Mitigate market risk with non-equity assets

"The value of the assets I hold outside my Sipp, including my home, fall within my inheritance tax allowance," says Steve. "I intend to leave the capital in my Sipp to my sons, and I also make annual contributions into my sons' and grandchildren's Sipps out of my income.

"I am aiming for the Sipp to make a total return of 5 per cent a year – 3 per cent income and 2 per cent growth," says Steve. "But I don't mind if the balance between the contributions from income and capital changes.

"I take a fairly high-risk approach with my Sipp as the capital risk lies with my heirs. My priority is maintaining the level of income it produces, and if possible increasing it a little each year, although this is not essential.

"I am transferring the funds I hold outside tax-efficient wrappers into my individual savings account (Isa), making use of my annual Isa and capital gains tax allowances. I want my Isa to also make a total return of 5 per cent a year. I use this pot of money to fund expenditure such as holidays, repairs to my home and a car, so I want this to be lower risk than the Sipp. The holdings in the Isa are mainly the ones also held in the Sipp which I consider to be less volatile.

"Overall, I could tolerate a loss of up to 20 per cent in any one year as I wouldn't need to realise the capital value of my investments during that sort of timescale.

"I have been investing for 25 years, and started out with direct shares. I've had good and bad results so realised I did not have enough time to research and monitor direct share holdings, and added a few funds and exchange traded funds (ETFs).

"I tend to invest in shares with a good dividend record or substantial cash reserves such as Apple (US:AAPL). But these attributes are not a guarantee of good returns as demonstrated by Provident Financial (PFG).

"I have been tempted to follow Investors Chronicle's tips of the year, but as timing of purchase is important this has not proved very successful. For example, I added a number of small holdings in housebuilders in 2016 to catch the first-quarter uplift, but my entry price and the market sentiment on these stocks mean this was not a successful move.

"I want to add funds but few seem to beat their benchmarks consistently over the long term, the timescale over which I'm investing. I have moved some of my assets into ETFs but they also seem not to deliver good results. For example, I sold SEGRO (SGRO) and bought HSBC FTSE EPRA/NAREIT Developed UCITS ETF (HPRO) about a year ago, but this is not performing well.

"So I have a mix of direct share holdings, active funds and ETFs. But I think my Sipp has too many holdings and I am trying to reduce them back to around 20, especially as the active funds and ETFs provide additional diversification. 

"Recent trades including selling Fidelity Moneybuilder Income (GB00B3Z9PT62), Rathbone Income (GB00BHCQNL68) and SEGRO, and reinvesting the proceeds in most of the ETFs I hold now.

"I am considering investing in Diageo (DGE), Burberry (BRBY), Cisco (US:CSCO), Computacenter (CCC), Headlam (HEAD), Scottish Mortgage Investment Trust (SMT), Fundsmith Equity (GB00B41YBW71), Harbourvest Global Private Equity (HVPE) andFP Crux European Special Situations (GB00BTJRQ064)."

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:

Although it looks quite sprawling, this portfolio seems to be betting quite heavily upon two factors.

One is cyclical risk, as you have relatively high exposure to construction stocks. These tend to do unusually well in upturns and unusually badly in recessions. They also tend to be seasonal, doing better than most in the winter and worse in the summer.

The other factor this portfolio is heavily weighted towards is monopoly power. You have big holdings in stocks such as Apple, Unilever (ULVR) and AstraZeneca (AZN), which have strong, entrenched market positions because of their powerful brands. LF Lindsell Train UK Equity Fund (GB00BJFLM263) also gives you exposure to this factor.

These two factors are to some extent uncorrelated. It's possible there will come a time when investors fear that big monopolies have become overpriced, and when this happens they'll probably rotate into value stocks which might benefit housebuilders. And the downturn fears that would hurt construction stocks might cause investors to switch into big familiar names which they regard as less recession sensitive. This would support the likes of Unilever and AstraZeneca.

In this sense, you've diversified nicely.

But no amount of equity diversification can protect you from the danger of the whole world market doing badly. If this happens, most of your holdings will fall – when the tide goes out all boats sink.

This risk is significant. Even if we assume that returns will average 5 per cent a year over the long run, there's a roughly 10 per cent chance of a 20 per cent loss in any one year. That means that over 10 years there's a two-thirds chance of such a decline.

The only way to protect yourself from this is to hold non-equity assets. You have relatively few of these: your cash holdings account for less than 4 per cent of your investment portfolio. Your commercial property investments would also suffer in a recession, and if they are high street properties they might suffer from the ongoing decline of bricks and mortar retailing.

However, as you're sharing this risk with your heirs it might be tolerable. But don't think it is insignificant.

Paul Taylor, chartered financial planner and chief executive officer of McCarthy Taylor, says:

We are agnostic as to whether we populate our portfolios with active or passive investments. We often use low-cost tracking investments to gain exposure to certain developed markets, but also invest in various active equity funds that give exposure to various geographic locations and have comfortably outperformed their benchmarks. We also invest in funds focused on different asset classes that have outperformed.

In view of your stated risk tolerance you may wish to further widen the geographic spread of your equity investments as around 80 per cent of your portfolio is in UK and US equities.

