This investor, who wishes to remain anonymous, is 65 and has been investing for 30 years, accumulating a portfolio worth £415,000. He has an index-linked pension of £50,000 a year and his wife has a £25,000 index-linked teacher's pension. They have no mortgage on their house.
He wants to move his portfolio, mostly held in an individual savings account (Isa) and a self-invested personal pension (Sipp), to an income basis to "fund more holidays and fun". He describes his attitude to risk as "high" because he has a good pension and no mortgage. He is thinking of adding Diverse Income Trust (DIVI) to his portfolio.
Isa and Sipp
Income and growth
ANONYMOUS INCOME PORTFOLIO
|Individual savings account|
|Bankers Investment Trust (BNKR)||£25,718||6|
|Caledonia Investments (CLDN)||£20,865||5|
|City of London Investment Trust (CTY)||£24,495||6|
|Finsbury Growth & Income Trust (FGT)||£25,765||6|
|Juridica Investments (JIL)||£19,830||5|
|Law Debenture Corporation (LWDB)||£22,705||5.5|
|Merchants Trust (MRCH)||£21,058||5|
|Pantheon International Participations (PIN)||£25,750||6|
|Temple Bar Investment Trust (TMPL)||£22,562||5.5|
|TR Property (TRY)||£26,360||6|
|Value & Income Trust (VIN)||£21,542||5|
|Witan Pacific Investment Trust (WPC)||£21,815||5|
|BlackRock Throgmorton Trust (THRG)||£12,526||3|
|Hansa Trust (HAN)||£9,797||2|
|Henderson Smaller Companies Trust (HSL)||£14,298||3|
|TR European Growth (TRG)||£13,112||3|
|City Natural Resources High Yield Trust (CYN)||£16,696||4|
|Close Brothers Group (CBG)||£19,955||5|
|Henderson Smaller Companies Trust (HSL)||£41,683||10|
|Juridica Investments (JIL)||£18,483||4|
Source: Investors Chronicle as at 1 June 2015
ARE YOU TAKING ON TOO MUCH RISK?
Chris Dillow, the Investors Chronicle's economist, says:
I like investment trusts - especially ones that are on unusually big discounts relative to their own history, because these can be a sign of unusually depressed sentiment and hence a buying opportunity. But there is a problem with them, which your portfolio demonstrates.
It's a simple mathematical fact that bundles of shares - which is all investment trusts are - will rise and fall together. This is because when a fund buys more shares it is diluting away idiosyncratic stock risk, but adding covariance risk - the danger that the portfolio will rise and fall as the global market rises and falls. Any two investment trusts will thus be likely to rise and fall together by virtue of their correlation with the global market.
This problem is especially severe if the funds are investing in the same segment of the market as some of your holdings are. For example, the biggest holdings in Merchants Trust (MRCH) are much the same as Law Debenture (LWDB): HSBC (HSBA), BP (BP.), Royal Dutch Shell (RDSB) and GlaxoSmithKline (GSK). I'm not sure they are to be blamed for this: if you're managing a £1bn-plus UK-oriented portfolio and want significant dividend income, your options are limited.
The upshot of this is that some of your holdings are massively correlated. Looking at annual price changes since 2000 tells us that the correlation coefficients between Merchants, Law Debenture, City of London (CTY) and Finsbury Growth and Income (FGT) are all over 0.9. This means they move in lockstep with each other.
Granted, you are diversifying fund manager risk - the danger that, in the long term, one fund will underperform the other. But many of your holdings are not diversifying market risk at all.
I'm not sure this problem is greatly ameliorated by your other holdings. One difficulty with legal claims and private equity, the investments in Juridica Investments (JIL) and Pantheon International Participations (PIN), is that they can be illiquid. In bad times, when investors want immediate cash, such funds could therefore fall to a discount to net assets.
In fact, there's another problem. In bad times, investor sentiment generally deteriorates, which widens funds' discounts. This means investors in investment trusts risk a double loss: not only do the shares held by the fund fall, but also the fund's price falls relative to the value of those shares.
You therefore have a risky portfolio. This isn't necessarily a bad thing: in good times, these risks go into reverse so you'd see nice profits. And my best guess is that the next three years will see more or less normal market conditions with modest returns on equities - although, of course, this is consistent with some biggish short-term falls.
But it poses the question: are you taking on too much risk?
The strongest reason to think not is that you have a good pension and so are investing for fun. There's absolutely nothing wrong with this, as long as you are aware of the risks.
And another thing. You say you are moving towards investing for income. I'd be wary of this. Stocks or funds only offer above-average income as compensation for something. This something is often the risk of doing badly in recession or the expectation that dividends won't grow very much. For this reason, income stocks vary enormously. They might be very dangerous - think of the big yields on mortgage lenders before the financial crisis! - or they might be defensives such as tobacco or utilities which have historically done well. Please bear in mind this enormous distinction.
