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Passive portfolio has several merits

Our young reader's promising portfolio of indexed investments could benefit from cheaper products and better diversification, according to our experts.
December 7, 2012 and Ian Thomas

Rob Hutchings is 31 and has been investing for one year. He wants to achieve a risk-adjusted return better than the FTSE All-Share index over 25 years, while having a moderate attitude to risk.

"I think I'm far more passive compared with an average investor," he says,"as my portfolio is almost completely indexed. I do not trade individual securities. For my age I presume I'm also more defensive than most investors."

Reader Portfolio
Rob Hutchings 31
Description

Passive portfolio

Objectives

Beat FTSE All-Share over 25 years

Rob Hutchings' portfolio

Name of share or fundNumber of shares/units heldPrice£ Value
Ishares FTSE Gilts UK 0-5 Inc (IGLS)114£131.55£14,996
Ishares Barclays Capital Index Linked Gilt Inc (INXG)1103£13.08£14,427
HSBC FTSE All-Share index Retail Acc3694363p£13,409
Legal & General Global Emerging Markets Index Fund R Acc639445.27p£2,894
L&G US Index Trust R Acc2946195.1p£5,747
L&G Pacific Index Trust R Acc311999.47p£3,102
L&G European Index Trust R Acc1421217.4p£3,089
L&G Japan Index Trust R Acc927929.74p£2,759
L&G UK Property Trust R Acc478250.48p£2,413
Total £62,836

Price and value as at 28 November 2012. Source: www.investorschronicle.co.uk

 

 

Chris Dillow, Investors Chronicle's economist, says:

There are two big things to like about this portfolio. First, it is largely passive. Even if we leave aside the old debate about the merits of active and passive funds - although I suspect this speaks in favour of your approach too - this has the great virtue of economising on charges. You're therefore obeying one of the first rules of investment: to minimise fees. (I hope you're minimising taxes too by investing through individual savings accounts (Isas) and pensions. If not, do so.)

Secondly, you've started investing quite early in life. This means you can take more advantage of the power of compound interest. And, as Albert Einstein said (probably apocryphally), this is the eighth wonder of the universe. To see his point, imagine you saved £1,000 a year for 25 years at 3 per cent a year. This would give you a sum of £36,459. But if you saved £1,000 a year for 30 years, you'd end up with £47,575. An extra £5,000 investment thus earns a return of £6,116 - more than 100 per cent.

What I also like is that you are diversifying internationally. At this point many readers might reply that such diversification doesn't work, because markets often move together. Perfect positive correlation (a correlation coefficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. For example, since January 1995 the correlation between annual returns on the UK and US markets (in dollar terms) has been 0.9. That between the UK and emerging markets has been 0.61 on average, but often higher.

Such high correlations on your portfolio holdings suggest international diversification is no way to spread risk. But it might be for a younger investor such as yourself. Your biggest asset is not your financial wealth but what economists call your human capital; the amount you'll earn from your work over the next 30 years.

And herein lies a danger. If the UK economy does badly relative to the rest of the world, your human capital will suffer, as will (many) UK stocks. Overseas shares help to diversify this risk.

You might think it unlikely that the UK will suffer a purely national depression. But the small chance of a big disaster is one that investors must consider. And it's certainly not unprecedented - just look at Japan's 'lost decades'.

So much for the things I like. There are, though, two smaller things I'm not so happy with.

One is your objective of achieving a better risk-adjusted return than the All-Share index over the next 25 years. I'm not at all sure you'll achieve that with this portfolio; if it does outperform the All-Share, it will probably be because you hold higher-beta emerging markets equities and so take on extra risk, in one sense. And I'm not sure we can even properly define 'risk-adjusted returns'; to do so requires us to know fully what the risks are, which is not easily done. This, though, argues for you forgetting that objective rather than changing your portfolio.

Also, I'm not sure about your two bond funds. These carry the - in my view, large - risk that bond prices will fall over the next few years. Bonds are a safe investment only if you hold individual ones to maturity, as only these give you a guaranteed return.

