Overdiversification can reduce your overall return

“I want to preserve the capital value of our investment portfolio and to be able to continue drawing about 3 per cent a year from it, as well as occasional lump sums,” says Tony. “We have made some financial gifts to our sons to assist with their first property purchases and have opened individual savings accounts (Isa) for our grandchildren. We want to make further financial gifts to our sons to reduce their inheritance tax (IHT) liability, as I am not particularly attracted to trusts or Alternative Investment Market (Aim) stocks.

"We also want to retain enough money to cover possible care costs in our later years, although consider our home as a source of financing for this. We would either sell it and move to a smaller property or do equity release.

"In 2014 I started to draw down from my self-invested personal pension (Sipp) as I had slightly exceeded my £1.5m lifetime allowance and paid the required tax. We used the 25 per cent tax-free cash sum to top up our pension income for two years, and put some of it into our Isas. Our investments are now all held in Isas and Sipps.

"Following the change in IHT treatment of Sipps a few years ago we now mainly draw money from our Isas and leave the Sipps alone. But this may change as I approach my lifetime allowance recalculation at age 75.

"I worked for a number of different employers so acquired a number of final-salary and additional voluntary contribution pensions. I transferred these to a Sipp about 10 years ago and the independent financial adviser I was using at the time invested it in funds. However, these and the platform via which I was invested had high fees, so I transferred it into a self-select Sipp.

"We take a 20 to 25-year view with our investment portfolio which has an income bias and yields about 3.5 per cent. I review it every three months and may sell a fund if its performance figures fall below the second quartile of its sector.

"I like to invest in each area I have exposure to via two or more fund managers, although I am aware this risks stock duplication.

"I am no longer interested in picking single stocks, and prefer to invest via investment trusts and a few passive funds."

Tony and his wife'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:

There’s a lot I like here. I think you are right to avoid funds with high fees and it’s reasonable to steer clear of Aim stocks. On average, their poor returns have offset any tax advantages they offer.

You also have a bias to the right types of stocks – defensives – companies that have economic moats so are less vulnerable to competition and have beaten the market for years. You also have exposure to these via funds such as Finsbury Growth & Income Trust (FGT) and Fundsmith Equity (GB00B4MR8G82).

You are reasonably well diversified despite only having a small allocation to cash, with a decent weighting in corporate bonds and property funds.

Your strategy of getting exposure to certain areas of the market via more than one fund manager is reasonable. The greater the fund manager risk relative to market risk, the more reasonable it is to do this. In private equity, for example, where returns can vary a lot from manager to manager, diversification can reduce risk a great deal. But in segments where market risk is high and funds’ dispersion of returns are lower, the gains of doing this are smaller.

The benefit of doing this is also smaller in segments where fund managers hold similar stocks. Many large UK equity income funds, for example, hold much the same shares as each other because there are only a few big dividend-paying shares. So diversification across these can achieve little.

Rosie Bullard, partner at James Hambro & Partners, says:

When planning how much to give to your children, it may be worth thinking about future care costs. Would you go into a home and sell your house to cover these costs, or would you like to be cared for at home and how much would that cost? You may also want to think about whether you want to make gifts to your children or if you would like assets to go straight to your grandchildren, in which case you must plan when this might be most appropriate or useful for them. 

You top up your income by taking around 3 per cent a year from your investment portfolio, and also draw occasional lump sums from your Isas as you no longer draw from your Sipp due to IHT planning. This means that to maintain the investment portfolio's capital value in real terms your Isas need to generate around 6.5 per cent to 8 per cent a year, including fees and assuming UK inflation of 2.5 per cent to 3 per cent. This could be achievable, but only if you are prepared to take equity market risk and are comfortable with the likelihood that there will be years when equity market returns are severely negative. Your current asset allocation suggests that you are willing and able to take this risk.

Ian Forrest, investment research analyst at The Share Centre, says:

“In terms of the overall structure of your investment portfolio (excluding your home) there’s a good mixture of assets, which provides diversification. Your largest asset exposure is equities, which account for about 60 per cent of your investment portfolio, if the shares held indirectly by your collective funds are included.

