Property consultant has too much property exposure

GILES' PORTFOLIO

Price and value by Giles as at 12 and 13 December 2012

Chris Dillow, the Investors Chronicle's economist says:

With its low holdings in defensives and exposure to emerging markets, banks and housebuilders, this portfolio has a distinct high-beta tilt. It should outperform in better times, and underperform in worse ones.

Speaking futurologically - which I don’t like doing as it shouldn't be a big basis for an investment strategy - this has a pro and a con. The pro is that sentiment - as measured by foreigners' buying of US equities or the level of Alternative Investment Market (Aim) shares relative to the FTSE 100 - has recently been unusually depressed. This is a bullish sign partly because unusually high risk aversion should, with average luck, lead to good returns and partly because sentiment often mean-reverts; when it's low it subsequently rises, giving shares a lift.

The con is that I can see few good reasons to expect western economies to grow very much this year. Any rise in the market, therefore, won't have an immediate economic basis - it'll be founded either in reduced tail risk or in betting on better times in 2014 - and would therefore be vulnerable to at least temporary reversals in the event of bad news.

Net, I suspect this strategy will pay off, but I’d only attach a subjective probability of around two-thirds to it.

There's something I’m less confident about. You say "all cyclicals will be managed down towards the end of the next cycle." I'm sorry, but I doubt this is possible. For one thing, downturns are not foreseeable; I hate that word 'cycle' as it implies a predictability which doesn't exist. And for another, I fear you’re ignoring the projection bias - our inability to predict that our tastes will change. You fail to anticipate that, at the top of a 'cycle' our appetite for risk increases and so we become inclined to buy rather than sell cyclicals.

I don't think this is an immediately pressing problem. But it will eventually become one.

There is, though, something that bothers me more. It’s that the tilt towards high beta shares is a patchy one. While you've massive exposure to housebuilders, you’ve no Aim, IT or engineering stocks, and only one second-line commodity share. And yet such stocks would also probably do OK if the market generally rises.

I suspect the reason for this pattern lies in your background as a property consultant. This means that property stocks and housebuilders are more familiar to you than (say) IT and commodity stocks.

And here, there’s a good and a bad reason for you to own such stocks. The bad reason is that you think that your professional expertise enables you to predict returns in these sectors. But it might not. Research into a large number of Norwegian investors has found that those who invest in shares in their own industry tend to underperform the market. This suggests that specialist know-how gives us overconfidence and the illusion of knowledge. There's a big difference between knowing an industry and being able to beat the market. The latter is a lot more difficult than generally realised.

There might, however, be a good reason for such exposure. It lies in uncertainty aversion. Shares are not only risky - in the sense of exposing us to known probabilities - but also uncertain, in the sense of exposing us to unknown unknowns. You might reasonably feel that your background makes property shares less uncertain to you, while IT or commodity stocks do carry uncertainty. To this extent, holding so many of them is quite reasonable.

And this raises a fascinating psychological point. This portfolio is best suited to someone who is tolerant of risk - it carries lots of market risk - but intolerant of uncertainty. Does this describe you? Are you ambiguity averse, in the sense that you're much happier betting on known probabilities than unknown ones? If it does, then this is a reasonable portfolio. If not, then perhaps you should shift out of some housebuilders and into safer assets.

Paul Taylor, managing director and founder of McCarthy Taylor, says:

Your portfolio is split between 45 per cent equities, 15 per cent residential property and 40 per cent bank bonds. We suggest taking advantage of returning confidence by increasing equity exposure, and adding other asset classes. Subject to your appetite for risk we would recommend adding commodities and infrastructure to the mix, largely using the cash from your maturing bank bonds. We suggest you use exchange traded funds (ETFs) to access markets cheaply (charges are typically 0.4 per cent to 0.6 per cent per year), and to diversify the portfolio by tracking markets, without the need to stock pick or pay investment manager charges which even on investment trusts can be around 0.7 - 2 per cent. Using ETFs reduces capital gains tax (CGT) issues, as CGT only arises on disposal of the ETF, not on the stocks held within it.

We do not share your confidence in the property market and construction. While London has seen growth, across the country the outlook for property and housebuilding remains uncertain. The fuel that drove these markets, cheap mortgages and a willingness to borrow, is missing and recovery is slow. Even with overall confidence returning, we don't expect to see the 'boom times' returning soon. To increase your already high property exposure would seem to be extending risk for limited upside returns.

The market does not share our view but often being contrary pays off, we might take profits here as the housebuilders in the portfolio are showing significant gains over 12 months. Of the property companies held, we would dispose of underperforming London & Stamford. Infrastructure is a viable alternative and we would put 1-2 per cent of your portfolio into HICL Infrastructure Company (HICL).

You have rightly concentrated on UK equities, a sterling-denominated global market, but have exposure to developing markets through some well chosen, albeit high-risk, investment trusts, particularly Aberdeen Asian Smaller Companies and Scottish Oriental Smaller Companies, up over 54 per cent and 43 per cent respectively in the last year. At 0.8 per cent of the portfolio, specific Chinese exposure is light. As China represents a rapidly growing economy, with 8 per cent growth and is expected to overtake America by exploiting its domestic market, we would recommend 10 per cent exposure, using the ishares FTSE China 25 ETF (FXC). This ETF holds Hong Kong companies trading in China.

You, understandably, have no exposure to Japan, given an extended period of underperformance, but changes of Government and stimulus packages announced recently suggest an exposure of around 5 per cent is sensible, by investing in the ishares MSCI Japan ETF (IJPA). The weakening yen is already helping Japanese exports and tracking this market should give additional returns above cash. Europe, on the other hand should still be avoided; they have yet to resolve the eurozone issues and the 'temporary' fixes are not a solution.

We do not favour Latin America largely because of political risks and avoid Russia for similar reasons. India needs to sort out its tax system and open up its markets to exploit its opportunities properly. The US remains the largest economy in the world and we suggest you ought to buy 20 per cent of equity here using the iShares MSCI North America ETF (INAA). These changes will reduce your cash by half leaving liquidity to take advantage of expected adjustments in bonds prices and to take advantage of opportunities from price volatility.