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Your goals require greater diversification

Our readers may be too focused on yield, and emerging markets
May 9, 2019, Colin Low and Andrew McMillan

Shimajo is 62 and his wife is 56, and their combined income is £150,000 a year. Their home is worth £900,000 and has an outstanding mortgage of £60,000 on it, which should be paid off in the next two years. They have two children who have amassed large student loans, which they plan to help pay off. They also want to help them with deposits to buy homes.

Reader Portfolio
Shimajo and his wife 62 and 56
Description

Sipps, Isas and trading accounts invested in funds and shares, defined benefit pension, cash, residential property

Objectives

Retire within five years and get an income of 3.5 per cent a year from investments, help children pay off student loans and buy homes, pass investments to children

Portfolio type
Investing for goals

“We hope to retire in three to five years and get an income of 3.5 per cent a year from our investment portfolio,” says Shimajo. “We would like to leave the capital to our children, although may run down the holdings outside tax-efficient wrappers and within individual savings accounts (Isas), if required.

"The investment portfolio is held roughly equally by my wife and myself. We have about £240,000 in a self-invested personal pension (Sipp), which we hope to increase to £350,000 before we retire. I also have a defined-benefit workplace pension worth £130,000, which I intend to transfer to my Sipp.

"Most of the rest is in Isas, alongside some holdings outside tax-efficient wrappers. We will both continue to use our annual Isa allowances and may also add to our Sipps before we retire.

"We have reduced the direct shareholdings and exposure to the UK over the past two years. We intend to have no more than 20 funds and no direct shareholdings.

"Over the past 12 months, we sold out of our holdings in Merian UK Dynamic Equity (IE00BLP59769), LF Miton UK Multi Cap Income (GB00B41NHD71), MI Chelverton UK Equity Income (GB00B1Y9J570) and HICL Infrastructure (HICL) because they have exposure to the UK. We sold Artemis Global Income (GB00B5ZX1M70) because we think it is too large, M&G Japan Smaller Companies (GB00B7FGLY29) because we weren't happy with the performance, and TR European Growth Trust (TRG) and Marlborough European Multi-Cap (GB00B90VHJ34) because we are afraid they will be negatively affected by Brexit.

"We used the proceeds of these sales to top up our holdings in Fidelity Global Dividend (GB00B7GJPN73), Guinness Asian Equity Income (IE00BDHSRD90), UBS Global Emerging Markets (GB00B7L34154), Morgan Stanley Global Brands (GB0032482498) and Utilico Emerging Markets Trust (UEM). This was to increase diversification and get income globally.

"We might add some Europe and UK funds when the uncertainty over Brexit clears, and a fund that includes exposure to gold miners such as BlackRock World Mining Trust (BRWM) for a little protection.

"Our portfolio is largely focused on active equity funds, so is higher-risk. But if it produces an income of 3.5 per cent a year and the capital value remains intact, I think we can live with it."

 

Shimajo and his wife's investment portfolio

HoldingValue (£)% of the portfolio
Fidelity Global Dividend (GB00B7GJPN73)103,0006.94
Guinness Asian Equity Income (IE00BDHSRD90)970006.53
UBS Global Emerging Markets (GB00B7L34154)75,0005.05
Lindsell Train Japanese Equity (IE00B7FGDC41)75,0005.05
CFP SDL UK Buffettology (GB00BF0LDZ31)65,0004.38
Aberdeen Standard Investments Global Smaller Companies (GB00BBX46522)54,0003.64
Edinburgh Worldwide Investment Trust (EWI)52,0003.5
Morgan Stanley Global Brands (GB0032482498) 50,0003.37
Pantheon International (PIN)45,0003.03
TB Evenlode Income (GB00BD0B7C49)39,0002.63
RWC Global Emerging Markets (LU1336213936) 36,0002.42
Royal Dutch Shell (RDSB)36,0002.42
Impax Environmental Markets (IEM)35,0002.36
Utilico Emerging Markets Trust (UEM)35,0002.36
Legg Mason IF Japan Equity (GB00B8JYLC77)34,0002.29
Worldwide Heathcare Trust (WWH)33,0002.22
BlackRock Throgmorton Trust (THRG)32,0002.15
Fidelity Asian Values (FAS)30,0002.02
Schroder AsiaPacific Fund (SDP)30,0002.02
Weir (WEIR)23,0001.55
Cohort (CHRT)20,0001.35
CME (CME:NSQ)19,0001.28
Wincanton (WIN)14,0000.94
Amino Technologies (AMO)6,0000.4
Walker Greenbank (WGB)3,0000.2
FireAngel Safety Technology (FA.)3,0000.2
TP ICAP (TCAP)12,0000.81
Flowtech Fluidpower (FLO)11,0000.74
Inland Homes (INL)9,0000.61
National Grid (NG.)9,0000.61
bigblu Broadband (BBB)8,0000.54
Character (CCT)8,0000.54
Telford Homes (TEF)8,0000.54
Centrica (CNA)7,0000.47
International Consoliated Airlines (IAG)6,0000.4
Shimajo's workplace pension130,0008.75
NS&I Premium Bonds8,0000.54
Cash225,00015.15
Total1,485,000 

