Join our community of smart investors

You have a problem with currency mismatch

This adventurous reader needs to face up to some hidden risks
July 12, 2018, Cynthia Bowring and Rupert Webb

Nicholas is 42 and works in South Africa as a teacher in a private school, although is a British citizen. He isn't married and his salary is more than enough for him to live comfortably, as his remuneration package also includes accommodation, medical expenses and insurance.

Reader Portfolio
Nicholas 42
Description

Funds, shares, buy-to-let property, cash

Objectives

Grow portfolio to a value £800,000 over next 23 years

Portfolio type
Investing for growth

Nicholas has a 20 per cent share in a house worth about £1m, and a share of a third in two flats, each of which is worth about £500,000. The three properties, which are in the UK, produce a monthly rental income of £2,000 for him. He uses some of this income to invest £300 into five funds every month, and may increase the amount of his monthly investments. Nicholas is liable to tax on his assets in the UK and pays income tax in South Africa.

"I hope to start a family soon and expect my salary to be enough to cover the extra expenses, although I would be willing to dip into my portfolio if I needed extra funds," says Nicholas. "If I stay in South Africa permanently I will use my portfolio to fund my retirement. The Sterling/Rand exchange rate is currently in my favour, so if my portfolio grows as much as I hope, it will be worth many millions of Rand. 

"My main objective is to grow my investment portfolio to a value of £800,000 by the time I am 65 to provide a good retirement fund. This would require growth of 4-5 per cent for the next 23 years, which I hope is realistic. 

"I have tried to create a well-balanced and fully diversified portfolio, which I will hold for at least 20 years. I mainly buy high-growth funds with the aim of holding them permanently. I have tried to diversify the growth segment of the portfolio by holding a mixture of developed, Asian and emerging market funds, invested in both large and smaller companies. 

"I have some good emerging market funds which have done well, and I would be prepared to increase exposure to China and India as they increasingly look as though they will dominate the global economy in the decades ahead – assuming I can find the right funds with which to do this. 

"Recent additions to my portfolio include Invesco Bloomberg Commodity UCITS ETF (CMOD) because I think a well-rounded portfolio should have some exposure to commodities. I am increasingly drawn to investment trusts and added Personal Assets Trust (PNL) as a defensive element that will hopefully limit the overall portfolio's downside during economic downturns. I also added First State Global Listed Infrastructure Fund (GB00B24HJL45) for some defensive diversification.

"I am prepared for the normal volatility of the stock market, and think that drops of 10 per cent to 20 per cent would be great buying opportunities. 

"I am thinking of investing in JPMorgan US Smaller Companies Investment Trust (JUSC) for high-octane growth, Worldwide Healthcare Trust (WWH) as biotech and healthcare stocks should always be in demand due to ageing populations, and Jupiter India Fund (GB00BD08NQ14) to increase my emerging markets exposure for long-term growth."

 

Nicholas's investment portfolio

HoldingValue (£) % of portfolio
Baillie Gifford Global Discovery (GB0006059330)184564.75
Baillie Gifford Shin Nippon (BGS)115532.98
Baring Europe Select (GB00B7NB1W76)223195.75
Fidelity China Special Situations (FCSS) 164274.23
First State Global Listed Infrastructure (GB00B24HJL45)106192.73
First State Greater China Growth (GB0033874321)262746.77
FP Crux European Special Situations (GB00BTJRQ064)247656.38
Fundsmith Equity (GB00B41YBW71)161684.16
JPMorgan Emerging Markets (GB00B1YX4S73)244866.31
LF Lindsell Train UK Equity (GB00BJFLM156)293767.56
Lindsell Train Global Equity (IE00BJSPMJ28)262116.75
Lloyds Banking (LLOY)65421.68
M&G North American Dividend (GB00B7565G26)261766.74
Man GLG Japan CoreAlpha (GB00B0119B50)168294.33
Marlborough UK Micro-Cap Growth (GB00B8F8YX59)109122.81
Old Mutual UK Mid Cap (GB00B1XG9482)169544.37
Personal Assets Trust (PNL)106512.74
Polar Capital Global Technology (IE00B42W4J83)124383.2
Royal Dutch Shell (RDSB)273607.05
Invesco Bloomberg Commodity UCITS ETF (CMOD)113202.92
Vodafone (VOD)173084.46
Cash51711.33
Total388315 

