Large number of holdings does not mean your portfolio is diversified

"I am seeking an income yield of 2 per cent a year to supplement my volatile business salary," says Paul. "I want that as part of a 5 per cent total return a year until I retire at age 60 or 65 when I will become solely dependent on my final-salary pension and the investments in my portfolio. So from age 65 I will be looking for a 5 per cent income yield a year, and looking to shift the portfolio to an income focus.

"We also want to pass on our investments to our children and grandchildren. I would say that I have a lower risk appetite, but am willing to take some risk to get higher returns within a balanced portfolio. So I will consider a few riskier equities or exchange traded funds (ETFs), if I have sufficient diversification to mitigate the overall risk to the capital and return from the whole portfolio. To reduce risk, in recent years I have moved more of the portfolio into ETFs for asset allocation purposes, rather than relying on individual stockpicking.

"I believe that diversification is important, so I am slowly trying to move away from my heavy reliance on Lloyds Banking (LLOY), and have recently reduced my holding in RPC (RPC). I am looking to diversify my holdings in individual shares by having a spread across sectors, and use ETFs in addition to these to give me a better spread across asset classes.

"I also try to keep a minimum of £10,000 in cash even though interest rates are low.

“As our investments have grown I have needed to start using tax wrappers. We previously held the investments in my wife's name as she isn't a taxpayer and the dividends were low. But in recent years we have been making more use of individual savings accounts (Isa) and self-invested personal pensions (Sipp).

"I have been investing for 25 years, initially into employee share schemes and more broadly over the past 10 years. I have made more use of investments such as ETFs over the past five years and am balancing my ETF exposure across sectors, and our Isas and Sipps. I am also updating my holdings to reflect this year's IC Top 50 ETFs list.

"Recent additions include iShares Core S&P 500 UCITS ETF (CSPX) and iShares £ Corp Bond 0-5yr UCITS ETF (IS15). And I am thinking of investing in an ETF to get exposure to water-related investments such as iShares Global Water UCITS ETF (IH2O).

"I am also considering investing in UBS MSCI EMU Socially Responsible UCITS ETF (UB39), db x-trackers MSCI EMU Index UCITS ETF (XD5S) and Lyxor iBoxx $ Treasuries 1-3Y UCITS ETF (U13G).

Paul'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

James Norrington, specialist writer at Investors Chronicle, says:

With the mortgage paid and your family grown up you have taken care of two of life’s main financial objectives. Your target of a 5 per cent total return isn't overly ambitious – the trick is not to take too much risk in the process. And you are right to focus on getting your strategic asset allocation right to achieve this.  

Judging by your rather large holding in it, I'm guessing you used to work for Lloyds and built up the position via a sharesave scheme. Other than Lloyds, your portfolio looks nicely balanced. Having about 75 per cent of it in equities, excluding the Lloyds holding, is adventurous. But you aren't relying on the capital at the moment, and have 10 to 15 years to make good on any losses you might suffer.

Nothing is certain, but it's likely that this portfolio will continue to pay out the income of roughly £3,000 a year that you require at the moment, and give you spare dividends to reinvest. Aided by the power of compounding, you should be able to meet your total return target.

Alan Miller, chief investment officer of SCM Direct, says:

It is good that you have a realistic total return target of 5 per cent a year. And I think investors should target total return – capital plus income – rather than just income, as a high level of income just normally means less capital. Your portfolio could simply be top-sliced for extra income. This is a much better option than investing in low-quality, low-growth income shares, or low-quality high-yield bonds, also known as junk bonds. 

Your portfolio is concentrated on one stock – Lloyds – and one region: UK equities account for about two-thirds of your portfolio. The average holding, excluding Lloyds, accounts for 1 per cent of the portfolio, so the impact of it rising or falling by 10 per cent is the same as Lloyds going up or down by just 0.4 per cent. 

Caroline Shaw, head of fund and asset management at Courtiers, says:

Your attitude to risk is a myriad of contradictions. You say your attitude is lower risk, and that you are happy to accept some risk for higher returns in a balanced portfolio, but are focused on growth until retirement. However, your portfolio has less than 15 per cent in bonds and commodities, and is heavily weighted to equities, so is above average risk.

Using a Top 50 ETFs list to rebalance your portfolio is not a robust investment strategy. Rather, you should reassess your portfolio based on your attitude to risk. Equity markets have been rising for several years, so it has been relatively easy to make money as long as you have been invested in equities – you must have surpassed your 5 per cent total return a year target over this period. 

But how would you feel if markets fall 20 per cent and your portfolio takes a hit? You shouldn't need to take this much risk for your target return, especially as you are dependent on these investments.