 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE READERS' CIRCUMSTANCES.

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

This portfolio is pretty well diversified. You are combining large relatively defensive stocks, such as those held by Fidelity Global Dividend, with smaller stocks such as those in Edinburgh Worldwide Investment Trust (EWI). That seems sensible.

 

Edinburgh Worldwide Investment Trust top 10 holdings (%)
Ocado5.2
LendingTree4.8
MarketAxess3.7
Alnylam Pharmaceuticals3.6
Chegg3
Wayfair2.8
Novocure2.6
Yext2.5
Zillow2.3
Exact Sciences2.3
Source: Baillie Gifford as at 31 March 2019

 

Also sensible is making fullish use of your Isas and Sipps. And I think it is reasonable to shift from direct shareholdings into funds if you don’t have the time or appetite to do your own research.

But your portfolio is quite heavily weighted towards emerging markets, at the expense of UK and US exposure. This could pay off in the near term if China’s economy picks up, as some tentative signs are suggesting. But good returns come at a price: when emerging markets do badly, they do really badly. So you need to manage risk.

 

Colin Low, managing director of Kingsfleet Wealth, says:

Your combined income exceeds £150,000 a year, meaning there will be a reduction in one of your personal allowances if either one of your incomes exceeds £100,000. So can this income be equally split between the two of you?

The aggregate value of your property and investment funds indicates an inheritance tax (IHT) problem as the total combined assets exceed £1m. If you want to pass your capital on to your children after you both die, you could either reduce the IHT liability or try to mitigate it by taking out a whole-of-life policy payable on the second death, written in trust.

Consider using the Sipp as a means of passing assets to your children after you die. If you do this, the Isas could be used as your main source of income over and above pension funds, and doing this would also help to reduce the value of your assets that are liable to IHT. Trust-based pension arrangements such as Sipps are not assessed for inclusion within an estate for IHT purposes.

From an IHT perspective, there are far more efficient ways of investing that could still provide you with capital and/or income. Two such solutions are gift and loan trusts, or discounted gift trusts. These are not typically available to private investors, so you should seek professional financial advice on their suitability. They could provide a way to invest your assets and draw an income from them, while also being more efficient from an estate planning perspective.

 

Andrew McMillan, head of planning at Octopus Wealth, says:

The most important thing is to lock down your goals. You mention helping your two children with their student loans, as well as their house deposits. So think about exactly how much you’ll need, as it’ll alter how you should structure your assets and investments from a tax perspective.

You and your wife appear to be at least higher-rate taxpayers, but intend to make full use of your Isa allowances and then perhaps add more to your Sipps, until you retire. Do the opposite – claim 40 per cent tax relief by making pension contributions your priority and use the Isas for any surplus.

If you properly structure your assets to target your 3.5 per cent yield, the remainder could be drawn down at 20 per cent income tax, increasing your returns by 20 per cent before any investment growth. On top of that, 25 per cent of the pot can be taken tax-free and – crucially – pensions are outside your estate for IHT purposes, which will save your children a 40 per cent haircut when they receive it.

Think carefully before you transfer your defined-benefit pension into your Sipp. There are some obvious benefits, but the positives of a guaranteed income shouldn’t be understated.

Your estate is quite large. With strong investment growth, you may find that you begin to lose the residence nil-rate band. So again, having money in pensions will help, as will gifting some of your money to your children.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

I’d watch the discounts on emerging market investment trusts. When these become unusually small, relative to the trust’s own history, it is often a sign of excessively positive sentiment towards the asset class in general. That’s a cue to get out.

Also, watch the price of trusts and funds relative to their 10-month or 200-day moving average. When the price falls below this average, it can often be a signal to get out. Emerging markets tend to be driven by sentiment and momentum, so small falls can lead to big ones. Sticking to a moving average rule can get you out of momentum-driven bear markets. That can save you a lot.

