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Reducing risk over time

John Baron explains his approach to portfolio diversification
February 5, 2016

Having outlined my investment strategy as we enter 2016 in last month's column ('Reflecting on a good 2015', 8 Jan), I thought it may be helpful if I explain my thinking behind the portfolios' diversification after the markets' volatile start to the year. I also update investors on a holding as its potential wind-up approaches.

 

Eggs in one basket

The aim of diversification is to reduce portfolio risk by investing in 'uncorrelated' assets - asset classes that tend not to move in the same direction over the same period. Equities, bonds, commercial property, commodities, infrastructure, 'real assets' (such as gold, vintage cars, rare stamps or fine wine) and cash are, to varying degrees, examples.

This is an important investment discipline. Yet it is one which is often overlooked, especially in rising markets. As we get older we do not want to see past gains lost because of stock market setbacks. Diversification will help to reduce the damage - and this is especially important if near to achieving investment objectives.

There are no fixed rules as to the pace and extent of diversification. An investor's risk profile, income requirement and investment objectives are key factors. But there are some general principles to which I tend to adhere.

Regular readers will be aware that the 'Growth' and 'Income' portfolios in this column are in fact the 'Summer' and 'Autumn' portfolios on my website, where I also share with visitors other portfolios including 'Spring' and 'Winter'. The four 'seasonal' portfolios reflect an investment journey over time and, as such, best illustrate how I gradually increase diversification as we progress through the portfolios.

When starting one's investment journey it makes sense to focus on equities because of their history of superior returns. However, as time passes, I increasingly diversify the portfolios primarily by introducing more bonds - mostly corporate bonds, as I am wary of government debt. Bonds usually act as a good counterweight to equities. Each is driven by different economic forces - as such, when one rises in price, the other usually falls. The weightings in the Growth and Income portfolios are around 10 per cent and 32 per cent respectively.

Other less-correlated assets also become increasingly evident as time passes. Commercial property accounts for around 10 per cent of the Growth portfolio and 11 per cent of the Income. In addition, commodities also come to have a decent weighting within the declining equity exposure. By contrast, there is little infrastructure exposure as these investment trusts look expensive.

How many asset classes should one employ? The answer, as with investment generally, is to keep it simple. As Warren Buffet once said, "Wide diversification is only used when investors do not understand what they are doing." Too much diversification also increases costs, particularly if one includes the more exotic asset classes.

Meanwhile, a further objective as time passes is for my portfolios to produce a higher income. In addition to assisting with greater diversification, decent-quality corporate bonds, commercial property and commodities all offer attractive yields.

But this higher income should also be one that continues to grow. A greater focus on higher-yielding equities with good dividend records, within the portfolios' declining equity weighting, helps to achieve this goal.

A properly diversified portfolio can help investors ride out volatile markets and reach their investment goals, while also helping to achieve a decent and growing income even in this low-interest world - my website's Winter portfolio is presently yielding 6.3 per cent.

 

M&G High Income Inc shares (MGHI)

MGHI are the Income shares of a split-capital investment trust called M&G High Income Trust (MGHP). Since its inception in 1997, Richard Hughes has done an excellent job in helping to ensure MGHI's dividend growth (including special payments) has exceeded the retail prices index (RPI), while MGHP's performance has beaten its FTSE All-Share index benchmark by over 1 per cent a year after costs.

Investors may remember that MGHP is split into three equal numbers of shares - Zeros, Income and Capital. Upon wind-up, the holders of the Zeros are entitled to the first 123p per share of MGHP's assets. The Income shares (MGHI) are entitled to the next 70p, while the Capital shares are entitled to whatever is left over and above the 193p threshold. MGHP's present net asset value (NAV) is around 165p.

Being entitled to accrue all of MGHP's dividends, MGHI is presently yielding around 15 per cent based on last year's payout of 6.6p and a price of 45p. The Income portfolio has been a happy holder for many years. But given a wind-up resolution is due to be put to an emergency meeting at the end of its stated 20-year life in March 2017, I recently caught up with Richard as to progress and outlook.

As 2016 unfolds, particularly after the May year end, the intention is to adopt a more defensive stance with regard MGHP's holdings while keeping an eye on ease of liquidity as the emergency meeting approaches. The relatively small weighting in bonds (around 5 per cent at year-end) will be increased towards 15-30 per cent, with a focus on short-dated gilts. Meanwhile, the exposure to smaller companies will be reduced.

However, MGHP will still be able to participate in the market by using derivatives - up to around 35 per cent of the portfolio - as a means of protecting the downside or gearing up if thought necessary. In other words, while cognisant of the approaching emergency meeting, Richard is also aware MGHP must continue to do its best for all shareholders up to the final moment.

MGHI holders will benefit from revenue reserves of around 2.5p, which will be paid out as part of MGHI's regular quarterly dividends as declared up to the May 2016 year-end. However, as the portfolio's holdings become more defensive thereafter, it will generate less income - a cautious estimate being an additional 3.5-4p up to March 2017. Of course, there can be no precise calculations as any portfolio activity will be influenced by market outlook.

However, I intend holding MGHI for the time being. I would like to see the board's proposals for any rollover of the shares - good-quality reasonably priced income is not easy to find. In addition, should markets recover from here, I will benefit up to a maximum of 70p from any increase in NAV- but investors should recognise that MGHI represents 'geared' exposure to both rising and falling markets. Meanwhile, the shares still offer a healthy yield.

Otherwise, there was no portfolio activity in either the Growth or Income portfolios during January.