HOW TO IMPROVE THE PORTFOLIO

James Norrington says:

Your preference for corporate bonds over government debt mirrors the tactical asset allocation decisions of many professional money managers who are put off government bonds by the paltry yields on offer.

The commodity holdings help to diversify the portfolio as these are not strongly correlated with other asset classes. UK property is a slightly different play on the country's growth prospects, but you can diversify further with an ETF that invests in global real estate, which might be worthwhile given the UK's Brexit risks.

Your asset allocation looks fine given your time frame, but as you have an uncertain income from your business it could be worthwhile having a larger cash pile as back-up for regular needs in case of recession. And while there is nothing much wrong with this portfolio it is not low-risk, and the peak-to-trough losses in bad times could be large.

Your individual shareholdings give the portfolio a UK equities bias, but plenty of your investments are global businesses that aren't dependent on the UK economy. From the point of view of making your portfolio simpler to manage, it might be worth setting a rule on having a minimum size equity holding. Positions worth less than £1,000 aren't doing much on their own and, regarding diversification, your ETFs give you broad equity market exposure.

You have a few funds that invest in the same markets as each other, partly because you hold both currency-hedged and unhedged ETFs in some overseas markets.

If you want to sell some of the smaller equity holdings, which in my view are superfluous to your objectives, and reduce some of the Lloyds position, you could use the proceeds to set some cash aside and invest the rest in your remaining holdings.

Alan Miller says:

You have holdings in various areas that don't offer great returns. You have 3.5 per cent in minimum volatility ETFs which track low-growth, highly rated stocks. You have 5.6 per cent in individual commodities, but their long-term returns tend to be abysmal. You have 2.8 per cent in government bonds, but their yields are too low. And you have 1.5 per cent in high-yield debt, but I don't think the extra yield this offers is justified by the higher risk of default.

My recommendation would be to find a low-cost broker or platform and concentrate the portfolio into 10 to 15 ETFs with, overall, 70 per cent in equity ETFs and 30 per cent in fixed-income ETFs. 

I would suggest investing 50 per cent of the equity portion in non-UK-based ETFs focused on Europe, the US, Japan and emerging markets. 

For the fixed-income allocation I would suggest ETFs focused on US corporate bonds hedged back into sterling, UK corporate bonds, and emerging market bonds denominated in US dollars and local currencies.

It is vitally important to look under the bonnet of all ETFs you are considering investing in and evaluate each holding. In terms of your recent purchases, iShares £ Corp Bond 0-5yr UCITS ETF is a very sensible fund that invests in sterling shorter-term corporate bonds. However, you could buy UBS Bloomberg Barclays US Liquid Corporates 1-5 Year UCITS ETF (UC82), which is hedged back into sterling and tracks bonds with a similar credit quality and maturity but has a higher yield – 2.2 per cent versus 1.6 per cent a year. 

I am concerned about the large US tech stock valuations so, rather than holding iShares Core S&P 500 UCITS ETF, I would suggest PowerShares FTSE RAFI US 1000 UCITS ETF (PSRF), which tracks an index whose constituents are included on the basis of fundamental criteria: sales, book value, cash flow and dividends.

iShares Global Water UCITS ETF, which you are considering, has performed well, but its shares on average look highly valued at about 20 times earnings for low growth. And its largest holding, Gerberit (GEBN:VTX), is not specifically a water company but rather a manufacturer of pipes, fittings and sanitary ware.

We avoid thematic and most sector ETFs because one of the main reasons for investing via ETFs is diversification, but you do not get this benefit with ones that have a narrow focus. 

Caroline Shaw says:

Despite having more than 70 different holdings your portfolio is far from diversified due to the heavy concentration in Lloyds Banking. If you hold this within your Sipps or Isas there is no reason to retain such high exposure to a single stock, as you can sell it without incurring capital gains tax (CGT). And if you hold it outside your Sipps or Isas then it would be wise to reduce it using your annual CGT allowance of £11,300, and maybe your wife's as well.

Other than this, your portfolio is well diversified and the ETFs increase the diversification, so there would be no benefit in diversifying it even more. It may be better to add to your existing positions or to slightly consolidate the portfolio, as this would reduce the amount of time you need to spend on it. Monitoring this range of assets is labour-intensive.

ETFs provide diversified exposure via just one holding. So I see little point in owning two ETFs that track, for example, the S&P 500 index. You should review the charges on the ETFs in your portfolio and try to consolidate them to minimise the ongoing charges.

The ETFs providing exposure to UK and global equities also duplicate some of your direct equity holdings, such as Rio Tinto (RIO) and BP (BP.) .

Think carefully about iShares Global Water UCITS ETF. This still provides exposure to equities and their risks, and may also duplicate some existing portfolio holdings.