How can I improve my asset allocation?

"I will retire next year aged 60 and receive an annual index-linked pension of £42,000 a year and pension lump sum of £160,000," says Duncan. "When I am 66 and start to receive the state pension of £8,000 a year and a second occupational pension of £4,000 a year, my annual income will rise to £54,000 a year. I also expect to inherit £200,000.

"My pension income should meet most of my day-to-day expenses, so I will only draw on capital if I need expensive medical care or go on extravagant holidays. But I have eight godchildren to whom I would like to make generous gifts or bequests from capital, so I am looking to protect my capital and, if possible, grow it in real terms. 

"As I do not currently need investment income I have a medium-term outlook and moderate appetite for risk. Around 15 per cent of my assets are in wealth preservation funds, and the rest of the investment portfolio is in low-cost tracker funds. I have intentionally got more exposure to Europe and Japan equities, to reduce my exposure to the US.

"But how can I improve my portfolio’s asset allocation and performance with my current risk appetite?"

Duncan'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

David Healy, director at Kingswood, says:

As a single person with no dependants, you should have in place an effective will and power of attorney, in case anything unexpected happens to you. You should find out who might be entitled to the income from your annual index-linked pension after your death. Many defined-benefit schemes do not allow the nomination of children or godchildren to receive the protected pension benefits after death.

Trusts are also an effective way of reducing potential IHT bills, while allowing you to keep an element of control over what happens to the assets in them and how they’re distributed

You will not benefit from the spousal death benefits of the index-linked pension, but you will retain a guaranteed, inflation-linked level of income throughout your lifetime. If the death benefits of the pension are of concern, you could consult a pension transfer specialist on the merits of transferring this defined-benefit pension into a money-purchase scheme. But in most cases, retaining your current pension arrangements and securing the guaranteed income for life makes the most sense. And you could assist your godchildren using other assets.

Your two properties, investments, pension lump sum and possible inheritance mean you have an estate worth over £2.5m – before you include any personal effects. If an estate is valued at more than £2m the additional residential nil-rate band is progressively reduced by £1 for every £2 that the value of the estate exceeds the threshold, making your inheritance tax (IHT) bill larger. So consider IHT planning using the annual gifting limits and maybe contributing into a private pension – but not so much that you exceed your pension lifetime allowance. If you start making larger gifts to your godchildren now, regular gifts worth more than the annual £3,000 limit will fully fall outside your estate after seven years.

Trusts are also an effective way of reducing potential IHT bills, while allowing you to keep an element of control over what happens to the assets in them and how they’re distributed. But trusts can be complex, so seek the advice of an independent financial adviser or solicitor. At your age, you should have enough time to properly address IHT. Having a properly drawn-up will, including to whom you leave your French property, is a key part of this.  

Consider allocating some of your portfolio to companies that qualify for business relief, which fall outside your estate for IHT purposes after you have held them for two years. This would both diversify it and help with IHT planning.

You have not said if you hold your investments in an individual savings account (Isa) or other tax wrapper. You should use your Isa allowance every year to make your investments as tax efficient as possible. This is currently £20,000. You can also use your annual capital gains tax (CGT) allowance to transfer assets into Isas to reduce the tax you pay on future growth and income. 

See 'Don't overlook the flexible benefits of Isas', IC, 22 March, for more on how to do this

Adam Ross, investment director at Canaccord Genuity Wealth Management, says:

Your financial objectives are rather vague so you should first spend some time putting more detail into your investment strategy. One of your priorities should be considering what level of losses you might be able to cope with, as we are likely to see more bouts of volatility over the next few years as this bull cycle comes to an end. When you have determined this, you should use it to shape your overall asset allocation. Investors are prone to making irrational decisions during periods of volatility and have been known to sell right at the bottom of a market crash as the emotion of losing money becomes too much for them. But if you have an idea of what level of drawdown you can cope with, then you can be better prepared by having an appropriate asset allocation for such a situation.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow, Investors Chronicle's economist, says:

Your desire to protect and grow your wealth is wholly reasonable. But there is a sharp trade-off between protection and growth. Traditionally, relatively safe assets such as cash and bonds have been likely to offer negative real returns. So you have to decide what to do about this.

The main issue here is how to protect your wealth. LF Ruffer Absolute Return (GB00B0XP2X86) and LF Ruffer Total Return (GB00B80L7V87) aim to do this by holding cash, gold and index-linked bonds.

[Listen to our interview with Duncan MacInnes, investment director at Ruffer, at www.investorschronicle.co.uk]

But I’m not sure you need to incur active fund fees to do this, because you could do it yourself directly. And if you do, you could more easily tailor your portfolio to address the specific risks you are worried about.

What matters is your portfolio as a whole. There is no single asset that does well in all circumstances. But holding a bundle of them together may make their overall return resilient to most shocks.

Bonds, for example, do a good job of protecting against the fear of recession or against increases in investors’ risk aversion. Their prices would rise in such circumstances offsetting some of the losses on your shares. But they would lose money if investors become more optimistic about the world economy, although such losses would be offset by gains on equities. And, even worse, bonds and equities might fall together if interest rates rise or investors fear that interest rates will rise.

So I’m not sure you should hold many bonds, especially as you already have a substantial allocation to bond-like assets. You should think of your index-linked pensions as equivalent to a huge investment in index-linked bonds – one that allows you to take on more risk with the rest of your portfolio than you otherwise would.

