Building a solid financial base for life after education

"We aim to provide our grandchildren with a solid financial base in life after education, either forming the basis of a portfolio of investments to supplement income or for a substantial deposit on a home. And the income might be a useful contribution to university living expenses after their 18th birthdays.

"My wife and I both have individual savings accounts (Isas), and have had these since they used to be called personal equity plans (Peps). We have never taken any income from them, so feel that as we don't need this to maintain our life style we can put some of it into our grandchildren's trust twice a year, after funding their annual Junior Isa allowances.

"Our Isa income is currently about £35,000 a year, paid quarterly. Last year, we reinvested the income from the investments into our Isas, as well as using our allowances in full, and we will continue to do this if possible.

"To reduce the time I spend managing the portfolio I have invested the trust in investment trusts and open-ended funds which hopefully will provide some diversification.

"I am happy with the performance the investments are delivering but wonder if I should put more into smaller companies, rather than the enormous corporations which make up most of the investments."

Tony's grandchildren's trust as at 5 June

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:

You've got a well-diversified equity portfolio, which might not be a wholly good thing.

I say this because of the simple maths of diversification. Many baskets of equities will move much like the global market does. This is because when you hold lots of shares you reduce idiosyncratic stock risk – the danger that a single badly-performing share will hurt your portfolio. But you also increase market risk – the danger that a fall in the market will drag down all your shares.

Of course, if you hold just one fund you are also taking on manager risk – the danger that they'll pick bad stocks. But this is small anyway, in part because of funds' risk controls and also because even a bad fund manager will pick a few good stocks. And you are diversifying it.

So what you have here is a portfolio that will move pretty much in line with global markets.

You've got some funds that are relatively defensive such as CF Woodford Equity Income (GB00BLRZQC88), Perpetual Income & Growth Investment Trust (PLI) and Edinburgh Investment Trust (EDIN). These should fall less when the market falls, and defensives tend to outperform on average over the long run. 

But these are offset by emerging markets funds that often do especially badly when the global market falls. Even over longer periods, this market risk is significant. If we assume an average annual return of 5 per cent per year after inflation, there's a roughly one-in-five chance of losing money in real terms over five years, and around a one-in-14 chance of losing money over 12 years – the time after which your oldest grandchild can access the capital.

How worrying these probabilities are is a matter of taste. From the point of view of your grandchildren, this is free money, and people tend to be willing to take risks with this. Richard Thaler and Eric Johnson called this the house money effect.

However, the fact that you are quite well diversified among equities suggests you might not be totally of this view. If so, whether you should hold more small caps is the wrong question.

Over the long run, I don't think it much matters, as small caps tend to do about as well as larger ones. In the UK, the FTSE Small Cap index's total returns have been much the same as those of the FTSE 100 since 1990. What small caps do give is cyclical risk – they do badly in recessions but well in recoveries. The fact that neither you or your grandchildren are working suggests this might be a risk worth taking, as you're not exposed to cyclical risk via the possibility you will lose your jobs.

But on the other hand, it is statistically highly likely that we'll get a recession at some time before your grandchildren get access to the capital, in which case losses on small caps would amplify losses on this portfolio, given the market's tendency to fall in downturns.

Instead, you should be asking yourself as to whether you want this portfolio to be fully invested in equities. If market risk bothers you, the easiest solution is simply to hold some cash.

Jason Witcombe, chartered financial planner at Evolve Financial Planning, says:

Regarding fund charges, taking the UK stock market as an example, you have a choice. You you could pay as little as 0.1 per cent a year for a very low-cost index fund that tracks the UK stock market or pay at least five times that, and in many cases well over 10 times, to invest in a fund where the manager aims to beat the market. With a portfolio of this size even just a small percentage difference in costs adds up to a lot in monetary terms.

