Is now the time to add emerging market funds?

"From the time I am age 55 I want my assets to generate a net income equivalent to £25,000 a year today,” says Sarah. “I do not have much in the way of pensions – just over £21,000 spread across three different providers. I have started paying £200 a month into a pension with my current employer, who adds a further £400 a month. But as this is a temporary contract I cannot rely on this building into anything substantial.

"I have always saved money and started investing in property 10 years ago. When I had a windfall four years ago I got a wealth manager to set up a portfolio of investments, but have since taken over their management myself. I am gradually transferring investments from trading accounts into my stocks-and-shares individual savings account (Isa).

"I try to invest for the long term without interfering too much, although I check the portfolio and markets every week. I sometimes make small investments in things that have been recommended and that I like the look of, but which I think are potentially risky. I don't like to lose any money, but understand that markets go up and down so would say that I have a medium attitude to risk. I like to have the majority of my money in what I consider to be safer investments, but am happy to take a risk with a small proportion of my wealth. 

"I am considering what to invest this year’s Isa allowance in. I'm not sure whether to top up my existing holdings, transfer some of the unwrapped holdings into the Isa, or sell some of the underperforming investments and buy something else.

"I am considering reducing my holdings in Invesco Income (GB00BJ04HX60) and Invesco High Income (GB00BJ04HQ93), and totally divesting of Perpetual Income and Growth Investment Trust (PLI) as these have been the worst performing holdings in my portfolio. I would reinvest the proceeds in a low-cost tracker fund as I do not like to pay higher charges, although I can see that some funds are worth higher fees because of the returns they make. I have recently invested £8,000 in Lindsell Train Global Equity (IE00BJSPMJ28), which I am impressed with, and may add to this. I may also add to Merian UK Smaller Companies (GB00B1XG9599).

"I am concerned that I have duplication of holdings across some of the funds I hold. I am also wondering whether I need to change the balance of the portfolio – I would like to add some emerging market funds, but I am not sure if it is the right time to do this due to global political issues.

Sarah's investment portfolio

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

THE BIG PICTURE

Rosie Bullard, portfolio manager at James Hambro & Partners, says:

You are on course to meet your objectives and have a sensible strategy. You have the ability to take risk, given the size of your asset base, time horizon and future expected expenditure. But although you say that you have a medium attitude to risk and classify your portfolio as balanced, you also say that you do not like to lose any money. Does 'losing money' mean over, say, a five-year period, leaving scope for fluctuations in the value of your capital within that period? Or do you not want to see any loss ever? To achieve the latter, you would have to only hold cash but you would lose money in real terms, unless the UK faces Japan-style deflation.

You are right to use as much of your Isa allowance as possible each year because of this wrapper's tax efficiency. We suggest keeping your Isa fully invested as there is limited benefit in holding lots of cash in one, unless for short-term trading.

You have a number of bond funds in your Isa. We are not keen on bonds at present, but where we do hold them we prefer to do so outside Isas. We hold assets in Isas that we think are going to generate the highest total return over time, such as equity investments.

You are right to question performance and fees, and sensible in also seeing the value active specialist funds can bring to a portfolio. Performance and fees are not the only criteria by which to judge funds. We consider factors such as the stability of the company that runs them, the experience of their managers, changes in the managers' style over time, known as style drift, and the size of the funds and ability to be nimble.

Michael Melrose, financial consultant at Alan Steel Asset Management, says:

Building an asset base of investments within tax-efficient wrappers such as Isas and pensions should be your starting point. This will help reduce your tax burden and reduce the level of return the investments need to make to produce a sustainable income.

Increasing the tax efficiency of your portfolio should ultimately help you achieve your retirement income requirements. Consider selling some of your investments outside the Isa and offsetting any gains against your annual capital gains tax (CGT) allowance, which is currently £12,000. Then reinvest the proceeds in a pension as you will be likely to get tax relief on the contributions and the money will be within a tax-efficient wrapper.

Continue to use your annual Isa allowance as these wrappers are also very tax efficient. Your annual contribution can be funded by selling unwrapped investments and offsetting any gains against your annual CGT allowance.

As the vast majority of your investment portfolio is held outside Isas and pensions, so subject to tax on dividends over and above your annual £2,000 allowance, I would aim to hold higher-yielding funds within the Isa where they are not subject to dividend tax. Hold any low or non-yielding funds that target capital appreciation outside the Isa and pensions. This will hopefully help limit the dividend income you receive outside these wrappers to below the annual £2,000 allowance.

