Young Isa investor has sound principles

OLIVER'S ISA PORTFOLIO

Source: Reader's figures

Last three trades

Baillie Gifford Global Discovery, Neptune Japan Opportunities, European Assets Trust

Watchlist

Templeton Emerging Markets, Ignis European Smaller Companies, R&M UK Long Term Recovery, a commodity fund and a green energy fund.

Chris Dillow, the Investors Chronicle's economist says:

I really love your approach to investing.

First, you’ve avoided the error of overconfidence, by recognising that you don’t have stock-picking skill. This is especially wise for a genuine long-term investor. In the long-run, there’s a high risk of individual shares doing badly or even collapsing because they become victims of creative destruction, bad strategic decisions or technical change. A man of your age has better life expectancy than the typical FTSE 100 company. The cheap and easy way to avoid these risks is to back the field rather than particular horses by holding tracker funds.

Secondly, you’ve recognised the importance of fund charges. These matter enormously, because apparently small fees compound horribly over time. For example, if two funds both return 5.5 per cent a year before charges over 20 years, a fund charging one per cent annual fees will cost someone with a £100,000 investment over £24,000 more than a fund charging 0.5 per cent. Do you really want to give a fund manager a brand new car for nothing?

I fear, however, that whilst your principles are superb, your execution of them is a little imperfect.

Put it this way. Vanguard Lifestrategy’s 100 per cent equity fund is like a global equity tracker fund - albeit with a big UK weighting - at low cost. Why do you need anything else?

I’m sceptical of the idea that other funds will deliver higher returns. Of course, it’s certain that some region or sector will beat the global market over the long-run. The question is: can we identify them in advance? I’m not sure.

You have several small cap funds. Granted, these have done well recently. But there’s no guarantee this can continue. Economic theory - in the form of Gibrat’s law - tells us that corporate growth is independent of size; big companies are as likely to grow well as smaller ones. And this isn’t massively refuted by the facts. In his survey of corporate growth Alex Coad at the Max Planck Institute finds that growth is largely random, idiosyncratic and unpredictable. And history shows that small cap stocks can underperform for years; in the UK, they did so from the mid-80s to mid-90s, for example.

I’d regard small caps not as a long-term growth play but rather as a cyclical one. If growth picks up, small caps should continue to do well. But if or when it falters, they won’t.

Similarly, economists have found that, over long periods, equity returns are only weakly related to GDP growth - partly because growth benefits workers or unquoted firms rather than shareholders and partly because expected growth is already embedded in share prices. This warns us against regarding emerging markets as a play on future growth. Insofar as emerging markets do outperform over the long-run, it is as a reward for taking on extra risks.

I’d recommend that you cut back on the number of fund holdings. Remember that most are highly correlated with Vanguard’s fund, simply because baskets of stocks are correlated with the global market.

My other doubt is your use of bond funds. These have their uses. They are a good way to hedge against: cyclical risk because prices of better-quality bonds tend to rise in recessions; some forms of equity risk, as bond prices rise if investors become more risk-averse; and annuity rate risk.

However, as you’re a long-term investor the last two might not apply to you. And unless you work in an unusually cyclical industry I’m not sure the first one does either. Worse still, you might be paying a high price for holding such funds. Insofar as interest rates rise over the long-term, bond funds would fall.

Of course, I appreciate that you don’t want to be fully invested in equities. But I suspect there are better, cheaper alternatives to bond funds. If you want certainty of long-term returns, you might hold gilts directly. Otherwise, cash might do a decent job of helping stabilise returns.

Douglas Millward, investment manager at Lowes Financial Management, says:

If you are confident you can leave some of these monies tied up until you retire, for greater tax efficiency we would advocate the use of self-invested personal pensions (Sipps) as well as Isas. Such plans carry all the tax efficiencies of Isas, with the additional benefit of receiving a tax rebate from the government on the amount you invest, dependant on your personal tax bracket. You can contribute up to your gross salary annually into a pension, capped at £50,000, dropping to £40,000 from April. Depending on your existing pension arrangements you mayalso be able to carry forward three years of unused pension allowances.

The portfolio which you have already constructed is invested across a range of asset classes. This diversification should hopefully mean that elements of the portfolio will perform in differing market conditions. The use of funds adds further spread. ETF usage has advantages in terms of cost and target market coverage. However, always ensure that you research the underlying ETF which you look to use, as some offer differing market coverage.

Your portfolio has a higher bias towards equities which is sensible given your longer time horizon. The global allocation, along with market cap spread, adds further diversification.

A dividend yield target on a pension fund may not appear an obvious remit, but one which can be advocated. As a pension fund we can assume that the income will be reinvested. This will allow you to benefit from compounding.

With regard to recent trades, the Baillie Gifford Global Discovery fund targets significant growth prospects in industries with potential for structural change and innovation.The fund has achieved top decile performance since 2011. The volatility of the fund could be more significant in down markets but can be afforded given the investment time horizon.

The Neptune Japan Opportunities Fund has performed strongly, benefitting from the tactical currency hedge in place. With Abenomics likely to lead to further yen weakness this hedge could continue to contribute.

The European Assets Trust (F&C) has performed very well. Total return has been enhanced by discount narrowing, in particular over the past 12 months, narrowing from 16 per cent to par. Moving forward there is little to no scope for total return enhancement via such narrowing.

Within your watchlist you have stated the Ignis European Smaller Companies Fund. This would provide exposure to the same investment arena as the European Assets Trust. However there is no crossover within the top 10 holdings. Europe appears to be finally delivering economic growth and therefore smaller companies may be an appropriate way to benefit from the domestic recovery.

The R&M Long Term Recovery Fund invests in UK equities that are seeing a turnaround in company profitability,with a style tilt toward earnings growth and revisions. This suits the current economic phase. The fund has achieved 1st quartile performance over 1, 3 and 5 years.

The Templeton Emerging Markets Trust currently trades at an 8 per cent discount to NAV following the sell-off in emerging markets. This potentially represents an opportunity. However, with tapering still causing concerns with regard to outflows from emerging markets as a whole, increasing exposure now maybe premature.

China, one of the largest consumers of commodities, still appears to be in a state of economic slowdown as it tries to move its economy to being more consumption led. Since the first quarter the price of copper, a barometer to industrial production, has been in a downtrend. It may therefore still be too early to consider a pure commodity play fund.

The Pictet Clean Energy fund seeks to achieve capital growth by investing in the shares of companies that contribute and benefit from the switch to lower carbon energy sources. This would be a significantly longer term play than a standard equity investment.

Overall, it is important to resist the temptation not to become over diversified in terms of fund holdings and sector coverage as you may dilute the advantage of using active management.