Watching the defensives

"We want to grow our portfolio 5 per cent a year and eventually take £25,000 a year in income, a target we raised from £20,000 following good performance" says David. "We also want to leave our children an inheritance, which we will partly do via our Sipps, which are worth about £320,000, to take advantage of inheritance tax (IHT) rules.

"If we retire at 60 we will have an income of £24,000 from my defined-benefit (DB) pension, which will increase to £44,000 at 65 when my second pension and Katherine's defined-benefit (DB) pension kick in. We will also get a state pension of £5,000 each from age 65 and have a cash fund for emergencies. 

"Because of this and having no debts we take a high-risk approach to investing and want to have a high allocation to equities. In the worst-case scenario we could easily scale back our lifestyle or even defer retirement.

"I prefer slow and steady investing, and buying value stocks and funds that might be underpriced. I stockpile dividends and use them to buy during market dips. This strategy has meant I have made an annualised return of 10 per cent over the past decade.

"Long-term holdings such as Diageo (DGE), Unilever (ULVR), BAE Systems (BA.) and Royal Dutch Shell (RDSB) have provided excellent returns. I bought Monks Investment Trust (MNKS), Witan Investment Trust (WTAN) and Murray International Trust (MYI) on wide discounts, but these have since narrowed and provided strong returns.

"As we approach retirement, I am conscious of market volatility and the risk in our portfolio, so I want to increase diversification. I've been taking profits on direct shareholdings and reinvesting them in funds, and will continue to do this. I aim to have a portfolio of core and diversified investment trusts with a few direct shares. I prefer investment trusts, and like investing globally into specific themes and sectors.

"I have recently bought Henderson Smaller Companies Investment Trust (HSL) and John Laing Infrastructure Fund (JLIF), taking advantage of recent volatility. I also bought Lookers (LOOK).

"I plan to sell my holdings in Rolls-Royce (RR.) and Centrica (CNA), and buy CQS New City High Yield Fund (NCYF) and City Natural Resources High Yield Trust (CYN)."

David and Katherine'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: "You’ve been doing a lot right: buying investment trusts on good discounts, investing regularly, preferring large defensive stocks and using tax breaks. There are, however, some issues to consider.

One is whether defensives such as Royal Dutch Shell, Unilever and Diageo are now fully priced, or even overpriced?

A reason for their good run in recent years is that investors cottoned on to Warren Buffett’s realisation that companies with 'economic moats' – barriers to entry such as high fixed costs or strong brand names – tended to be underpriced. It’s better to have a constant or rising share of a mature market than a shrinking share of a growing one.

There might be a parallel here with the fate of small companies in the mid-1980s. Back then, investors learned that these had been underpriced for years. So they piled in. With the result that they then underperformed for a decade. Large defensives might face the same fate.

This, though, isn’t certain. Many conventional fund managers have traditionally been loath to hold them for fear that, being defensive, they might underperform a rising market. This has kept them underpriced in the past. This benchmark risk hasn’t disappeared; if anything, it might have become stronger. The question is whether it's strong enough to offset the risk that investors have wised up to their historic mis-pricing. 

Nobody knows for sure. Net, though, I suspect you are wise to want to diversify out of them.

Which raises a second issue: how do you do this? Generally speaking, investment trusts are a good idea, especially broad international ones, alongside some private equity investment trusts. I suspect that future growth might come disproportionately from unquoted stocks. These trusts, however, do not protect us from one big risk – the danger that world stock markets might fall.

But do you have enough non-equity assets to diversify this risk? High yield is not the answer. In the event of a recession, credit risk will increase, causing losses on high-yielding bonds. 

Instead, you've two other diversifiers. One is your defined-benefit pensions, which are in effect safe bonds as they pay a guaranteed future income. The other is your human capital – your willingness to keep working. If these are sufficient protection from a 20 per cent fall in general share prices, then you have no problem. If not, consider increasing your cash holdings.

Rachel Winter, senior investment manager at Killik & Co, says:

Repositioning your portfolio to incorporate a higher proportion of collective funds should lower your risk level by increasing diversification. It would also, arguably, be a lower-maintenance approach. However, it could be more costly due to the annual fees levied by fund managers. Fund houses are now required to publish Key Investor Information Documents outlining full details of their ongoing costs, so I would recommend checking these for each of your investments. 

I would also keep an eye on the long-term performance of each investment. Murray International, for example, has achieved a cumulative share price performance of 26.6 per cent over the past five years, falling well short of its benchmark, which has risen 72.3 per cent over the same time period.

Freddie Cleworth, chartered wealth manager at EQ Investors, says:

While this portfolio has a high-risk approach being 100 per cent equities, it is well diversified across collective funds and direct shareholdings. The geographic allocation has a natural home bias towards the UK (66 per cent) with the next significant exposure in the US at 11 per cent. Nearly 80 per cent of the portfolio is invested in giant, large and mid-caps, providing further structural support. There is also limited exposure to riskier markets such as emerging markets and Latin America, which helps reduce portfolio volatility given the high equity exposure.

Your strategy of drip-feeding money into the market and using dividends to buy the dips is also sensible. Strong performance to date means taking an income of 4 per cent a year should exceed your target of £25,000. So I suggest holding one to two years' income in cash, allowing flexibility in market downturns when portfolio withdrawals would be detrimental to recovery. There is a balance to be struck between required income yield and capital appreciation, which will be important in maintaining and growing capital in real terms after inflation.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You have responded to good investment performance by raising your target income. Unless your target was too low originally, I'm not sure this is wise. A good run-up in prices is a sign that underpricing has disappeared, perhaps to be replaced by overpricing. This is a reason to expect more modest returns, and perhaps even losses, and to make your portfolio more cautious.

At current levels, your portfolio could generate a total return of  £20,000 a year, which is what matters. Do you really need to take risk to chase the possibility of even higher returns?

Rachel Winter says:

While there is certainly a wealth of evidence supporting the view that value investing is an effective strategy over long time periods, I think both value and growth investments have a place in a portfolio of this size.

As you have a mortgage-free property and a guaranteed income stream you can afford to take some risk. I would consider a greater focus on technology. The portfolio lacks sufficient exposure to key growth themes such as online streaming, cloud computing and mobile payments. Monks and Witan have some exposure to this, so I would consider increasing these holdings or purchasing other funds that focus on large multinational growth companies.

Your target income of £25,000 equates to a yield of over 4 per cent. While technically achievable, this would necessitate a concentrated focus on higher-yielding areas of the market such as telecommunications and financials. It would also require an emphasis on UK stocks as these tend to have relatively high payout ratios.

If you do not actually need £25,000 of income, you could instead target an annual return figure, incorporating capital growth and income as opposed to just income. This would allow for a more diversified portfolio, both geographically and by sector.

Growth themes

Source: Baillie Gifford, Witan IT, as at 30.06.2018

Freddie Cleworth says: 

You are nearing the pensions lifetime limit, so you could add the maximum possible to your wife's Sipp. A simple cash flow modelling exercise would help you visualise the impact of withdrawals on the portfolio, but also help to figure out how best to help your children get on to the housing ladder. If the DB pension income and the joint portfolio are more than sufficient, it could make sense to use some tax-free cash from the Sipps to help your children.

The portfolio is light on healthcare, particularly given the longer-term time investment horizon. Worldwide Healthcare Trust (WWH) offers global exposure. You could also consider replacing John Laing Infrastructure Fund, which could be bought out, with HICL Infrastructure Company (HICL). The portfolio's highest sector allocation is financial services at 17 per cent – this is worth keeping an eye on in light of Brexit negotiations.