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Fine tuning my Isa to supplement pension income

Our reader is approaching retirement and wants to know how to reduce his funds and add increased diversification to his individual savings account portfolio

Jake is 59 and aims to retire at 60. He describes himself as an "adventurous investor" and over 20 years has built up an individual savings account (Isa) portfolio worth £236,000. He aims to use the income from this portfolio to supplement his secure pension. So he is seeking yield from the portfolio, plus some growth to keep pace with inflation.

"My holdings are too numerous and not diversified enough," he says. "I want to reduce the number of funds held and the management charges.

"I also aim to diversify the portfolio by adding a commercial property trust and other trusts, hopefully bought at a discount to their underlying net asset values. I do not see value in bonds or in adding gilts."

Jake's watchlist includes: TR Property Investment Trust (TRY), City of London Investment Trust (CTY), Scottish Mortgage Investment Trust (SMT), Edinburgh Investment Trust (EDIN), Finsbury Growth & Income (FGT), Troy Income & Growth Trust (TIGT) and Merchants Trust (MRCH).

He is also looking for a long-term European (ex-UK) trust, possibly European Assets Trust (EAT) or Fidelity European Values (FEV) and an Asian focused trust, possibly Aberdeen New Dawn (ABD)

Reader Portfolio
Jake 59
Description

Individual savings account

Objectives

Income & growth

JAKE'S PORTFOLIO

Name of holdingNumber of shares/unitsPrice Value%
Artemis Global Income I Inc (GB00B5N99561)1944387.91p£17,0927
Troy Trojan O Inc (GB0034243732)3224216.94p£6,9943
CF Woodford Equity Income Fund C GBP Inc (GB00BLRZQ620)9183117.53p£10,7925
M&G Global Emerging Markets I Inc (GB00B3FFXY53)1151221.05p£2,5441
CF Miton Total Return Fund I Acc (GB00B9572G80)2413103.37p£2,4941
Old Mutual UK Equity Income Fund R Inc (GB00B1XG9151)7798141.25p£11,0145
Rathbone Income I Inc (GB00B7FQLQ43)823915.41p£7,5333
Royal London UK Equity Income M (GB00B3M9JJ78)5015763p£38,26416
Threadneedle UK Growth & Income ZNI (GB00B8848T44)5998£1.39£8,3374
Vanguard FTSE UK Equity Income Index Acc (GB00B59G4H82)9£236.34£2,1371
Artemis High Income I (GB00B2PLJN71)1057486.12p£9,1064
Artemis Income I Acc (GB00B2PLJH12)863378.01p£3,2621
Newton Global Income Institutional Shares W Net Inc (GB00B8BQG486)7156123.32p£8,8244
First State Asia Pacific Leaders B Inc GBP (GB00B57S0V20)5041185.96p£9,3744
Fundsmith Equity I Inc (GB00B4MR8G82)8312£2.04£16,9567
Murray International Trust (MYI)26291035.14p£27,21311
Rathbone Global Opportunities I Acc (GB00B7FQLN12)5028140.36p£7,0573
Schroder Global Equity Inc Z Inc (GB00B76V7N76)1348777.7p£10,4794
Schroder UK Alpha Income Z Inc (GB00B073JS25)4578184.2p£8,4324
Threadneedle UK Equity Income ZNI (GB00B8169Q14)15713£1.37£21,5269
Standard Life UK Smaller Companies Trust (SLS)1334288.63p£3,8502
North American Income Trust (EUS)320881.25p£2,8201
TOTAL£236,100100

Source: Investors Chronicle, as at 24 April 2015

 

LAST THREE TRADES

Fundsmith Equity (buy), CF Woodford Equity Income (buy) and Artemis Global Income (buy).

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

Are you sure you want income? You can, in effect, create your own income simply by selling some holdings. For many investors, doing so makes sense because it is tax-efficient: although most of us make full use of our income tax allowance, we don't always maximise our £11,100 capital gains tax allowance. We should.

Even if this doesn't apply to you because all your holdings are in an Isa, there's still a reason to be wary of such a big focus upon income stocks. It's that income comes at a price. A high yield is a sign either that investors regard a stock as unusually risky, or that they are pessimistic about its growth prospects.

