Hold trackers as a core and add commercial property

ANONYMOUS PORTFOLIO

Source: Investors Chronicle, *Hargreaves Lansdown. Price and value as at 29 January 2014.

Chris Dillow, the Investors Chronicle's economist says:

The good news here is that your aim of annual income of £12,000 from this portfolio is quite reasonable. It’s equivalent to just 3.3 per cent of your shares and funds - which is less than the current dividend yield on UK equities. Over time, on average, you should be able to take an income of this size - or maybe more - while preserving capital.

However, you face two big trade-offs here. One is between preserving capital and producing income. You can’t do both. The best way to preserve capital is to switch to cash or to safe bonds with a fixed maturity. But these pay nugatory income - generally less than the dividends on shares.

The other trade-off is between security and income generation. The problem here is that yield often has a price; as every Yorkshireman will tell you, you don’t get owt for nowt. This price might be higher risk. For example, utilities have a decent yield but face political risk, while some resource stocks have nice yields but face cyclical risk. Or the price might be worse growth prospects. Tobacco and telecoms, for example, have nice yields because the market doesn’t expect much growth.

The case for buying income stocks is that the Yorkshiremen are wrong - it has been known - and that income stocks are under-priced on average. This has often been the case in the past - but not always, as investors who bought Northern Rock and Bradford & Bingley on high yields in 2007 will tell you.

If you want an income, you can create it yourself by selling some shares. By all means, buy income stocks if you think they’re under-priced. But don’t distort your portfolio by chasing something you can get in other ways.

I have a bigger gripe with this portfolio, though. And it’s one you yourself see, when you say you’ve not given enough thought to the balance of the overall portfolio. The problem is that, in holding several funds, you are taking on correlated bets. Take for example, Rathbone Income. Its biggest holdings include GlaxoSmithKline, AstraZeneca, BAT and Imperial Tobacco. But Invesco Perpetual High Income’s biggest holdings also include Glaxo, AstraZeneca, BAT and Imperial Tobacco. The two funds are thus quite similar.

We wouldn’t think much of a football manager who bought a load of central defenders, even if they were all good ones. But this is what you've been doing. Investors should ask not “is this a good investment?” but “what is this offering me that I haven’t got already?” Even with a lot of effort, you’ll find that funds rise and fall together, simply because any basket of stocks is correlated with the market. But you’re adding to this problem by not asking this.

This sort of mistake is pernicious because it arises from good motives. It's good to be a buy and hold investor. But doing so runs the risk that you gradually add one or two funds to your portfolio every few months, and end up with a messy portfolio that merely tracks the market badly.

You might object that there’s nothing much wrong with tracking the market. I agree; I hold lots of trackers myself. However, you’re tracking the market expensively. Actively managed funds charges of a bit over 1 per cent per year might not sound much. But they compound nastily over time. And they are easily avoided, by buying a cheap tracker rather than a lot of active funds.

It’s in this context that we ask the question: “in what ways do you differ from the average investor?” The thing is, the average investor must, by definition, hold the market portfolio. It is only if you differ from the average - say by being exposed to different risks or (less likely) by knowing something the average doesn’t - that you should deviate from the market portfolio. But you see yourself as very average. So why not, therefore, simply hold a low cost tracker fund - accompanied, if necessary, by a few interesting plays?

Paul Taylor, a chartered financial planner with McCarthy Taylor says:

We have tested your portfolio against the FTSE All-Share Index and you have outperformed, over the past five years. You now want to switch to income and generate around £12,000 per year from Investments. You plan to take 25 per cent of the Sipp as cash and we suggest units are sold to facilitate this soon, as we anticipate volatility to remain in 2014 and while the FTSE may peak as high as 7000, we expect to see that come off, as profit taking and interest rate fears take effect, along with the impact of quantitative easing coming to an end. While we have no long-term fears for equities, you need to make sure your cash requirement is secured from sudden market falls.

Your direct equities are well chosen although we would not hold Aim shares, FirstGroup, or Clarkson who have under-performed. Aviva, Catlin, GlaxoSmithKline and Huntsorth all yield above 3 per cent and have gained value.

The emphasis on UK funds is right and indeed we would go further. The UK not only offers reduced currency risk but also access to global companies at sterling rates. However, to manage risk and achieve greater diversification we would recommend holding some trackers and ETFs, as core holdings.

Here we recommend iShares UK Dividend UCITS ETF (IUKD) whose objective is to provide exposure to the 50 highest-yielding stocks, within the universe of the FTSE 350, index excluding investment trusts. It pays out quarterly. With charges of 0.4 per cent a year and no initial charge, its a low cost option that has outperformed the sector by approx 9 per cent.

Likewise, the Vanguard FTSE UK Equity Income Index Fund (GB00B5B74684) tracks by investing in securities which make up the index, holding each stock in approximate proportion to its weighting in the index. The yield is 4.2 per cent paid half yearly and costs 0.25 per cent a year.

We also like the Temple Bar Investment Trust (TMPL) run by Alastair Mundy. With annual costs of 0.44 per cent and a yield of 3.01 per cent, it returned nearly 28 per cent last year. Mr Mundy shares your view of a long-term hold and although highly concentrated, the trust will do well.

We would retain the income funds already held, for example Newton Global Income and Artemis Income but replace accumulation funds such as Artemis Global Growth, Fidelity Global Special Situations and Jupiter Emerging European Opportunities. We consider Europe to be a volatile market with an uncertain outlook, preferring to concentrate on UK and US markets in a portfolio of this nature.

We would increase property to around 10-15 per cent of the portfolio at the expense of Corporate bonds, which are likely to suffer a further fall in value as investors appetite for equity returns increases. British Land Company (BLND) has a yield of 3.27 per cent and the F&C Commercial Property Trust (FCPT) 5.11 per cent albeit at a total cost of 1 per cent a year. Picton Property Income, which you already hold in your Sipp has been a good performer, with a 5.3 per cent yield and 66 per cent gain, should be retained although gearing (currently 216 per cent) should be watched with interest likely to rise, this may drag performance.

We also consider come moderate infrastructure exposure would provide a consistent yield. For example the HICL Infrastructure Company (HICL) managed by Tony Roper, generates income through having a well-diversified portfolio, with revenue predominantly from government backed and inflation linked projects. This fund is more conservative than its peers and invests mainly in the UK. The yield is 4.79 per cent but it's not cheap at 1.6 per cent a year.

Finally, 10-year gilts yield just under 3 per cent and offer a low cost fixed interest element and some index linked bonds and gilts should be added to hedge inflation.