Cut your holdings to reduce your costs

Geoff receives an index-linked occupational pension, and they both receive the state pension. The income from these, together with quarterly drawdowns from Geoff’s self-invested personal pension (Sipp) and individual savings account (Isa), amounts to about £45,000 a year and enables them to live comfortably. He limits the drawdowns to a maximum of 2 per cent a year, although they would like to spend more on travel and holidays. “We would like to leave a capital sum to our children, as well as supplementing our own income, so want a combination of growth and income,” says Geoff. 

“Over the past 10 years the portfolio has had an average growth rate of 5 per cent a year net of the 2 per cent withdrawals, giving a gross return of 7 per cent a year. Could this be improved without having to increase the risk profile of our investments? If I were to increase the drawdowns to 3 per cent a year to spend more on holidays, could I still maintain the growth rate at a net 5 per cent a year?

“I have 60 per cent of my investment portfolio in equities, of which 45 per cent is in the UK, 15 per cent in Europe, 23 per cent in the US, 7 per cent in Japan and 10 per cent in Asia Pacific. And 10 per cent of the investment portfolio is in bonds, with 25 per cent in property, commodities and absolute-return funds, and 5 per cent in cash.

“I think there will definitely be pullbacks or even a recession, when equities could easily fall 20 per cent. So is this portfolio sufficiently diversified to withstand that and to mitigate the negative impact on performance? And should I hold more liquid assets to cushion market falls and take advantage of a subsequent recovery, in case there is another financial crisis? 

“Our Isas and Sipps are held across four different investment platforms and invested in funds I have chosen on the basis of their managers’ performance. However, the absolute-return funds have only made slightly better returns than cash. So would it be better to switch them into other types of assets, for example property or equities, and could I do this without changing the risk profile of the overall portfolio?

“Fees eat up an increasingly large proportion of performance gains and the total cost may reduce performance by a further 2 per cent, so how could I reduce this cost?”

Geoff's investment 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:

Is an annual average 7 per cent total return over the past 10 years average? I'm afraid so. During this time MSCI World index has returned 11 per cent a year in sterling terms. Gilts have returned 6 per cent and cash, of course, very little. So you're pretty close to average.

I would not, however, bet on this repeating itself. I find it difficult to imagine both equities and bonds doing as well in future as they have over the past 10 years.

How you should allocate your wealth between equities, bonds, commodities and other assets is largely a subjective matter, which depends on your personal appetite for returns rather than safety. One consideration is what risks bother you. If they include inflation, there's a case for commodities. If you are concerned about a recession then you need bonds. And cash protects you from the risk of higher interest rates, and the danger that equities and bonds might do badly together – perhaps a significant risk.

Unless you are a seasonal investor I would rarely rebalance your portfolio. There's a case for running winners as there is momentum in some asset classes. The rule of buying when prices are above their 10-month average and selling when they are below it applies to equities and gold. On the other hand, a higher dividend yield – lower prices – is a buy signal for equities over longer time horizons. So rebalancing around once a year should be sufficient.

You ask whether the possibility of another crisis justifies having more cash. The point of wealth is to give us peace of mind, so do you have this? If you're worried that you are not growing your portfolio sufficiently you have too much cash. But if you're worried about a crisis, you have too little. The asset allocation that’s right for you is the one that minimises worry.

But I would add that the next crisis might not be like the last one, which was in a sense mild. Equity losses were offset by profits on bonds and the stock market bouncing back strongly. However, we have no assurance that the next crisis will be so kind.

Alan Mellor, chartered financial planner and managing director at Phillip Bates & Co, says:

Your want to maximise your own income and leave a capital sum to your children, a realistic objective. A longstanding secure or sensible withdrawal rate of 4 per cent a year should enable your capital to last for the rest of your lives while protecting that income against inflation. As you are only taking 2 per cent a year this leaves a comfortable margin that should allow you to draw at this level for the rest of your lives and leave some capital for the next generation.

But increasing your annual drawdowns to 3 per cent a year while maintaining the growth rate at 5 per cent seems ambitious. This would require an ongoing growth rate after charges of 8 per cent, which is highly unlikely.

However, reducing the cost of your investments would allow a higher rate of withdrawal while ensuring that your capital is not being depleted. So identify what is responsible for your estimated 2 per cent costs and reduce them significantly.

Look at the investment costs you are incurring from the four platforms you use. With the size of your Isa and Sipp you should be able to achieve total investment and platform charges of at most 1 per cent.

The total cost may also be inflated by your excessive number of holdings. And while a large number of holdings may seem like a good way to achieve diversification it is difficult to keep track of more than 30 funds. Also, your portfolio is so diversified that a simple index tracker fund may produce a similar return but at a significantly lower cost.

Alan Steel, chairman of Alan Steel Asset Management, says:

As your home is worth £600,000, almost at the joint inheritance tax (IHT) exemption level, it makes sense to allow the Sipp to grow as it does not incur IHT. You should take income from the Isa as this would not incur capital gains or income tax.

