Rethink your cyclical exposure

"I'm looking for a yield of around 4.5 per cent," says Gordon. "And I've an outstanding mortgage on my home of £260,000, which will hopefully be paid off with funds from my investment portfolio. This will probably happen when the mortgage interest rate rises and the gap with the yield narrows. So, I'm looking for growth such that when the mortgage is paid off, the effect on the remaining investments is lessened.

"However, should the portfolio not perform sufficiently, an alternative would be to pay off the mortgage from the sale of our house when we eventually downsize.

"I also have £32,000-worth of shares in a US oil company. The value of the holding is significantly below what I bought it for, but I'm happy to wait for a recovery in the oil price. I'm prepared to sit on large unrealised losses if the portfolio continues to generate income - I can wait for valuations to recover.

"My portfolio is largely composed of investment trusts, which I prefer to open-ended funds. Having said that, my second-largest single holding is Standard Life Investments UK Equity Unconstrained Fund (GB00B0LD3C08). I started off a monthly savings plan many years ago and I've kept it as its performance has been very good for the most part.

"The portfolio has been built with a somewhat scattergun approach, initially aimed at growth, but now that I'm retired I'm becoming more focused on income - a trend that needs to continue.

"I've not been good at top-slicing and as a result have missed opportunities to realise profits. For example, Biotech Growth Trust (BIOG) had been up over 50 per cent since the time I bought it, but has fallen back to 10 per cent more than I paid for it.

"Recent trades include the purchases of housebuilding shares Bellway (BWY), Berkeley (BKG), Galliford Try (GFRD) and Inland Homes (INL). I also bought Aberforth Geared Income Trust (AGIT) and JPMorgan European Investment Trust (JETI) to boost income. I also recently bought BlackRock World Mining Trust (BRWM).

"I have on my watch list Henderson High Income Trust (HHI), HICL Infrastructure Company (HICL) and Murray International Trust (MYI).

Gordon's portfolio

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

The striking thing about this portfolio is that it contains more than the usual amount of cyclical risk. In the event of a recession or increasing market fears of one, your housebuilders would probably do worse than most stocks - as would smaller companies.

This exposure is mitigated by your holdings of City of London Investment Trust (CTY) and Finsbury Growth & Income Trust (FGT), both of which hold lots of defensive stocks. But it's magnified by your background risk.

You say you intend to move to a smaller house. But a recession that pushes down house prices might thwart this: if house prices fall at the same proportionate rate across the country, you'll lose more on your current home than you'll gain from being able to buy a cheaper place.

This exposure to cyclical risk might, though, have a justification - albeit not the one you think.

You say you're prepared to take large losses if the portfolio continues to generate income, but I'm not sure this is sensible. For one thing, in the event of a severe recession, there would be a real danger of dividend cuts. And, for another, what matters is total return rather than income. You can create your own dividends simply by selling some shares occasionally. In fact, you can often save yourself a tax bill by doing so: you have an £11,100 annual capital gains tax allowance.

But there's a different justification for this cyclical risk. It's that you're exposed to the risk of rising mortgage rates, and your portfolio might provide a rough hedge against this danger. A world in which mortgage rates rise would be one in which the UK and world economies are doing so well they generate inflationary pressure. But such circumstances are likely to be the ones in which cyclical stocks and trusts do well. An increase in your liabilities would therefore be offset by an increase in your assets.

It's true that housebuilders and small-caps might wobble around the time of a rate rise. But any falls would probably come from higher levels, as investors rejoice in stronger growth. The converse is also true. In the event of an economic slowdown, your equity portfolio might do badly, but you could comfort yourself by knowing that interest rates won't rise so your mortgage outgoings will stay low.

But is this a sufficient justification for your cyclical bias?

We can't adjudicate this by assessing the risk of a recession, because it is genuinely unpredictable. We can say that we're approaching the time of year when cyclical risk traditionally pays off: small-caps and housebuilders usually do well in the winter. But there's no assurance that what's been true in the past will remain so.

If I were you, I'd think about having a slightly greater defensive bias, but this doesn't mean you should rush to take profits on your cyclical holdings.

You say that you're no good at top-slicing: I wouldn't worry about this as it's usually a good idea to run your winners. I would, however, consider using a 200-day moving average rule to moderate cyclical risk. If or when your cyclical holdings dip below such an average, take the opportunity to reduce exposure and top up your defensives.

Rob Burgeman, divisional director, investment management at Brewin Dolphin, says:

Requiring your portfolio to pay off an outstanding mortgage is a serious concern. Any investment strategy involves a degree of risk and, once retired, your ability to rebuild capital is negligible. Your capacity for loss is lower, and this should be reflected in your investment strategy. There are enough clouds on the horizon to warrant considering paying back all or some of the mortgage.