HOW TO IMPROVE THE PORTFOLIO

Rosie Bullard says:

We would be wary of holding the Invesco Income and Invesco High Income funds, and Perpetual Income and Growth Investment Trust in the same portfolio because they are all managed by Mark Barnett, meaning that you have a lot of exposure to one management style. His funds' holdings may overlap with Neil Woodford’s positions given their historic Invesco connection, and Mr Woodford is now a forced seller of many positions.

You mention new opportunities and highlight UK and emerging markets. But although certain areas of the UK equity market look cheap, this is for a reason and we see limited short-term catalysts to make these stocks perform. When looking overseas, we would suggest considering regional or thematic funds rather than global strategies. 

You may question the timing of new purchases in overseas equities, given sterling’s current weakness, but if you identify an excellent long-term investment, put money into it. Don’t try second guessing politics and short-term currency moves.

Chris Dillow, Investors Chronicle's economist, says:

You are right to worry that some of your funds duplicate each other. BP (BP.) and Royal Dutch Shell (RDSB) are among the 10 largest holdings of Temple Bar Investment Trust (TMPL), Schroder UK Opportunities (GB0007218398), City of London Investment Trust (CTY), M&G UK Income Distribution (GB00B70D5799) and Invesco High Income. And many of these have one or more of GlaxoSmithKline (GSK), HSBC (HSBA) and British American Tobacco (BATS) in their 10 largest holdings.

There’s a simple explanation for this. Large funds looking for decent dividends from UK stocks only have a few investments to choose from, so many of these crowd into the same ones.

But it means that you are heavily weighted towards big UK dividend payers. The solution to this is to trim your holdings. Another reason to try to reduce your number of holdings is that you are incurring the fees of many active funds – despite your assertion that you do not like to pay higher charges.

The duplications may arise from a widespread error – the failure to take a top-down view of your investments. If you just look for what seem like good funds investing becomes a supermarket sweep – a dash around the aisles filling your basket with everything that seems like a good investment.

Rather, you should first consider what proportion of risky and safe assets you want, and then, taking into consideration what sort of equity holdings fit this, consider what segments of the market you need. Big UK dividend payers such as BP and Royal Dutch Shell might be a part of this, but not perhaps as big a one as they currently are.

I agree with your reservations about emerging markets. These tend to be driven by sentiment and momentum, which are currently going against them. As I write, MSCI Emerging Markets index is below its 10-month average and in the past this has been a warning to get out. You also already have exposure to emerging markets via funds such as BNY Mellon Asian Income (GB00B8KPW262), and commodity focused investments such as BHP (BHP) and CQS Natural Resources Growth and Income (CYN). Historically, commodity stocks have tended to rise and fall with emerging markets. So I would not load up any more with emerging markets exposure for the time being.

Lindsell Train Global Equity (IE00BJSPMJ28) has a good track record due to having a clear strategy. It invests in stocks with what renowned US investor Warren Buffett calls economic moats: companies with sources of monopoly power. Some of its largest holdings, such as Unilever (ULVR), Diageo (DGE) and Walt Disney (DIS:NYQ), have massive brand power. Such stocks have historically been underpriced, hence the fund’s good performance.

But there is a danger that investors might have wised up to this underpricing and piled into them, causing them to become overpriced. If this has happened or is about to happen, the fund’s good performance could go into reverse. "Wising up risk" is a danger funds with a good performance record face.

Your portfolio includes good quality bond funds. These make sense if you want to protect yourself from falls in share prices caused by fears of recession or increased risk aversion. Such protection, however, comes at the price of negative real returns in average times, and worse losses if or when the world economy strengthens. So cash might be a better way of protecting yourself from losses than bonds.

Michael Melrose says:

Some of your holdings, such as M&G Global Dividend (GB00B39R2R32), are excellent funds with excellent managers. However, 30-plus holdings is far too many. Some of the positions are too small to really make much difference to your overall return. So it would be more effective to have a more concentrated portfolio of perhaps 10 funds that provide a risk appropriate blend of assets with a low correlation to each other. 

Due to your comments on risk you should consider adding some more cautious funds, for example Troy Trojan (GB00BZ6CNS31) run by Sebastian Lyon who combines US government bonds, gold and large-cap growth companies with sustainable revenues. Because of where we are in the economic cycle and increasing market risks, with potential liquidity and political challenges on the horizon, reconsider adding to Merian UK Smaller Companies and look at alternative options.

But if you are keen to add more growth generators I would suggest a fund with a global mandate such as Rathbone Global Opportunities (GB00BH0P2M97). It has an excellent track record and its global mandate allows its manager, James Thomson, to invest in areas of the world he thinks will offer the best investment returns.