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:

It is realistic to hope that your investment portfolio will double over the next 23 years. A total real return of just over 3 per cent a year on average should achieve this. A reasonable expectation for equity returns is 5 per cent a year, so you should be able to double the value of your portfolio even if you hold some low-return, lower-risk assets such as cash.

However, I don't like your high exposure to emerging markets, and desire to increase your exposure to India and China on the basis that these economies will grow well. Although they may grow, history tells us that good long-term economic growth does not necessarily translate into strong equity returns. One reason for this can be because economic growth is already reflected in the prices of shares. Another, which many investors underappreciate, is that economic growth does not necessarily fully benefit quoted companies. It might instead benefit workers, overseas companies, unquoted companies or companies that don't yet exist.

The case for emerging markets is that there are some occasions when they are cheap enough to more than compensate for their risks – such occasions sometimes occur because emerging markets are prone to overshooting their fundamentals. I'm not sure, though, that now is one of those times. So keep your powder dry.

I think you're right to be increasingly drawn to investment trusts. Recent research from Cass Business School has found that, on average, investment trusts have outperformed comparable open-ended funds by an average of 0.8 percentage points per year. Over 20 years, this compounds to a massive sum – over £35,000 per £100,000 invested. 

I'm not sure that stock market falls of 10 per cent to 20 per cent would be great buying opportunities. In serious bear markets shares can fall a lot more than this, for example MSCI World index fell 48 per cent between 1999 and 2003, and 55 per cent between 2008 and 2009.

One way to protect yourself from such falls is to apply a 10-month average rule: sell when prices fall below their 10-month average, and buy when they rise above it. This rule will lose you money if there are short dips in prices, but also protect you from the worst bear markets. And over a 20-year investment horizon you can expect at least two of these.

You have a problem with currency mismatch. If you stay in South Africa, your liabilities will be in Rands, but your assets in sterling. And this could go against you. 

The problem is not so much that inflation tends to be higher in South Africa than in the UK. In principle, over the long run higher inflation should mean a fall in the nominal exchange rate, so money invested in UK funds should go as far in rands as it would in sterling – although this wouldn't be the case over the short term.

Rather, the danger is that the South African economy will grow faster than the UK economy, something that is plausible. If this happens, South Africa's real exchange rate will probably rise, meaning that your portfolio won't be worth as many rands as you hope. Economists call this the Balassa-Samuelson effect.

This isn't a near-term problem, but could become one. So at some point consider investing in some South African rand-based funds to mitigate this danger.

 

Cynthia Bowring, portfolio manager at Sanlam UK, says:

In terms of your objectives, the first point to consider is your target retirement pot size. Why £800,000? Assuming the required level of growth is achieved, 4 per cent of this £800,000 portfolio would produce an income of £32,000 a year. Does this level of income appear sufficient compared with your current salary and for the standard of living you would like in retirement?

Your accommodation, healthcare and insurance may not be paid for in retirement. If this is the case, what level of income would you realistically need to support you and your future family during your retirement?

A portfolio yield of 3 per cent is more realistic as this would allow for investments other than income-orientated assets, enabling greater diversification.

The target level of growth you suggest is slightly on the low side once inflation is taken into account. If we assume that inflation runs at 2 per cent over the long term, your portfolio would need to grow by 5.15 per cent to reach £800,000 in your specified time frame. If you are considering moving the money to South Africa, you need to consider the impact of the inflation rate there on your investments.

And if you wish to take £32,000 a year from the portfolio from age 65 and we assume no growth on the portfolio value of £800,000, albeit a very unlikely scenario, your portfolio will only last for 25 years. But average life expectancy for a man of your age in the UK is 91 years, according to Aviva's life expectancy calculator, so there could be a small shortfall.