The other key issue is timeframe. At 61, you still have a considerable period of time ahead of you. By looking to achieve a gross yield from the portfolio of 4.5 per cent, the danger is that you are not going to leave enough in the tank to allow the portfolio value, and hence the income, to keep pace with inflation. So 3 to 4 per cent is a more realistic objective.

James Norrington, specialist writer at Investors Chronicle, says:

With interest rates at rock bottom your mortgage is an efficient use of debt and it doesn't make sense to pay it off, if you can earn a higher rate of return from your investments than you are paying in interest. Having a secure pension income means you have the security of being able to meet the mortgage payments and take a relativity long-term view with your portfolio holdings. It is also good that you have a plan B to downsize your home should the portfolio fail to perform.

You don't specify whether the US oil company you hold is a major oil market player or a speculative exploration company. If it is the former and a committed dividend payer such as ExxonMobil (XOM:NYQ), for example, it is not out of place with your longer-term income strategy. Receiving payouts in dollars would also offer a currency gain if sterling continues to suffer as Brexit negotiations take place next year.

If the holding is more of an exploration play, that's all right if you are aware of the risks the company may face if the oil price remains weak for longer than you expect. You could make a big gain if oil comes back very strongly, and your overall financial position is solid enough to absorb a loss if it doesn't. But be aware that a holding like this is something of a punt.

HOW TO IMPROVE THE PORTFOLIO

Rob Burgeman says:

Your portfolio restructuring needs to continue because as it stands it is very growth orientated, although some of the funds you hold are good quality. One of the biggest issues facing those in retirement is how to produce income without taking undue risk. Traditional routes such as sovereign debt and high-quality corporate bonds will simply not produce the kind of income return you are seeking, and I am not entirely convinced that emerging market debt and high-yield bonds are the answer.

International diversification can, however, play a key role in spreading the income streams that you receive as well as diversifying some of the capital risk. So, for example, Aberdeen Asian Income Fund (AAIF) produces a gross income yield of 4.57 per cent and would give you access to a region you don't currently have exposure to.

I would also not restrict yourself to investment trusts. There are a number of providers of exchange traded funds (ETFs) listed on the London Stock Exchange offering very competitive exposure to regions and strategies. For example, SPDR S&P US Dividend Aristocrats UCITS ETF (USDV) tracks the performance of a universe containing the US stocks that have increased their dividend every year for 20 consecutive years, and offers an income-paying exposure to US markets and an expense ratio of 0.35 per cent.

Alternative sources of income are also worth considering. You have HICL Infrastructure Company on your watch list, but you could also add funds such as Tritax Big Box REIT (BBOX), which invests in industrial warehouses, GCP Student Living (DIGS), which invests in student accommodation, MedicX Fund (MXF), which invests in primary healthcare properties, and Princess Private Equity (PEY). These would add further diversification and hopefully secure income with less equity market risk.

James Norrington says:

The use of collective investment vehicles such as investment trusts gives you reasonable diversification across different sectors. But as investment trust shares trade on the main market there is price volatility, and they can trade at premiums and discounts to net asset value, which doesn't happen with unit trusts and open-ended investment companies (Oeics). As you are a long-term investor, share price volatility is less of a problem for you, but still one worth highlighting.

You are going through a transition between the growth and income phases of your portfolio. In the current environment when everyone is chasing yield, a lot of quality dividend-paying stocks are expensive. So given that you don't need to pay off the mortgage right away and that the money borrowed is cheap right now, it makes sense to maintain a split between growth and income styles in your portfolio.

The textbook answer would be to move into bonds and defensive stocks now that you are retired, but thanks to six years of unprecedented monetary policy government bonds are expensive and offer a yield far below your requirements. On the basis you have the pension income to cover the mortgage and your other living expenses, the rebalancing of the portfolio towards more of an income strategy can be a process of considered evolution.

Overall you demonstrate a good understanding of risk and reward, and have managed your portfolio sensibly. But there are a few things that you should watch out for, such as becoming over-concentrated in certain sectors.

In aggregate the four housebuilders that you bought only account for 7.75 per cent of your portfolio, but the level of exposure to cyclical sectors needs to be monitored.

Also, when adding new holdings be sure to check that you are not duplicating what other funds in your portfolio are doing. Some of the UK equity funds will hold the same shares as each other, so you may need to make a choice between funds to avoid racking up unnecessary charges.

It is good that you have some international exposure with JPMorgan European Investment Trust and Jupiter European Opportunities Trust (JEO). But more internationally-focused funds would further diversify the portfolio.