9329.87
InterContinental Hotels (IHG)8,9165.9
Lloyds Banking (LLOY)3,8092.52
Marks and Spencer (MKS)6560.43
Mitchells & Butlers (MARS)900.06
Wm Morrison Supermarkets (MRW)6,0273.99
National Grid (NG.)26,78717.71
J Sainsbury (SBRY)1,8461.22
SSE (SSE)5,5303.66
Standard Life (SL.)9,7506.45
Vodafone (VOD)1,9041.26
Whitbread (WTB)14,8919.85
Share (SHRE)2700.18
United Utilities (UU.)4,8013.18
Experian (EXPN)6,3144.18
Centrica (CNA)1,8551.23
Glencore (GLEN)4830.32
BP (BP.)2,2081.46
HSBC (HSBA)4,2452.81
Artemis Income (GB00B2PLJH12)4,7933.17
Newton Global Equity (GB00B8376K50)5,1783.42
M&G Gilt & Fixed Interest Income (GB00B734BY83)17,83711.8
Total151,212

None of the commetary here should be regarded as advice. It is general information based on a snapshot of the reader's circumstances. 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You're getting two big things right here. One is that you're reinvesting dividends. This is a good idea because the chances are that most equity returns will come from dividends.

To see why, assume that shares are now fairly priced, so the dividend yield on the All-Share index stays at its current 3.6 per cent. And assume that dividends in real terms rise at the same rate as real gross domestic product (GDP). Let's call this rate 2 per cent, which has been its historic average. This implies that share prices will rise 2 per cent a year in real terms.

This means that if you take dividends out each year, over 10 years £100 invested in equities will grow to £122 after inflation. But if you reinvest dividends that £100 will grow to £172. Over two-thirds of your returns thus come from dividends. This is because of the power of compounding and the likelihood that yields will exceed real growth rates.

The second thing you're doing right is having a big weighting in defensives. We must, however, be clear why these are a good investment. It's because they tend to outperform on average over the long run. This might be because investors underweight the importance of the sort of monopoly power that flows from barriers to entry such as high capital requirements or brand loyalty. Or it might be because fund managers don't want to risk holding stocks that would underperform a sharply rising market.

This case for defensives, however, is very different from the notion that they are safe. They are only relatively so. In a sharp market downturn they would probably fall - just by less than the general market.

 

Ian Forrest, investment research analyst at The Share Centre, says:

I like that you have a well-diversified portfolio spread across a broad range of sectors, consisting mostly of large FTSE 100 companies. Your strategy of riding out the ups and downs of the market is also a good strategy as the best returns usually come from long-term investment in shares. They are, however, inherently more volatile than other asset types, and that has been especially apparent in recent months with big swings caused by the vote for Brexit and the US election.

Looking more closely at your portfolio, the only possible gaps I can detect are your relative lack of exposure to emerging markets and the construction sector, both of which offer the potential for future long-term growth. On the former I would advise caution given the speculation that US president-elect Donald Trump may seek to protect US markets by increasing trade tariffs and renegotiating existing trade agreements. That would probably hurt emerging markets, which have become more volatile in recent weeks.

However, Mr Trump has also strongly signalled his intention to boost spending on infrastructure, which could be good news for companies such as Ashtead (AHT), the equipment rental firm which generates most of its income in the US.

James Norrington, specialist writer at Investors Chronicle, says:

With no mortgage and the children off your hands, the main objective is generating income for retirement. Your investment portfolio is worth about £150,000, so your goal of around 4.5 per cent annual yield would give you an income of £6,750. You don't mention any occupational pension schemes, so in addition to your state pension entitlements, this would give you and your wife a joint annual income of around £20,000 to live on. If there is rent from your wife's properties in excess of any mortgage or upkeep costs, then the same overall income could be achieved with less reliance on the securities portfolio. Although historically a 4.5 per cent yield is not huge in the current climate it could be difficult to achieve without taking significant risks.