This is more than I would expect to see if your focus is on preserving capital and generating a steady income. While having a greater allocation to equities should increase growth over the longer term it also increases the portfolio's risk, so it would be wise to reduce this to about 40 per cent over time. Having 11 per cent in property funds is also more than I would expect for this kind of investment objective, so I suggest reducing these to nearer 5 per cent.

As you like to invest via collective funds and want to preserve capital, consider RIT Capital Partners (RCP), an investment trust chaired by Lord Rothschild with an excellent long-term track record.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Your portfolio is exposed to political risk. There’s a reason why your utility stocks have huge dividend yields – a future Labour government might nationalise them on unfavourable terms [for their shareholders]. So even if you are no longer interested in picking direct shareholdings you should not forget to monitor the ones you still hold. And consider whether you still want to have exposure to utilities.

Another danger is cyclical risk. On a 20- to 25-year view it is pretty much certain that we’ll suffer at least one recession or probably more. This would be detrimental to your portfolio because shares generally fall in economic downturns, during which property also tends to be hit. A downturn would also be detrimental to your corporate bond holdings as credit risk rises in recessions. That said, if you hold your direct investments in corporate bonds to maturity you will only lose money if that risk actually materialises. But corporate bond funds would also suffer.

Funds such as Fundsmith Equity and Scottish Mortgage Investment Trust (SMT), meanwhile, have done well for years by investing in companies with strong market positions. These have thrived because investors have in the past underpriced what high profile US investor Warren Buffett calls economic moats and monopoly power in the US has risen. But it’s quite possible that investors have now wised up to the possibility that they are overpricing moats, and over the longer term today’s monopolies might be weakened by future changes in technology or regulation.

None of this is to say this is a bad portfolio and it should, on average, comfortably enable you to take an income of 3 per cent a year without reducing its capital value. But it isn't risk-free, so keep an eye out for signs of the dangers I have highlighted.

Rosie Bullard says:

It looks as though the income you are drawing is only coming from the dividends and interest generated by the Isas. While there is logic to this as there is less concern about short-term capital fluctuations, a large proportion appears to come from fixed-income holdings. Fixed income can be a valuable source of income and diversification in portfolios, but we are wary of holding too much when interest rates are rising. We are also wary about the marketability of those holdings when bond markets are challenged as the discount on pricing could be material. 

Also, if an investment strategy is too focused on income returns you can miss out on capital growth. For example, much of the technology sector has near zero dividend yields but it has been the best-performing sector from a capital perspective in recent years. So consider reducing the exposure to the less attractive bonds and preference shares, diversifying the portfolio, and taking 3 per cent a year from income generated and capital growth. 

We agree with the equity bias in your Sipp as you plan to leave it untouched, but it could benefit from more exposure to higher-growth markets such as Asia and certain parts of emerging markets.

We agree with your approach of getting exposure to a given investment area via at least two different managers. However, you have a lot of funds that account for a relatively small portion of your portfolio, and as these are already pretty well diversified you could consolidate this list, leaving fewer funds to monitor.

Ian Forrest says:

Your preference for funds, especially investment trusts, helps to achieve greater diversification, lowers the overall risk level, and provides exposure to sectors and regions that are more difficult for most private investors to access. The downside to this approach is that it results in higher fees, and you need to be careful that there isn’t too much stock duplication due to holding similar funds that essentially invest in the same assets.

Your strategy of getting exposure to a given sector via two or more fund managers may improve your chances of success, but also increases the number of funds you have to monitor. The investment portfolio has more than 50 holdings, which is a lot to keep track of and, as many are funds, it is probably unnecessary to have so many.

While diversification is good, if you overdiversify you can reduce your overall return, and increase costs and practical difficulties. 

A good way to start reducing your number of holdings would be to review the direct shareholdings. These account for less than 10 per cent of your investment portfolio and are generally defensive with fairly reliable dividends. The appeal of utilities is understandable given the portfolio’s income bias, but they are not without their problems as SSE’s (SSE) recent profit warning shows. 

You could also remove some of the individual bond holdings and replace them with a fixed-income trust such as Henderson Diversified Income (HDIV), City Merchants High Yield (CMHY) or F&C UK High Income (ICTA).”