I wouldn't necessarily disagree with holding a mix of ETFs, active funds and direct shares, but I would be wary of the potential for duplication in your portfolio. For example, you have 5.73 per cent of it in Apple but also hold two S&P 500 trackers, and Apple accounts for about 4 per cent of each of those funds.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

I think it's a good idea to invest in factors such as momentum, low volatility and value, but these also carry lots of market risk. The case for holding ETFs focused on these factors is that they might slightly outperform the market on average over the long run. But that doesn't mean they won't fall when broader indices do.

I'd also warn you against a very common mistake. You say that moving into ETFs such as HSBC FTSE EPRA/NAREIT Developed UCITS can backfire. It is, however, a certainty in a well-diversified portfolio that some investments will lose money. What matters is to have others that do well when this happens. Do not worry about losses on single holdings. It's your portfolio as a whole that matters.

It's this principle that is the key to simplifying the portfolio. Don't try to assess whether a security is a good investment, as you'll always find a reason to believe it is. Instead, consider whether it would give you anything that your other holdings don't. If the answer's not much, which is true of some of your housebuilders, cut it.

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

Your Isa portfolio is diversified via MSCI World index, emerging markets, S&P 500 and FTSE 250 ETFs.  It would be sensible to make full use of the £20,000 annual allowance for the 2018-19 tax year by investing some of your £20,000 cash in the Isa, or transferring in some of your holdings in Marlborough UK Micro-Cap Growth (GB00B8F8YX59) and Lindsell Train Global Equity (IE00BJSPMJ28) that are outside the Isa.

To reduce the chances of future individual stock disappointments, you could use more broad ETFs that are well spread in terms of geography, sector or stocks.

Your Sipp has 39 holdings and the 20 largest account for 84 per cent of its value. I would diversify the Sipp to reduce the concentration in individual stocks such as Persimmon (PSN), Apple and Costain (COST), which respectively account for 8.9 per cent, 7 per cent and 6.7 per cent of it. And you should also look to reduce the concentration in certain geographic regions – the UK represents 59 per cent of the Sipp's value and the US 23 per cent.

The stocks in your Sipp tend to be high income with an average yield of 4.5 per cent and have a low average price-earnings (PE) rating of 13.8 times. But their rate of prospective earnings growth is low at 7 per cent a year.

I would suggest switching at least half of the direct equity holdings into the following three ETFs, in the stated proportions. The stocks within these ETFs have a lower average yield of 3.1 per cent, but also have a lower PE rating of 12.7 times and a much higher rate of earnings growth of 9 per cent a year.

I would put half of the proceeds of the disposal of the shares into Vanguard Global Value Factor UCITS ETF (VVAL). This is an actively managed global equities fund that selects shares based on various fundamental measures of value, for example, price-to-book, price-to-earnings ratio, estimated future earnings and operating cash flow. It holds around 1,200 stocks and its largest geographical exposures at the end of February were the US, which accounted for 55.8 per cent of assets, Japan, which accounted for 10 per cent, and Europe, which accounted for 25.3 per cent. The ETF has an ongoing charge of 0.22 per cent but also incurs transaction costs of 0.13 per cent year associated with its active management.

I'd use 35 per cent of the proceeds of disposing of the shares to invest in Lyxor Core Morningstar UK UCITS ETF (LCUK). This tracks an index that includes the large- and mid-cap segments of the UK equity market. It has a very low charge of 0.04 per cent and very low estimated transaction costs of 0.01 per cent a year.

I'd put 15 per cent of the proceeds of disposing of the shares into iShares Core MSCI EM IMI UCITS ETF (EMIM), which has 29 per cent of its assets in China, 15 per cent in South Korea and 12 per cent in Taiwan. It has high forecast earnings growth of 12.3 per cent a year, although its dividend yield is lower. It invests in a broad range of small-, mid- and large-cap companies in emerging markets and holds about 1,960 stocks. It has an ongoing charge of 0.25 per cent.

Paul Taylor says:

You have a direct holding in a commercial property, around 20 per cent of your investment portfolio is in building and construction stocks, and 6 per cent is in property funds. This represents a large proportion of your overall wealth, so it is important to correctly diversify within that sector, or reduce the exposure to property and consider other asset classes. Options include short-dated investment grade corporate bonds, direct holdings in gilts (UK government bonds) or commodities.

F&C Commercial Property Trust (FCPT) has performed reasonably well and has a yield of about 4.2 per cent. But we would complement it with something like Kames Property Income Fund (GB00BK6MJF73), which has a yield of about 4.4 per cent, a low allocation to London and focuses on smaller property sizes.

You could also add an allocation to something different to your existing holdings, such as Tritax Big Box REIT (BBOX). This invests in the warehouse and distribution sector, which has benefited from the rise of internet shopping and next day delivery. This fund offers a good yield and has a good performance record.

You could diversify further by adding infrastructure funds such as HICL Infrastructure Company (HICL). There has recently been negative sentiment towards the sector following the collapse of Carillion (CLLN), which provided services for some of the projects they invested in, but this could represent an opportunity. HICL Infrastructure has a UK focus, tends to hold up well in down markets and has a yield of 5.8 per cent.