A better form of portfolio protection could be cash, which you already hold. Its returns are low, but it has little downside risk. As inflation is unlikely to rise much, in a worst-case scenario real losses on cash would be lower than those on gilts or equities.

If you are worried about a recession, foreign currency exposure might be a good idea. Because sterling is a riskier asset than US dollars, euros or Swiss francs, it would probably fall in the event of a recession, giving you profits on safer foreign currencies. You already have some exposure to foreign currency via your French property. But this exposes you to liquidity and recession risk – property is hard to sell quickly and does badly in recessions.

Forget trying to optimise your portfolio – that’s impossible. Just hold a combination of cash, foreign currency, bonds and gold alongside your equity-focused investments, and set the allocation to each of these two areas in accordance with your risk appetite. 

I like that you have invested the growth part of your portfolio in tracker funds. However, no amount of diversification within equities can do much to reduce exposure to the US market. If US shares fall, they will drag down almost all stocks around the world. If you are worried about the US market being overpriced or heading towards recession, you should hold fewer equities in general rather than hope to escape a falling market by holding non-US-listed shares.

David Healy says:

Your goal of protecting and growing capital in real terms is a sensible strategy as you approach retirement and the age of 60, and in the current stage of the business cycle. The asset allocation of your investments excluding your properties is 41.6 per cent equities, 45.9 per cent alternatives, multi-asset and property funds, and 12.5 per cent cash. However, the LF Ruffer Absolute Return and LF Ruffer Total Return funds each have around 40 per cent of their assets in equities, so your allocation to this asset is higher.

Cash will be eroded by inflation over time and lose its purchasing power in real terms. So consider putting some of your cash into a low-risk short-duration fixed-income fund that aims to grow your money in real terms – as per your stated objective. Funds whose holdings overall have a high credit quality and low interest rate duration are a good option because the capital value of your investment in them is less susceptible to interest rate increases.

[See our tip on  AXA Sterling Credit Short Duration Bond Fund (GB00B5VL0B78) in the issue of 25 January]

Also consider such a fund, or a fund focused on investment-grade bonds, as a diversifier to the Ruffer funds. These have very similar underlying holdings, so you do not get much diversification by holding both. 

For additional diversification and more capital protection, iShares Physical Gold ETC (SGLN) gives exposure to an asset class that is generally inversely correlated to equities. This can perform well during times of market volatility such as in the last three months of 2018, when it made a return of 10 per cent at the same time as the FTSE 100 fell by more than 10 per cent.

Your index-tracking funds provide exposure to different indices and markets at a low cost. But these funds track the underlying indices, so will not beat their performance. Your overall asset allocation should protect and grow your capital in real terms over the longer term. But as your pension income will cover your day-to-day expenditure, you could add some active funds to have exposure to a more specialist approach and the possibility of beating equity indices.

For example, you could add Smith and Williamson Artificial Intelligence Fund (IE00BYPF3314) to complement Legal & General Global Technology Index (GB00B0CNH163), and perhaps a more specialist active emerging markets fund. We very much like technology at the moment and this forms a key part of the thematic elements of our portfolios.

Index-tracking passive funds are good for lowering overall portfolio costs and some of our clients hold them for this reason. But it is very important to use active funds in more complex areas such as emerging markets, technology and artificial intelligence, and infrastructure. We also use active funds where our clients want to take ethical and/or environmental, social and governance (ESG) approaches.

Adam Ross says:

You have a substantial portion of your assets in the LF Ruffer Absolute Return and LF Ruffer Total Return funds. Ideally, the most one fund should account for in your portfolio (excluding property) should be around 10 per cent so that you are not over concentrated in one manager. Consider reallocating a material portion of your investment in them.

I would suggest adding some fixed-income exposure, even though you don’t necessarily need the income. Fixed-income funds would provide diversification and a different type of return to your equity holdings, and are likely to be less volatile. Jupiter Strategic Bond (GB00BN8T5935) and MI TwentyFour Dynamic Bond (GB00B5VRV677) could provide some protection against rising interest rates and contain a good mix of international exposure.

Also think about increasing your exposure to alternative assets such as convertible bonds, absolute return funds, or funds that directly invest in commercial property. These would help to meet your return requirements, add diversification and hopefully smooth your returns over time.

Index trackers are an excellent way of getting core exposure to equity markets and are very cost-effective. However, they are not the only solution, so I would consider some active funds, which can offer attractive returns. This is particularly true with more niche areas of the market and smaller companies, where active managers have a good record of outperforming passive benchmarks.

For example, Polar Capital Global Technology Fund (IE00B42W4J83) has materially outperformed Legal & General Global Technology Index. Active technology funds can also take stakes in earlier-stage private companies, particularly in the tech space, which tend not to list until much later in their lifecycle due to the amount of private and venture capital funding they can get. Trackers do not offer any exposure to this part of the market so you are missing out on this potential source of return.

The UK's vote to leave the European Union has had a material effect on sterling, which is trading at historically very low levels against most major currencies. If Brexit goes smoothly, we expect sterling to strengthen materially. Around 20 per cent of your equity exposure and some of the Ruffer funds' exposure is to overseas currencies, so be aware of the possible effects. Consider the hedged share classes of passive funds as a possible replacement.