So think carefully before investing in BlackRock World Mining Trust. It mostly invests in mining stocks, which tend to be highly correlated with emerging market shares. Holding it in your portfolio might add to the risks you are already bearing. A better alternative from the point of view of diversification might be a gold exchange traded commodity (ETC), which gives you exposure to the metal rather than mining stocks. But with low interest rates, the expected return on gold is low. Its value is as a diversifier – not a high returner.

Also, be careful that you are not duplicating holdings. One of Fidelity Global Dividend's largest holdings is Royal Dutch Shell (RDSB), which you also hold directly. And another two of its 10 largest holdings are Diageo (DGE) and Unilever (ULVR), which are among TB Evenlode Income's (GB00BD0B7C49) 10 largest holdings.

 

Fidelity Global Dividend top 10 holdings (%)
Deutsche Boerse3.9
Roche3.7
Royal Dutch Shell3.7
Wolters Kluwer3.7
Procter & Gamble3.7
U.S. Bancorp3.6
Taiwan Semiconductor Manufacturing3.2
Colgate-Palmolive3.2
Unilever3.2
Diageo3.1
Source: Fidelity as at 31 March 2019

 

TB Evenlode Income top 10 holdings (%)
Unilever8.8
Diageo7.2
RELX6
Sage5
Compass4.6
Reckitt Benckiser4.4
Smith & Nephew4.1
Smiths3.6
GlaxoSmithKline3.5
Pepsico2.8
Source: Evenlode Investment Management as at 31 March 2019

 

The problem isn’t you or these funds' managers. It’s that there are very few big dividend-paying stocks, so large UK equity income funds have a limited number of stocks to choose from. This means that they can hold the same ones as each other, so investors who hold several UK equity income funds are less well-diversified than they think.

And these types of equities carry the risk that investors might have wised up to their pricing. Historically, big defensive stocks have been underpriced because investors have been too confident in their belief that they’ve become 'ex-growth' and have underweighted the virtues of monopoly power. The good run in some such stocks, however, suggests that investors might have wised up to this error and corrected, or even overcorrected, it. This means big income stocks might be overpriced.

So should you really be so keen on getting income directly? What matters is total return. You can create your own dividends by realising capital gains.

You have some holdings that diversify away from big income stocks and these are worth maintaining.

 

Colin Low says:

Although your investments are diversified, there is very little in the way of lower volatility assets other than cash. So a gold fund could be a useful diversifier away from equities. Although gold funds typically have minimal yields, they are often a good store of value in volatile times. If markets become more volatile in the near future, it would be better to already have a gold fund rather than add one at the time.

 

Andrew McMillan says

You’ve got a significant amount of direct shareholdings outside Isas and Sipps. So you and your wife should consider using these or your cash to make use of any unused pension allowances, because even after your £2,000 dividend income allowances, a 3.5 per cent yield would mean an annual tax bill of £1,680 at present.

You’d be better off switching these investments into ones targeting capital growth, to make use of your capital gains tax allowances, which are currently £12,000 each. Once in retirement, you can sell these equities and reinvest the proceeds in your Isas.

While clearly you’re an experienced investor, drawing down on investments rather than just watching them grow changes mentalities. This is money that at that point you rely on, meaning that market downturns can be far more painful.

I’d argue that your goals require greater diversification. You can achieve this yourself by adding funds from specific sectors, or there are a variety of multi-asset funds that contain a good spread of the key asset classes.

Take a look at the MSCI WMA Private Investor Index Series. These indices provide a range of model asset allocations for varying goals. For example, for an investor targeting income they suggest a split of 52.5 per cent equity, 25 per cent bonds, 5 per cent cash, 5 per cent real estate and 12.5 per cent alternatives. Although I don’t agree with everything in that spread, you can see it’s some way removed from how you’re invested.

 

MSCI WMA Private Investor Income Index asset allocation (%)
International equities25
UK equities27.5
Government bonds5
Corporate bonds17.5
Inflation-linked bonds2.5
Cash5
Real estate5
Alternatives12.5
Source: MSCI

 

Although I’m a big fan of your desire to think more globally, I’d challenge your focus on yield. You may find you get overexposed to sectors such as cyclicals or unloved recovery stocks, areas that can expect greater volatility in market downturns.

Instead, focus on total return. You’re in the fortunate position of having the majority of your assets in Sipps and Isas. That means you aren’t paying tax inside either of these wrappers, so there’s no downside to picking good stocks [that are not necessarily high yielders] and selling some of them each year. By not restricting yourself, you could have less volatility and probably a better experience, meaning higher returns and a better retirement.