So to provide greater security, whether for you or your future family, I would suggest targeting a higher portfolio value, perhaps of £900,000, and a corresponding higher target rate of return.

Exchange rate risk is also high. The South African Rand is a volatile currency and has moved 21 per cent versus the pound in the past 10 years, although during this period it went in your favour.

Another consideration is whether double taxation treaties exist to prevent you paying tax on your investment portfolio in both the UK and South Africa. I would consider taking specific tax advice to determine this.

 

Rupert Webb, chartered wealth manager at WHIreland, says:

Your portfolio is well diversified as it is invested in a number of funds that are likely to be able to meet your objective of annualised growth of 4 per cent over the next 20 years. 

You view falls in markets as opportunities to invest cash. But your allocation to it is below the 5 per cent allocation we suggest to ensure investments can be made at opportune times.

Most of your investments are actively managed funds, but it is widely accepted that in the long run including some low-cost exchange traded funds (ETFs) will improve your returns because the overall costs of your portfolio are lower.

You are increasingly interested in closed-ended investment trusts. But due to the leverage (debt) taken on by most closed-ended funds I would caution against investing the portfolio only in one type of investment vehicle.

 

HOW TO IMPROVE THE PORTFOLIO

Cynthia Bowring says:

Your portfolio is almost entirely invested in equities, which means that its value is likely to be very volatile, particularly given the high exposure to China and emerging markets. Your long-term investment horizon means that you can take a higher level of risk than when you are getting near to retirement. So the high exposure to China and emerging markets is suitable – as long as you are prepared for the associated volatility.

But you say you are comfortable with falls of up to 20 per cent in value and this portfolio could fall by significantly more. So I would suggest moving some assets into fixed income and increasing the weighting to alternatives to improve diversification and reduce volatility. Options include another infrastructure fund with a different underlying focus, or a clean energy or positive impact fund, which would sit well alongside the other thematic investments you are considering.

The high exposure to Japan and very low weighting to North America is unusual. The US is a more significant economic power than Japan and benefits from better demographics. You could increase your exposure to North America with a growth-orientated fund such as Old Mutual North American Equity (GB00B1XG9G04).

The three direct equity holdings –  Vodafone (VOD), Royal Dutch Shell (RDSB) and Lloyds Banking (LLOY) – produce a good income, but also add stock-specific risk to the portfolio. I would sell them and invest entirely through collectives, or at the very least reduce Royal Dutch Shell.

Your recent purchase of Personal Assets Trust seems sensible as it is a multi-asset fund with holdings in gold bullion and index linked bonds, as well as an allocation to cash. Although this means it is likely to lag in a strongly rising market, it will also protect you in a down market. So I would increase the allocation to Personal Assets Trust to around 6-8 per cent of your investment portfolio.

When considering investment trusts against open-ended investment companies (Oeics) and unit trusts, the possible benefits of the former are the gearing they can take on [allowing them to invest more than their assets in the market], as well as the possibility that you might be able to buy them at a discount to their net asset value. However, this can work against you if the discount widens further after you have purchased the trust.

 

Rupert Webb says:

You are at the more adventurous end of the risk spectrum and your objective is growth, so your investment portfolio is underweight fixed-interest assets. However, these play an important role in protecting capital over the long run due to their historic negative correlation to equities. For exposure to fixed interest we favour the Royal London Corporate Bond (GB00BD3GHQ03) and Baillie Gifford High Yield Bond (GB00B1W0GF10) funds.

Introducing infrastructure and commodities to the portfolio adds some exposure to alternative assets, which can be beneficial as their returns are uncorrelated to equities. Funds seeking total returns might also be useful in the long run, and we would suggest Troy Trojan (GB00B01BP952) or Newton Real Return (GB00BSPPWT88).

In terms of your geographic allocation, your exposure to emerging markets of about 17 per cent is of concern. Although this is a high-growth area this allocation is too high for a diversified portfolio. So maybe trim this and reinvest the proceeds in fixed-interest and total-return funds.