Some actively managed funds do beat their benchmark index after costs, but the majority don't, and picking next year's winner is nigh on impossible. Future performance is uncertain whereas future costs are certain.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

From a longer-term perspective you might also want to consider private equity investment trusts. If you believe we're approaching a new industrial revolution in which artificial intelligence will transform the economy, there's a danger that existing quoted stocks will be devalued by creative destruction, while the beneficiaries of that process might be companies that aren't yet listed. Private equity helps diversify this risk – although it exposes you to the risk that fund managers won't pick future winners.

Overall, though, this is a good equity portfolio. The question is: should your current selection account for the whole of the portfolio?

Dennis Hall, chief executive officer of Yellowtail Financial Planning, says:

I avoid complexity by sticking to a few simple investing principles. I treat diversification as a friend and try to weight my portfolio broadly in line with world market capitalisation, though I still have not completely dropped my UK bias. Ideally half the portfolio would be in the US, with approximately 13 per cent in Europe, 8 per cent in Japan, and just 6 per cent in the UK. The rest of the world would account for the remainder.

Long term, smaller companies tend to outperform larger companies so I skew my investments to capture some of that out performance. Your portfolio already has some smaller company exposure but I would increase it by adding to F&C Global Smaller Companies (FCS), or alternatively with Vanguard Global Small-Cap Index Fund (IE00B3X1NT05).

There is some evidence to suggest that momentum is another long-term factor that captures market out performance. There are fewer funds that use this approach and many of these also target smaller companies, so buying these funds offers the potential of getting two success factors for the price of one. Options include Standard Life Investments Global Smaller Companies (GB00BBX46522) and another favourite of mine is Marlborough Special Situations (GB00B907GH23). 

However, adding more funds to the portfolio without trimming the existing ones would create too much complexity. Doing this would make it difficult to have an overarching strategy and turn the portfolio into a general mish-mash.

Some of the existing holdings replicate each other in terms of what they're trying to achieve and the companies they invest in. Edinburgh Investment Trust and Invesco Perpetual Income & Growth Investment Trust are almost identical. And it's hard to differentiate between Witan (WTAN) and Alliance Trust (ATST): they're so diversified I'd sell them and reinvest the proceeds in Vanguard Lifestyle 100% Equity Fund (GB00B41XG308).

Pictet Robotics (LU1316549283) looks like a technology fund with a fancy name. My preferred technology play is Polar Capital Technology Trust (PCT), though Fidelity Global Technology (LU1033663649) and AXA Framlington Global Technology (GB00B4W52V57) are also good funds.

You have a reasonable holding in RIT Capital Partners (RCP), which has been in my own portfolio for longer than I care to remember, though it's been a bit of a disappointment in recent years. I'm thinking of switching it to HgCapital Trust (HGT) for a purer private equity holding.

Jason Witcombe says:

This portfolio is predominantly invested in equity funds which is something that you should appraise from time to time. Given your grandchildren's ages, you may be perfectly comfortable accepting the inevitable volatility, but as they start approaching the point of taking withdrawals you may wish to consider whether this strategy remains appropriate. It would be a shame, for example, if there was a stock market crash shortly before one of the grandchildren planned to put down a deposit on a property.

From an equity diversification perspective, most investors around the world will have a home bias – invest a disproportionate amount of their portfolio in their home market - as you currently do.

The UK stock market represents around 6 per cent of the world equity market capitalisation, excluding China 'A' shares. The extent of the home bias in a portfolio is a personal decision, and there is no right or wrong answer. The UK market is dominated by multinational companies but a home bias in the UK means an over-exposure, compared to the world market, to certain industries such as energy and an under exposure to ones including technology. This is something for you to be aware of and monitor.

For the overseas allocation, a starting point would be to allocate the portfolio in proportion to the market capitalisations of the various regions. You partly do this by holding global equity funds but you also hold some regional funds. If you do not hold these overseas equity holdings in the same proportion as their share of world equity market capitalisation, then you are making a bet on one region's future prospects over another's. The next time you are due to add to the portfolio it might be worth analysing its geographic spread in a bit more detail to see if there are any regions that are underrepresented.