Investing in risky Aim stocks is putting the cart before the horse

"The grandchildren are a mixed bunch, so my investment time horizon is quite mixed," says Toby. "One has special educational needs and several of the others will probably go on to further education. The eldest is now 10, so will need money for this in eight years, while the as-yet-unborn grandchildren might not need funds for a long time after – maybe 25 years from now.

"I originally invested in child trust funds (CTF) for the eldest grandchildren, but when the government ended the opening of new CTFs I set up a discretionary trust for all of them. I am fairly comfortable with the compliance formalities and costs of this, and a trust structure gives me greater flexibility over the dates when I pass on the benefits.

"I add about £7,000 a year of new money to the trust – or more when I can afford it. I like to invest it in lumps of £10,000. I try not to deal too frequently, although recently I sold Standard Chartered (STAN) at a loss and topped up United Utilities (UU.).

"When looking for investments to add to the grandchildren's trust I go for ones tipped in Investors Chronicle that I also like. I'm keen on Alternative Investment Market (Aim) shares, in part because the tax relief they offer can be useful for family trusts if they get large enough. I also crop any gains each year to use my capital gains tax (CGT) allowance.

"I currently reinvest income, so it would not be a big problem if an investment missed a dividend payment. But I generally don't like collective funds because of their management charges and the risk that their holdings might overlap with my holdings in direct shares.

"I am gradually diversifying the fund, so recently added a 20 per cent share in a residential property which yields just under 4 per cent. It is unlikely to change much in value, so I consider its role in the portfolio as an equivalent to a corporate bond. 

"But where should I invest new money in 2018?"

Toby's grandchildren'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:

A distinctive feature of this portfolio is its long and variable time horizon, and how this affects your investments. It could be argued that if you review and rebalance the portfolio regularly, your time horizon will be only as long as until the next rebalancing. But as you have really long-term investment horizons there are some things you can do.

You can afford to take liquidity risk, which you are doing with a property investment. Your variable horizon is especially useful here, as it allows you to ride out economic cycles. So if a recession depresses prices in, say, eight years' time, you can just hold on until the upswing.

An argument against this, however, is that prices are high, so expected long-term returns are low. This advocates only a moderate holding in property.

James Norrington, specialist writer at Investors Chronicle, says:

Portfolio management is always a balancing act between capital preservation, growth and income requirements. With several beneficiaries who will need to draw from the trust at different times, choosing an investment policy that is suitable for all of them is a challenge.

With any investment policy you should review your positions at regular intervals. As the trust gets towards the end of the eight-year pure accumulation horizon, steady income may be more suitable for the needs of the beneficiaries.

Although you want to invest as tax-efficiently as possible it is also important to tailor risk to your objectives. You have a long time horizon, but as capital protection is important and you need to be fair to the beneficiaries who will receive benefits later, investing in risky individual Aim stocks because of inheritance tax (IHT) benefits is possibly putting the cart before the horse.

This is not to say you should avoid risk. With eight years until the first beneficiary is likely to need money from the trust, it is reasonable for a higher proportion of the portfolio to be invested in equities. It's just that you should probably take less concentrated risk than individual Aim stocks. These are more suitable for hobbyist investors who can afford to absorb any losses, or those playing with money that would otherwise be gobbled up by IHT.

Academic research shows that there is a very real premium for investing in small companies, especially those darlings with momentum. With your tricky investment goals, however, it would pay to remember that while you could strike gold with a company such as Fevertree (FEVR), the risks of an Aim company blowing up, such as Globo and Quindell did, is also very real.

Rebecca Williams, client director at Brown Shipley, says:

The trust is catering for a wide range of beneficiaries with significantly different time horizons and needs. Cash flow modelling would help to quantify what amounts are needed when, and determine your investment strategy. A cash flow model would take account of projected growth rates, future contributions and charges, and help to estimate whether the trust will have sufficient funds to pay for each grandchild's further education in full. This will help you to decide what levels of future contributions to make to the trust, your longer-term risk appetite and alternative planning options.

Also consider setting up an offshore bond within the trust. Offshore bonds are deemed to be non-income-producing, meaning there is no income tax liability for the trustees to pay on gains arising within the bond. Investments made within the bond can be bought and sold without incurring CGT – this is often referred to as gross roll-up.

The trustees, meanwhile, can access up to 5 per cent of the amount invested in an offshore bond each year without creating any immediate tax implications within the trust. The 5 per cent allowance accumulates so, for example, if nothing is taken in year one, then 10 per cent is available in year two and so on.

If the trustees want to make a distribution of more than 5 per cent they can usually do this more tax-efficiently by assigning segments of the offshore bond to beneficiaries. The beneficiaries surrender the segments in their own name and pay UK income tax on any gain made on the investment. The advantage is that if the beneficiary is a non-taxpayer, which is likely if your grandchildren are in education, or a or basic-rate taxpayer or higher-rate taxpayer, they will pay income tax at a lower rate than if the trustees surrendered segments of the bond, in which case any gain is taxed at 45 per cent.

Using an offshore bond also simplifies the tax reporting requirements for the trust because it does not create a liability to UK income tax or CGT. This means there is less administration for you.

You could also set up an offshore bond outside the trust in your own name. This gives you some future financial security as, unlike with the trust, you have access to the money should you need it, but also the flexibility to assign segments to your grandchildren. And if you keep the value of the trust below the IHT nil-rate band by making investments elsewhere, you should avoid incurring periodic charges.

