Beware naïve diversification

The following shares are held in Graeme Smith's wife's name (who is a lower-rate taxpayer)

Source: Investors Chronicle, price and value as at 19 October 2012.

The following funds are held either in Graeme Smith's Sipp or Isa:

Chris Dillow, Investors Chronicle's economist says:

Your equity portfolio is a classic defensive one, with big weightings in utilities, food retailers and the safer insurers. However, this does not mean it is without risk.

For one thing, defensive stocks carry market risk – just less than others. If shares generally fall, so too would these shares. They’d just probably not fall as much, if the market has a bad week or month.

And for another thing, defensives carry behavioural risk. The case for holding defensives is not that they are relatively safe; if you want to reduce risk, you should hold cash, not less volatile shares. Instead, the case for them is that they are, on average, under-priced and so offer unusually good returns on average.

But herein lies a risk. It’s possible that investors will eventually wise up to this fact and buy defensives, thus bidding up their prices to levels from which subsequent returns will be poor. The fact that defensives have done well in recent months might be a sign that they have done just this. If so, they’ll do badly from now on.

I don’t say this to suggest the portfolio is bad. It might well not be, as there’s no way of knowing for sure whether or when behavioural risk will materialize. Just be aware that this portfolio is not safe.

This, though, is not my main problem. Instead, it’s your fund holdings I don’t like. My table shows why. It shows the returns for some of the equity income funds you hold – though my point also applies to your emerging market funds. It’s clear that these returns are quite similar; all the funds suffered in 2007-08, bounced thereafter and have done OKish since but for a lacklustre 2010-11. What you’re doing, then, is diversifying away a small risk – fund manager risk, the risk that one fund will do worse than its peers – whilst taking on a bigger risk, that the market generally will fall.

This is not a fault of the fund managers. It’s a simple mathematical fact that if you hold a few dozen stocks, you’ll have a portfolio that’s correlated with the market and with other portfolios.

What you’ve got is something like a global tracker fund, because you’re taking market risk and little fund manager risk. But you’ve got this at too high a price. Annual management charges on actively managed funds are higher than those on trackers; L&G’s international index fund, for example, has an annual charge of 0.7 per cent, while several of your funds have charges of 1.5 per cent or more. In a world of low returns, such fees make a difference.

I fear you’re committing quite a common error here – that of naïve diversification. It’s tempting to think that we can spread risk by holding lots of different assets. But this is not true if those assets are correlated with each other, as equity funds are. It would be cheaper to reduce these funds, and replace them with a tracker.

You might object that a tracker doesn’t necessarily give you the exposure to income stocks that you’d like. In theory, though, there’s no reason to like high yielders. A high yield comes at a price – of either unusual risk or unusually poor growth. Remember, in 2007 Bradford and Bingley and Northern Rock were income stocks.

But what if theory is wrong, and high yields are a sign that shares are underpriced? You’ve three options here. You could buy the individual stocks you consider under-priced yourself. You could entrust one fund manager to do so, if you think he has the requisite skill. Or you could back the field of income stocks by holding iShares dividend plus ETF. This is a cheaper way of buying income stocks than a spread of equity income funds.

Ben Yearsley, head of investment research at Charles Stanley Direct says:

You have too many holdings - 42 fund holdings and 17 shares. You also talk of wanting income growth from his portfolio - yet of the 42 funds only six are actually income share classes. Obviously many of the shares are good dividend payers, which clearly helps offset the accumulation bias in the fund side.

Dealing with the share portfolio first, you (and your wife) generally invest in blue-chip stocks with reasonably high yields. This is a pretty sensible strategy to be honest. There is a range of sectors covered too; some with a very international feel and others with more of a UK bias. It's hard to be critical of the share portfolio (as I have quite a few of them myself). As your wife is a low rate tax payer, dividends paid should be relatively tax efficient from the share portfolio and there is unlikely to be much further if any tax to pay.

Turning to the fund portfolio, there are simply too many holdings. In addition why own multi-manager funds alongside single strategy funds as there is a definite case of doubling up. For example, the Invesco Perpetual Income and High Income funds are held in the HL Multi Manager Income and Growth Trust, as are Psigma Income, Artemis Income and Liontrust. There is no problem having a core and satellite approach with MM funds being the core, but then make sure your satellites aren’t already held in the portfolio.

Collectively there is very little wrong with the funds in the portfolio. Most have quality managers with a sound process. A few leave a bit to be desired, for example the Fidelity International Fund has probably seen better days as has the Invesco European. Rather than add to the fund list, you could simply add to some of your existing holdings - Jupiter European and Lindsell Train Global Equity for example.

Another area you are short of is overseas income - you could consider looking at funds such as the First State Global Listed Infrastructure Fund, or trusts such as the Aberdeen Asian Income Trust.

The only other area I would highlight is with your bond holdings. You have three funds - and two of those have an equity weighting. I would almost question why bother having such a small bond holding in his portfolio. Why are they there? Is it for income or is it to add a more cautious holding? If you do want to add a bit more caution to the portfolio then you may want to consider adding more at some point in the cycle - not necessarily today, but funds to consider include Jupiter Strategic Bond.

Overall you have a good list of shares and funds across your portfolios - but I think you do need to shorten the fund list and rethink your strategy slightly due to the duplication between multi manager funds and some/many of the funds you already own.