HOW TO IMPROVE THE PORTFOLIO
1. Asset allocation
Mr Liddell says: In terms of asset allocation, with the security provided by your pension and the current low level of interest rates, it seems right to concentrate largely on equities in this portfolio. That is not to say that in the future it may not be worth looking at fixed income, when returns are somewhat more attractive.
There is a lot to like in terms of diversification. Ex Juridica Investments (JIL), the portfolio yields about 2.4 per cent and has underlying exposure of roughly 63 per cent to the UK; the other significant holdings are 13 per cent in Europe, 10 per cent in Asia Pacific including Japan and 9 per cent in the US.
Gavin Haynes, managing director, Whitechurch Securities says: The portfolio is a higher-risk equity-dominated strategy with a spread of investment trusts with an objective focused towards capital growth. Given your financial position, with a good level of index-linked pension funding (and no mortgage) your are both in a position to and are willing to maintain the higher-risk focus.
While you are looking to generate more income to supplement your lifestyle, I would urge against a wholesale change in the portfolio strategy towards high-yielding investments. Given the current demand for yield, many high-yielding areas of the market are looking expensive. For example, the UK property and infrastructure investment trust sectors trade on premiums of 8 per cent and 14 per cent, respectively.
There is no harm in top-slicing investments and using your CGT allowance as opposed to simply taking natural yield and this can prove more tax effective. There are also plenty of opportunities to skew the portfolio more towards an income and growth strategy, which can boost the yield while still offering potential to grow capital and provide an attractive total return.
2. Portfolio holdings
CUT EXPOSURE TO JURIDICA
Mr Haynes says: The largest holding is the esoteric Juridica Investments (JIL), which is a Guernsey-domiciled Aim-listed closed-ended fund. This fund was launched in 2007 to provide litigation financing. While this has provided attractive returns to investors and has provided a good source of income, it is very specialist and it is important to be aware of the unpredictability of the strategy and not let it become too large a position.
Mr Liddell says: Juridica is an interesting holding, where you have also recently increased your position. It is attractive in that, in financing and investing in US legal claims, it should be largely uncorrelated with equities. It also paid a 20p dividend in respect of 2014, giving it a historic yield of 17 per cent. However, it is on a premium of c.7.5 per cent and it is not clear how sustainable or regular dividend payments will be going forward, since effectively they are financed out of capital gains, making it perhaps less than ideal for an income portfolio. The managers are optimistic about future prospects but it is one to treat with a little caution.
Mr Haynes says:
I have focused my selections on investment trusts and would advocate maintaining an equity income focus at the core of the strategy.
In addition to current core UK holdings, Troy Income and Growth (TIGT) and Edinburgh Investment Trust (EDIN) both provide good core defensive UK exposure. BlackRock Throgmorton and Pantheon International Participations add little in the way of income generation and could make way for the Diverse Income trust that you have been considering. The trust is managed by the highly regarded Gervais Williams and offers exposure to a portfolio focused on UK smaller companies.
There are opportunities to take more of an equity income focus overseas, reducing the lower-yielding global trusts. Henderson International Income (HINT) provides a high and growing level of income through a portfolio of 60 stocks globally (ex UK) and yields 3.4 per cent. For Asian exposure Schroder Oriental Income (SOI) is a trust that I rate highly and could provide an alternative to Witan Pacific (WPC), although it doesn't offer the Japanese exposure.
The sector-specific exposure will have certainly led to mixed fortunes. The mining-focused City Natural Resources (CYN) will have been painful, but yields look compelling and this could offer a good recovery story. At the other end of the spectrum, TR Property (TRY) has had an exceptional run and its net asset value has doubled over the past three years. It could be a good time to take profits and, if looking for an alternative sector-focused fund, then Polar Capital Global Financials (PCFT) looks an interesting option at the current stage of the cycle.
Mr Liddell says:
The most obvious move would be to reduce the amount invested in Henderson Smaller Companies (HSL), your biggest holding, which has been on a good run since the UK election result; this fits in with both trimming the UK exposure slightly and increasing the yield. A replacement could be Aberdeen Asian Income (AAIF) or JPMorgan Global Emerging Markets Income (JEMI). We would consider selling Pantheon International Participations, although performance has been relatively strong, on yield grounds and replacing it with North American Income Trust (EUS) to increase marginally the US exposure.
Rather than Diverse Income Trust, since you already have good UK small-cap exposure in Henderson Smaller Companies and BlackRock Throgmorton (THRG), consider Edinburgh Investment Trust (EDIN) or London & St. Lawrence (LSLI), both of which have good long-term records. Another possible move would be to swap TR European Growth (TRG) for JPMorgan European Income (JETI). Close Brothers (CBG) stands out as a single equity exposure, but you have just added this. Hansa Trust (HAN) has been a relatively poor performer.