Sure, the funds might well do well if shares fall in the next few months. But you're a young investor with long-term horizons. So why bother protecting yourself from a risk that doesn't much trouble you. I'd be happier if you had cash and/or particular gilts which mature when you plan to retire.

One other thing. If you're not doing so already, try to contribute a regular monthly sum to these funds. This will have the double virtue of getting you into the habit of saving, and forcing you to buy more shares if or when the market falls. For younger people, future wealth depends more upon how much you save than the precise assets you buy.

 

Ian Thomas, managing director of Pilot Financial Planning, says:

The probability of your portfolio outperforming the FTSE All-Share on a risk-adjusted basis is high, given two astute decisions you appear to have already made. Firstly, you've diversified - both internationally and into different types of asset - and secondly you've selected a range of low-cost funds with no additional active management risk. The empirical evidence suggests that both these strategies are likely to be highly effective.

Although you say that you are more defensive than most investors, equities account for around half the portfolio, which is not so unusual. Of course, whether or not this is an appropriate mix of assets in your particular circumstances depends entirely on your underlying objectives.

It can be useful to think about investment risk from three different perspectives: tolerance, capacity and need. Your psychological tolerance to financial loss is an individual personality trait which can now be reliably measured. Risk capacity is less subjective; for example if some of your investments may be required in the next couple of years, you probably can't afford to take a risk with this part of your portfolio. On the other hand, with 25 years left until you need to draw on your funds there is more scope to place a significant emphasis on real assets such as equities. Finally, given that risk and return are two sides of the same coin, how much risk do you need to take in order to meet your goals? Constructing a portfolio that best matches these three, potentially conflicting, risk measures lies at the heart of effective financial planning and wealth management.

Looking in more detail at your portfolio, several of the equity funds are not priced particularly competitively, which may result in higher tracking errors when compared with similar funds from the likes of BlackRock, HSBC & Vanguard. But price isn't the only issue to consider: it's also important to pay close attention to factors such as a fund's tracking methodology and stock lending policy. For example, Vanguard returns all stock lending profits to its funds to improve returns for investors.

International developed market funds have a broadly similar risk and return profile to their UK counterparts, so it's worth considering whether anything could be done to enhance long-term growth or improve diversification even further. You may like to introduce modest weightings to small-cap & value stocks, which would provide a significant uplift in expected returns, albeit at the cost of somewhat higher volatility. I would suggest the Vanguard Global Small-Cap Index and Dimensional International Value funds (Dimensional funds are only available via independent financial advisers).

In terms of non-equity investments, the L&G UK Property Trust is held in a number of my own clients' portfolios. It's a 'bricks & mortar' fund, which gives access to real property assets and should therefore benefit from low correlations with your other equity holdings. Property securities funds, such as the HSBC FTSE EPRA/NAREIT Developed ETF you're currently considering, can access international markets; however their performance is linked to listed real-estate companies whose valuations often move in tandem with equity markets more generally. Instead, further diversification might be achieved by making a small allocation to commodities. The Lyxor Commodities Thomson Reuters/Jefferies CRB TR ETF offers broad-based exposure to a range of oil products, metals and soft commodities.

In the defensive portion of the portfolio your assets are concentrated in UK government debt, which introduces a singular credit risk to the existing interest rate uncertainty facing all bond investors at the moment. The use of short-dated gilts mitigates the latter risk to some extent, but nearly two-thirds of your index-linked fund is made up of bonds with 15 years or more to maturity. Although index-linked gilts do help insure against unexpectedly high rates of inflation, this fund would be impacted negatively by any significant rise in interest rates. Broadening the coverage of your bond investments, both internationally and into high-quality (AA & above) corporate bonds, would make your portfolio more resilient. My preferred investment in this area is the Dimensional Global Short-Dated Bond fund.

My final observation would be that the tax efficiency of investments is a critical factor in achieving your financial goals, particularly in the current low-returns environment. Make sure that your assets are structured as efficiently as possible and don't forget to rebalance your portfolio regularly, ensuring that it doesn't become more (or less) risky than you originally intended.

http://www.pilotfinancialplanning.co.uk/