Rethink your high cash allocation

“I want to build the biggest sum I can,” says Barry. “There is support in the form of two relatively small defined-benefit (DB) pension schemes from my time in the civil service and local government. And I’ve also got some cash and Premium Bonds. I’m not sure whether I need to be tax-efficient and wonder whether I should be using a self-invested personal pension (Sipp).

“I started investing via funds, but then started buying some direct shareholdings – normally defensive and safe FTSE 100 stocks. As time went by and my confidence grew, I added some FTSE 250 stocks and more recently I started buying Alternative Investment Market (Aim) stocks – mainly for the growth prospects. 

“The Lindsell Train style of investing is one I like – buying quality companies and holding for a long time, and own Lindsell Train Global Equity Fund (IE00BJSPMJ28). I also like stocks like National Grid (NG.) and Unilever (ULVR) – low risk, but growing.

“Despite liking this style, I think I have a decent risk tolerance. I’ve had some blow-ups with Carillion (CLLN) and Conviviality, but I’ve carried on. I would be okay losing 4.5 per cent of my invested portfolio.

“I have also started momentum investing and had mixed results. I buy into the concept, but want to do this via funds rather than individual stocks.

“The funds I'm using for this are Baillie Gifford Emerging Markets Leading Companies (GB00B06HZN29), First State Greater China Growth (GB0033874321), Janus Henderson China Opportunities (GB00B5T7PM36), Legg Mason IF Japan Equity (GB00B8JYLC77), Polar Capital Technology Trust (PCT) and Smith & Williamson Oriental Growth (GB00B5448K84).

“I’m also thinking about adding US equities as I don’t have a dedicated fund, and need to decide whether to go for large or small-caps. I’m also thinking of investing in Legal & General (LGEN), Prudential (PRU) and XP Power (XPP).”

Barry's portfolio

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

THE BIG PICTURE

Chris Dillow, Investors Chronicle’s economist, says:

What matters is your whole portfolio. What should make you relaxed about losses on, for example, Conviviality is not so much your high risk tolerance but the fact that you are sufficiently diversified so its losses are only a small part of your total wealth.

Your overall portfolio is that of somebody who isn’t especially risk-loving. Taking into account your cash and Premium Bond holdings, you have less than 60 per cent of your financial assets in equities. Many would think this quite modest.

Whether this is still too high doesn’t just depend on the outlook for equities, but also on your job security. If you can stay in work, you have a sort of insurance against stock market falls: you can work and save to top up your wealth. If, however, you lose your job you lose this insurance. Personally, I wouldn’t much increase my equity weightings if my job were insecure.

I’m intrigued by your experiment with momentum investing in funds. There is evidence that this works – although I’d warn you that it’s much less extensive than is the case for individual shares. Two things, however, give me hope here. One is simple maths: if there’s momentum in stocks there should also be momentum in portfolios of them. The other is that we know that momentum investing works in asset classes that are hard to value conventionally, such as emerging markets and technology. Funds that invest in such sectors should therefore also have momentum.

Paul Derrien, investment director at Canaccord Genuity Wealth Management, says: 

Your portfolio is likely to have performed well in recent years – you certainly picked a sweet spot to start investing. However, it is unlikely that these returns will continue indefinitely and with your investment time horizon now shorter, with retirement ahead, it is a good time to review your portfolio.

I like the mix of funds and direct equities. This provides a level of diversification that is appropriate and means that shocks such as Carillion and Conviviality can be absorbed, having a more modest impact on the overall total return.

But the structure of the portfolio is not set up to deliver your objective of longer-term income. You have around 60 per cent of your savings invested in shares. This is sensible, but your cash is a drag on both performance and income.

Duncan Arthur, chartered financial planner at Blackadders Wealth Management, says:

You need to consider how much income you actually need from your pensions, savings and investments. This is crucial for establishing what amount of capital you need to build up prior to your retirement. You should also establish what guaranteed (index-linked) income stream can be produced from your state and DB pensions. Use a BR19 form to establish your state pension forecast.

Zubin Kazak, chartered wealth manager at Blackadders Wealth Management, says:

You may view the probability of permanent capital loss as relatively low, but its impact when it does occur can be high. Is this a risk worth taking, especially as your income stream will drop in five years?

I have some concerns about your investment style. If your interpretation of a momentum strategy is deciding which funds to buy, hold or sell over an arbitrary rolling time period, this is something we would avoid. Blindly buying a fund purely because it was the most popular over an arbitrary time period is not recommended. It can morph into a ‘greater fool’ investment strategy with a danger that one day, you end up the fool.

Momentum trading applied to fund selection would require high monitoring, discipline and incur costly fund switching charges – the polar opposite of what most investors buying funds wish to achieve.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

In terms of using a Sipp, one of the first rules of investing is to take advantage of legal tax breaks. Sipps offer these – not least of which is the tax relief on contributions. I know it’s tedious to deal with bureaucracy, but you only have to once.

Your holdings of big defensive monopoly-type shares such as Unilever, Imperial Brands (IMB) and Royal Dutch Shell (RDSB) are certainly good ideas insofar as history is a guide. These have traditionally been underpriced. I wonder, though, whether they still are.

My concern here is exacerbated by the fact that utilities are not as defensive as they once were. They now carry political risk: a Labour government might nationalise them on ungenerous terms. Their high yields reflect this risk as well as a lack of growth potential.

On the other hand, though, there’s a genuine reason for defensives to be underpriced. Some fund managers avoid them for fear of underperforming a rising market. So I’m not sure whether your bias to monopoly and utility defensives will continue to pay off.

I also must warn you that momentum works in both directions. You must have an exit route. One strategy would be to sell when prices of funds or of the asset class they invest in fall below a 200-day average. The problem is, though, that any profits you make by momentum trading might be eaten up by dealing costs.

Paul Derrien says:

It could be more tax-efficient to hold some of your equity income shares in an individual savings account (Isa) and ensure the cash is working as well as it can, to at least beat inflation. You may wish to consider National Grid and Severn Trent index-linked bonds which need to be held in an Isa to be tax-efficient, as these will provide returns above inflation.

Bond funds such as MI TwentyFour Dynamic Bond (GB00B57TXN82) are good, and may help achieve your income and return targets and provide diversification from equities.

Also, the ongoing trade ‘spat’ between Donald Trump and Asia will not have been positive for your Asia and emerging markets exposure, which is significant. I would think about adjusting this in favour of your longer-term objective of defensive income and adding more global equity income funds, which will improve the geographical exposure and reduce your risk profile slightly.

You could also add to Artemis Global Income (GB00B5N99561), which has been a consistently good performer for several years.

Duncan Arthur says:

You hold £160,000 as cash, which is a helpful asset class, but its value will be eroded by inflation over the long term. Holding cash worth three years' of your income is normally a sensible amount. The remainder should fund your Isa allowances for this tax year and future tax years, be added to your investment portfolio over time or used to fund a new Sipp. 

Zubin Kazak says:

Adopting a buy/sell discipline when undertaking periodic reviews will help avoid an inefficient allocation of your risk budget. You should consider reducing your direct equity exposure and reinvesting approximately one-third in equity funds. The remainder could then be reinvested in funds that traditionally exhibit a low correlation to equity markets such fixed income, absolute return, infrastructure and renewable energy funds.

Passive funds also provide a useful low-cost alternative.

Doing this should provide an equivalent or better overall risk-adjusted return, and give your portfolio better downside resilience for the next phase of the economic and business cycle. More importantly, it will significantly reduce the prospect of a permanent loss of capital. You can then make greater conviction allocations to the remaining holdings, ensuring they meaningfully contribute to performance.