The case for buying income stocks, insofar as there is one, is that investors might be too pessimistic about their growth or their risks. Otherwise, buying for income makes little sense.

You are absolutely right to look for investment trusts that trade on discounts to net asset value. There's some evidence that big discounts can be a sign that investors are irrationally pessimistic about a trust and when this is the case there are genuine bargains to be had. However, what matters is the trust's discount relative to its own history: discounts can vary across trusts for other reasons so a big discount on a particular trust relative to others is not necessarily a good thing.

In this context, the key thing to ask is: is my pension income enough to live comfortably on? If it is, then you can afford to take on equity risk and so it's reasonable to look for a general international investment trust - perhaps doing so by selling some higher charging funds.

However, I would assume - as a rule of thumb - that there is a roughly one-in-seven chance that an international equity portfolio would lose 20 per cent over a three-year period: this means that over a 25-year horizon such a loss is almost inevitable at some stage. If you are comfortable with such a prospect, stick with your equity orientation. If not, think about having some more of that much underrated asset, cash.

 

Adrian Lowcock, head of investing at AXA Wealth, says:

You have too many funds - 22 is at the top end of what I would suggest. There is also a lot of duplication with the majority of the portfolio invested in either UK equity income or global funds.

You are keen to get some income and grow the portfolio to keep ahead of inflation, so a combination of income and growth would be most appropriate. The portfolio currently achieves a yield of around 2.8 per cent, which would suggest you are not far from the target.

The portfolio is dominated by equities, with little exposure to bonds. You say you dislike bonds, which given their recent strong run and high valuations, I can sympathise with. You may be an adventurous investor, but your portfolio is very adventurous and therefore subject to stock market volatility which could be significant. This is particularly dangerous as you approach retirement: a 10 per cent loss in the first couple of years of retirement would have a huge effect on your overall wealth and ability to draw an income.

 

HOW TO IMPROVE THE PORTFOLIO

Mr Dillow says:

This portfolio illustrates a common problem - of how the hunt for income can lead us astray.

Take the Threadneedle UK Equity Income fund. Its five biggest holdings are: AstraZeneca (AZN), Imperial Tobacco (IMT), GlaxoSmithKline (GSK), BT (BT.A) and Royal Dutch Shell (RDSB). Four of these are also among Artemis Income's and CF Woodford Equity Income's five biggest holdings. And three are also in Royal London Equity Income's top five. These funds are therefore highly correlated.

However, although you're not getting much diversification you are incurring fees. If you want a fund of equity income funds, you can get one at lower cost by holding the iShares UK dividend UCITS ETF (IUKD).

I agree that you are not diversified enough and that you should look to cut out some correlated holdings.

But shift into what? You are already quite well diversified internationally, thanks to your emerging markets and overseas funds. The problem here is that global stocks are highly correlated, so a significant fall in one probably means a fall in all. In this sense, I fear that in holding so many actively managed funds you have something like a global tracker fund, but at a higher cost than a tracker with little offsetting benefit.

I'm not sure if TR Property solves this problem. It invests mainly in property shares rather than direct property - and property shares also rise and fall with the general market.

 

Mr Lowcock says:

I would suggest three steps to improve your portfolio:

• reduce the number of funds by consolidating your investments, particularly the global funds;

• diversify the income generated from the portfolio with a view to maintaining a similar yield; and

• introduce some risk management into the portfolio by adding some non-equity investments.

Typically a portfolio should have between 10 and 20 funds to ensure each investment is able to make a significant contribution to the performance, so I would suggest one core global equity fund around which a few geographic specific funds can be used. Given the need for income, an equity fund such as M&G Global Dividend (GB00B39R2R32) would suit. Manager Stuart Rhodes has an impressive track record and his focus on dividend growth results in a more diversified portfolio. I would suggest this instead of Artemis Global Income (GB00B5N99561) and Newton Global Income (GB00B8BQG486) which you already hold to ensure diversity across different groups.

Newton, for example, has strong Asian and emerging markets income funds which would help diversify the income stream, while Adrian Frost, manager of Artemis Income Fund (GB00B2PLJJ36), provides a good core UK fund.