Consider moving the CTFs set up for your eldest grandchildren into Junior individual savings accounts (Jisas), which offer a much broader range of investment choices. Jisas are very tax-efficient investment wrappers, and should have lower running costs and involve less administration. The downside is that the money in the account belongs to the child when they reach 18, although this is the same whether the money remains in a CTF or is transferred to a Jisa.

You already use the IHT exemption to make gifts out of surplus income, but you also have an exemption that allows you to gift £3,000 a year without IHT implications. You can carry any unused exemption forward to the next year.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

A genuine long-term investor would hold very few listed companies directly. This is because the next 20 years will see a lot of creative destruction, which could gravely weaken any company. Very few have such strong economic moats that we can be confident of them withstanding decades of competition and technical change. Of your holdings, I'd consider only Unilever (ULVR) as possibly fitting this bill.

Instead, over such a time horizon, you should back the field rather than any particular horse, so a global tracker fund should be the centrepiece of a long-term portfolio.

You might think that long time horizons justify big holdings of equities because these do well over the long run. I'm not sure this is right: there's a significant danger of shares falling even over 10 years or more. The case for loading up on risk is more that this will be free money for your grandchildren, so they shouldn't be as concerned as others would be if they get less than they might expect.

You say it wouldn't be a problem if a company missed its dividend. It would. Dividends are signals: a company only cuts its dividend if it is in real trouble, so a dividend cut is almost always accompanied by a big price fall. If you must pick stocks, attach great importance to the chance of a company maintaining and growing its dividend.

You also say you like Aim shares, partly because of their tax breaks. I don't think you should because this is not a strong argument for them, and certainly not for a long-term investor. 

A tax advantage is often embedded in prices so that what you gain from lower tax you lose in lower returns. This might be one of many reasons why Aim has underperformed mainline shares during its lifetime. The case for investing in Aim stocks is that you might sometimes want to ride a wave of sentiment, not because there are tax breaks.

There's a case for holding private equity because over the long run it's very possible that corporate growth will come from firms that are not yet listed on the stock market. So consider some private equity investment trusts which give you exposure to such growth investments.

James Norrington says:

If you are looking to keep charges to a minimum and capture the broad global equity premium, consider a global tracker fund. Tracking the global market's capitalisation gives you high exposure to US-listed mega-caps which, thanks to the stretching of valuations in the quantitative easing (QE) era, could deliver a lower overall average rate of return than in the past. But the US should be part of any global investing strategy over the longer term.

You could also use products such as exchange traded funds (ETFs) as cheap building blocks to create your own balance of global equity exposure. This way you could maintain broad equity positions but tweak percentage allocations so you have, say, higher exposure to eurozone, UK, Japanese and emerging market equities than you would get from a straightforward market cap weighted global index tracker.

Although ETFs are a valuable addition to an investor's armoury, it is worth diversifying across product structures. Another type of collective fund is investment trusts, the shares of which trade on the stock exchange. These can also be used as global equity building blocks, for example, see Investors Chronicle columnist John Baron's portfolios. Dips in developed stock markets could be an opportunity to buy investment trusts when their shares are cheap compared to the value of the assets they hold.

Your property income provides some useful diversification in lieu of any significant bond holdings. Given where we are, seemingly at a secular turning point at the end of a 30-year bull market in bonds, it is probably worth avoiding this asset class in the short term as many bond funds will suffer capital losses as rates rise.

Performance 01 Jan 2009 - 31 Jan 2018 (%)

Leonora Walters, personal finance editor at Investors Chronicle, says:

Investors Chronicle columnist John Baron's portfolios are an excellent example of how to use active funds to create a diversified portfolio. However, remember that these are an example – not an allocation that may be suitable for you. Each individual investor has different allocation requirements depending on a number of factors such as the purpose of their money, time horizon and risk appetite. 

You need to determine an asset allocation that will help to meet your investment objectives, and then choose funds with which to express it. We run many articles on this issue.

If keeping charges to a minimum is a priority then some of the funds featured in John Baron's portfolios may not be the best option for you as they have relatively high charges, even by the standards of active funds.

Passive funds such as trackers and ETFs are the cheapest options, so have a look at our IC Top 50 ETFs for some ideas.

However, if you want the possibility of outperformance such John Baron's portfolios have very successfully delivered, then you will also need to consider active funds. There are many with good records of outperformance that have charges below 1 per cent so if you do your research, you should be able to find them.

Look across the entire universe of funds available to UK private investors - don't just limit yourself to one type of fund such as investment trusts. These can be more expensive than their open-ended peers because some of them have performance fees – something virtually unheard of among open-ended funds. But there are also some very cheap investment trusts that don't have performance fees and deliver excellent returns, for example, see this week's tip. So don't choose a fund according to its legal structure, choose it according to its individual merits.

A starting place could be the IC Top 100 Funds, but to get the best possible outcome look far more widely than just this list. We certainly do, and highlight other good funds in our articles and weekly tips.

Another way to keep costs down is not to have too many funds in your portfolio. Ideally you should not have more than about than about 15 funds, and preferably fewer. If you have many funds it means the outperformance of individual ones will have less of an effect on your portfolio's overall return, which could end up resembling that of a passive tracker fund. But this would be at a far higher price because you are paying the charges of each active fund.

A core and satellite approach can be useful, whereby you have a fund to give you core exposures, and then some smaller allocations to funds which invest in more unusual assets not contained within the core holding.

You already hold Foreign & Colonial Investment Trust (FRCL) which could be used as a core holding. This offers exposure to a diversified selection global equities, as well as unlisted securities and private equity. It has outperformed FTSE World Index over one, three and five years, and has a reasonable ongoing charge of 0.79 per cent.