I assume all the investment decisions are made by you, so how would your wife would manage if you died first? That is one good reason for you to simplify your holdings and strategy.

You have nearly 30 holdings in the Isa and around 25 in the Sipp, with some held in both portfolios. A number of these account for less than 2 per cent of your investment portfolio, and some less than 1 per cent. Holdings of this size have minimal positive impact as any growth from them does not make a significant contribution to the returns of the overall portfolio. Portfolios should be diversified to mitigate risks at sector or country level, but many investors make the mistake of overdiversifying.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You ask whether your allocation to absolute-return funds could be better invested elsewhere. Very probably, yes. Many absolute-return funds do not achieve more than reasonable combinations of shares, bonds, cash and commodities. So they add little to your portfolio relative to what you're getting already. What matters is not an investment in itself, but rather its contribution to your overall portfolio.

You could reduce your overall portfolio costs by minimising your allocation to actively managed funds. Exchange traded funds (ETFs) or tracker funds can often generate similar returns for a lower cost.

Alan Mellor says:

You need to establish what you objectives are, how much investment risk you are comfortable with and your capacity for loss. This will determine how much of your wealth should be in risk investments and the appropriate strategy for it. Then reduce the number of funds you hold, and focus on ones that offer diversification at reasonable cost. Holding no more than 12 to 15 funds would be more manageable and make it easier to analyse them. It would be likely to reduce your costs.

Holding so many funds means that there is likely to be overlap in terms of their underlying holdings. For example, BP (BP.) is one of the largest holdings in five of your funds and GlaxoSmithKline (GSK) is held by seven of them. 

Your asset allocation, with 60 per cent in equities, suggests you are taking a relatively adventurous approach. The geographical split of the equity allocation seems fairly logical, although the absence of any emerging markets exposure means you are missing an opportunity for diversification and exposure to an area that will have growing influence on the world's economies over the next decade.

Your overall exposure to property of just under 5 per cent may be a little underweight, even if there are concerns on UK commercial property due to the declining importance of the high street.

Equity market falls of 20 per cent or greater happen occasionally. However, I would caution against your belief that you can predict equity falls and mitigate them with liquidity. There are few examples of even professional investors accurately predicting stock market falls. Time in the market makes more sense for long-term investment strategies such as this, rather than trying to time the market.

Your allocation of 15 per cent to absolute-return funds is also to some degree a leap of faith as you are trusting their managers to control volatility while providing a consistent return.

Alan Steel says:

I'm older than you and my strategy is to reduce holdings and put together a collection of funds like a football team. So I have risk-averse funds – goalkeepers, defenders and defensive midfielders, and attacking midfielders and forwards. And when you build this team you must make sure that they complement each other with different skills, instead of having a collection of funds that do the same as each other.

I have no exposure to absolute-return funds because I think they are too complicated and expensive.

If you want a defensive fund – a goalkeeper – look to one run by David Jane at Miton, such as LF Miton Cautious Multi Asset (GB00B0W1V856) or by Sebastion Lyon, such as Troy Trojan (GB00B01BP952). Over a cycle these should do a better job. But don't have more than two 'goalies', and also consider reducing your number of bond funds.

Then pick four or five defenders. Go for strong long-term performers, like Rathbone Income (GB00BHCQNL68) run by Carl Stick, Artemis Income (GB00B2PLJJ36) and Artemis Global Income (GB00B5N99561).

But holding too many income funds that are similar to each other will have reduced the return you could have potentially made over the past few years. And your UK exposure is too high and likely to have held back the portfolio's growth over the past 10 to 20 years. Your many UK income funds have a similar style or factor exposure and similar large-cap holdings to each other.

The US is an efficient market so why bother with a non-index fund? And why do you have three US index funds? Just have one of these.

In 'midfield' have some multi-cap income funds and a defensive global fund. You could add to Newton Global Income (GB00B8BQG486) or back the man responsible for that fund's long-term performance – James Harries – who now runs Troy Trojan Global Income (GB00BD82KQ40). And have a greater allocation to Fundsmith Equity (GB00B41YBW71) and consider adding Lindsell Train Global Equity (IE00BJSPMJ28).

You have a guaranteed income from your pension, which is index-linked, so you could take a bit more risk with your investments. Underexposure to small and mid-cap funds, and fast growth funds will have reduced the return you could have potentially made over the past few years. And you have no exposure to technology.

So you could 'sign' two or three world-class 'strikers'. Options include Baillie Gifford Global Discovery (GB0006059330) run by Douglas Brodie, a smaller companies fund you can take a longer view on such as Old Mutual UK Smaller Companies (GB00B1XG9599) and Rathbone Global Opportunities (GB00B7FQLN12) run by James Thompson. See this week's tip on p45 for more on this.

As we are approaching the end of a market cycle it might be worth having more in funds focused on long-term quality that may recently have underperformed growth.