Many of the investment trusts you mention are trading close to or are at a premium to their net asset value. Investment trusts play a great role in portfolios and do particularly well as markets recover, as they are often geared to stock markets (use debt to fund more investments) so rise more as markets rise. However, we are six years into a bull run and while there may be longer to go, I am wary of you taking that extra risk at this point in time: the geared nature of investment trusts will also exaggerate any falls adding additional volatility just at the wrong time.

Diversification is important in a portfolio so I also suggest Artemis Strategic Bond Fund (GB00B2PLJS27). It is still possible to get a reasonable yield in bonds, and with the right manager good returns. Holding some bonds in the portfolio will reduce the overall volatility of your investments in the early years of retirement and provide an alternative source of income.

Finally, I would add some protection in the form of Standard Life Global Absolute Return Strategies (GB00B7K3T226), which should provide a consistent, inflation-beating return which is less volatile than equities, together with Architas Diversified Real Assets Fund (GB00BRKD9X30). [Editor's note: Architas is a member of the global AXA Group, which Mr Lowcock works for. However, this fund does look interesting.] The fund invests in a broad range of infrastructure investments which are not correlated with UK equities or bonds, providing an alternative asset class and an income stream.

My suggested portfolio is much more concentrated than the original but also benefits from greater diversification including exposure to European markets. While it is appropriate for an adventurous investor it also gives more protection and a slightly higher income.

 

Adrian Lowcock's suggested portfolio

FundYield (%)Portfolio weight (%) 
M&G Global Dividend3.0510
Newton Emerging Income 4.195
Newton Asian Income4.315
Artemis Income3.410
Threadneedle UK Equity Income3.715
Schroder European Alpha Income3.2610
North American Income Trust 3.1710
Franklin UK Smaller Cos0.6210
Standard Life Global Absolute Return Strategies1.2410
Artemis Strategic Bond4.615
Architas Diversified Real Assets410
Total average yield3.17

 

Lee Robertson, chief executive officer at Investment Quorum, says:

You have some excellent funds within your portfolio. However, some changes might further diversify your portfolio in current conditions and give you a better chance of meeting your objectives.

I suggest you sell the M&G Global Emerging Markets Fund, Miton Trust Income, Threadneedle UK Growth & Income Fund, Artemis Income Fund, Newton Global Higher Income Fund, Standard Life UK Smaller Companies Fund and North American Income Trust.

The reasoning behind these sales is purely based upon widening your asset allocation while adding a few of our favoured funds into the mix. This we believe would give your portfolio an opportunity to participate in some very interesting funds but more importantly fund managers that consistently deliver investment performances on a risk-adjusted basis.

I recommend you buy the Franklin UK Managers' Focus Fund (GB00B7MPWT49), which gives exposure to large-, mid- and small-cap UK stocks, under the stewardship of managers Colin Morton, Ben Russon, Richard Bullas and Paul Spencer. For specialist ideas we suggest the CF Miton UK Value Opportunities Fund (GB00B8QW1M42), managed by George Godber and Georgina Hamilton.

I would also like to see within the portfolio a wider exposure towards Europe and Japan given that both the European Central Bank and Bank of Japan will be continuing with their quantitative easing programs for some time which should act as a tailwind for their equity markets. Therefore, with this in mind you should at least consider BlackRock Continental European Fund (GB00B4VY9893) and Baillie Gifford Japanese Fund (GB0006012651). Also we think that parts of Asia look interesting such as India, Korea and China therefore investing in BlackRock Asia Fund (GB00B7VS8S56) would allow you to participate in these exciting economies and stock markets.

In terms of a property diversifier, while investment trusts are an option, consideration could also be made in favour of Kames Property Income PAIF (GB00BK6MJC43). It is worth noting here that the newly launched Property Authorised Investment Funds are very tax-efficient from an investment perspective.

The investment trusts that you are considering are on premiums to their net asset values. Consequently, we would suggest waiting for a better opportunity given that we are likely to experience some form of a correction in the markets after a six-year bull market, possibly as soon as the results of the general election are known.