You have wisely set aside a sizeable cash sum to take care of any unexpected expenses and to help you ride out any nasty stock market falls. However, I'm not a fan of premium bonds as these offer very little interest and poor odds of actually winning a substantial prize. As you already have a decent cash cushion, the £40,000 in premium bonds might be put to better use in your investment portfolio, especially if you and your wife are yet to use this year's Isa allowances.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You say you're only prepared to lose a maximum of 10-15 per cent in a year, but this portfolio might well lose more in a very bad year.

Your cash Isas offer you a lot of protection, and you also get some from M&G Gilt & Fixed Interest Income Fund (GB00B734BY83), although you could get cheaper exposure to gilts via an exchange traded fund (ETF).

Here, though, I'd remind you of a key rule that's often forgotten: what matters is your portfolio as a whole - not only any individual component of it.

As I write, gilts have suffered heavy losses since Mr Trump's victory in the US presidential election: but global equities have done OK. This is because investors think Mr Trump's likely fiscal expansion will be good for shares but bad for bonds. This reminds us that a reason for holding bonds is as a hedge against equities: what's good for one is often bad for the other. Viewed in isolation, bonds look like a bad bet now. But if you view them as a way of spreading equity risk, which might well return, there is still a case for them.

A further issue is whether you have sufficient overseas exposure. It's quite possible that global markets will outperform the UK in coming months, for example if Mr Trump's fiscal easing and a possible upturn in the euro boost global equities while Brexit-related uncertainty hurts the UK. You have indirect exposure to this because UK stocks are correlated with global ones, and a fall in sterling would help overseas earners such as Glencore (GLEN) and the oil majors.

But do you have enough? You might want to consider a global equity ETF as a way of diversifying domestic equity risk.

 

Ian Forrest says:

I like your policy of reinvesting dividends given that you do not currently require the income. Seeking stocks where dividends are covered twice by earnings helps ensure that the payments are sustainable.

However, I would also recommend that you combine that with a search for companies with a long-term track record of raising dividends above inflation - the so-called dividend aristocrats. Moving out of Morrison into Royal Dutch Shell makes a lot of sense given the competitive pressures in the supermarket sector and better yield on offer at Shell, although it is worth keeping an eye on the oil price in case it continues to fall.

The general quality of the stocks held is also helping to reduce the portfolio's overall risk level. While diversity is a good thing, with 26 separate holdings it may be worth cutting the smaller holdings in Glencore and Mitchells & Butlers (MAB) where the dividends are either non-existent or below average.

The commercial property sector, accessed via investments such as real estate investment trust (Reit) British Land (BLND), is attractive at present given the discounts on offer and relatively high yields. But you should be aware that the vote for Brexit has increased the degree of uncertainty over future demand for property, especially offices in London.

 

James Norrington says:

Several of the holdings in your equity portfolio have dividend yields that would meet your target of around 4.5 per cent. However, this is not without risk. As an experienced investor you seem to have a realistic appreciation of these risks and, having run your equity holdings (but not your funds) through the Prairie Smarts tail risk analysis software, it is estimated that in the worst 0.5 per cent of months, on average, your share holdings would lose 25 per cent.

There are some good defensive positions here in utilities and non-life insurance stocks, although I think that you are a bit overexposed to banking and the broad financial sector. Many commentators are saying that it is time to switch into value stocks, but it remains to be seen whether all of the headwinds facing the banking sector have subsided. It may be worth reassessing your holdings in banks and selling the weakest.

This portfolio is very UK-focused, even with your holding in Newton Global Equity Fund (GB00B8376K50), and while diversification benefits can be overstated, particularly in highly correlated developed markets, adding further international exposure will broaden the available set of income-generating investments.

Amid all the political and economic uncertainty, government bond prices and yields are likely to face further volatility in 2017, so it is difficult to recommend that you significantly increase holdings in bond funds - which face the risk of capital losses if yields rise suddenly. However, it might be worth switching some of the premium bond cash into an index-linked bond fund that pays out an income that keeps pace with inflation.

Another fixed-income possibility is retail corporate bonds, which can be bought on the London Stock Exchange's ORB exchange: these are less liquid than the bonds bought by institutional bond funds but some of the larger and most solvent issuers offer a worthwhile coupon, plus the return of the principal at maturity. Clearly, there is a higher degree of capital risk than from premium bonds, but it is still less than from equities and at least you can expect a regular income.