Diversify beyond bonds to meet your return target

"We have a financial adviser who has dealt with the complexities of our NHS pensions and the sale of a commercial property,” says Mike. “We manage our investments, and would like them to make enough of a return to finance some luxuries while we are still fit enough to enjoy them – so maybe 5 per cent a year. We would also like to preserve enough of their capital value to cover care costs, if one of us requires that in future. 

"We reinvest dividends and do not take income from the portfolio. I would say that we are fairly cautious investors but, given our circumstances, could probably afford to take a little more risk.

"There are, in effect, some duplications across our investments because we treat our two individual savings accounts (Isas) as one portfolio. We have two accounts so that we can both make use of our annual Isa allowances."

"We have also made provision in our wills to give 10 per cent of our assets to charity, to save our beneficiaries some inheritance tax."

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

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

Your Isas have a heavy weighting to bond funds, but this asset offers low expected returns. Adjusted for expected inflation, yields on developed market government bonds are negative. This means that investors in them will lose money unless the market is surprised by developments such as weaker than expected economic activity, a further reduction in investors’ appetite for risk or an intensification of the global savings glut. Such surprises are possible, but we shouldn’t assume that they will happen as our central scenario. A likelier possibility is real losses.

Many of your funds charge an annual fee of more than 0.6 per cent and, in some cases, more than 1 per cent. Such fees compound horribly over time, so if you do invest in bond funds, consider passive exchange traded funds (ETFs), which have lower charges. Always consider whether you can get exposure to a given asset more cheaply. Because very often you can by investing in it via passive ETFs rather than actively managed funds.

Bond funds can also be risky. If you hold a bond directly you get a payout on the maturity date, although this might be eroded by inflation and corporate bonds carry some credit risk. But with bond funds you do not have the prospect of a payout on a given maturity date. However, your investment in them might make losses if bond yields rise, which would happen if the global recovery proves stronger than expected and/or investors rediscover their taste for riskier assets.

However, bond funds offer insurance against equity bear markets. This is because a recession, fear of a recession or increased aversion to risk would mean that bond funds do well, offsetting some of the losses of equities.

But you are taking out lots of insurance against a risk that you do not have much exposure to. Your equity holdings are smaller than those of many investors and many of them are in funds that invest in relatively defensive stocks.

Your exposure to bonds, in effect, is much greater than what you hold in your Isas. Your NHS pensions are, for all practical purposes, a bond. They pay a regular secure income just like the best bonds.

And a key principle of investing is that what matters is your portfolio as a whole, which includes all your assets, such as pensions, work income, business interests and home. If you owned a business, in particular one that was greatly exposed to recession risk, a large allocation to bonds would be wise insurance. But if your other assets are safe, as is the case with an NHS pension, they are not so necessary. So you could afford to take more risk.

But just because you can afford to do something doesn’t mean that you should. Instead, consider how much risk you are willing to take. As a very rough rule of thumb, a global equities portfolio should return 5 per cent a year, with a one-in-six chance of an annual loss of more than 10 per cent. If such a prospect seems too risky, add either bonds or cash.

Rob Burgeman, divisional director, investment management at Brewin Dolphin, says:

You have not provided details of your spending and how it relates to your income, but from the information given appear to have a good level of pension income. You also have a reasonable level of cash reserves so can take a longer-term view on your Isa investments, only drawing from them for additional expenses rather than essential spending.

Most people’s retirements break down into two stages. There is an active period just after you retire when you are hopefully healthy and wealthy enough to do the things that you promised yourself you would do, such as travel. This stage is characterised by spending on such non-essential costs. The second stage is passive retirement when you do not want to do so so much, and the focus is on paying for greater support in your own home or somewhere more sheltered.

Your two Isas, roughly, have a 40 per cent allocation to bonds and other fixed interest, and 60 per cent to equities. This type of allocation could experience a degree of volatility as would have been the case in March and April this year. But it appears to be relatively cautious for you in view of your wider financial position and age. You might have a 30-year time horizon for the portfolio, so have the time frame and the capacity for loss. A range of funds and avoidance of false diversification – buying different versions of the same fund – should help ensure the longevity of your Isa investments.

Over 30 years you are likely to see at least one market crash – if not more. Over the past 20 years, for example, the technology bubble has burst, and the global financial crisis and Covid-19 have happened. To get greater returns than cash you have to accept this volatility. But over a decent time frame a broadly diversified portfolio has a better chance of delivering the returns you seek.

Anna Murdock, head of wealth planning at JM Finn, says:

Consider what type of care in later life you might require. For example, would you prefer care to be provided in your own home or a care home? Knowing this allows you to estimate the cost of this. You can then assess your existing assets and income to determine how best you can meet this objective. For example, there are financial products available, such as care annuities, that may or may not be appropriate.

Continuing to use your full annual Isa allowances and reinvesting dividends when you do not need the income each year will serve you well in the long term, as you will benefit from compounding. This is particularly the case within the tax-free Isas. Also consider investing any additional spare money you have above your annual Isa allowances, as you each have an annual capital gains tax allowance of £12,300 and dividend allowance of £2,000. These allowances can make quite a difference to your returns.

Also ensure that you retain sufficient funds in cash – at least three to six months' income – as your investments should be a last port of call for emergency funds. Leaving them allows them to make the most of their growth potential.

Viewing your two Isas as one pot is a good strategy because a spouse can inherit a deceased spouse’s Isa with all the tax efficiencies.

Make sure that you have powers of attorney (POAs) in place so that one of you, or another trusted individual, can continue to manage the Isas if either of you were to lose capacity.

HOW TO IMPROVE THE PORTFOLIO

Rob Burgeman says:

In the current ultra-low interest rate environment, the return on bonds has fallen to historically low levels. There is little – if any – scope for capital appreciation and income from this asset. And a lot of your equity exposure is via income or distribution funds. But, for example, between 15 July 2015 and 14 July 2020, the Jupiter Distribution (GB00B52HN049), BNY Mellon Real Return (GB00B8GG4B61) and Kames Diversified Monthly Income (GB00BJFLQY60) funds have delivered annualised returns of 2.8 per cent, 3.31 per cent and 4.2 per cent, respectively, according to Bloomberg data. Even if you look at the five-year period to 1 January 2020, which excludes this year’s market volatility, only Kames Diversified Monthly Income met your return goal of 5 per cent a year.

The latest market setback has been particularly harsh for income-orientated investors and those who prefer to take a lower-risk, value-based approach to investing. Value companies have had the longest period of underperformance versus growth companies on record. This is partly a reflection of the market strength of a number of companies that are changing the way we live. But it is also a function of the real weakness in the shares of companies whose traditional business models have been undermined by these growth companies. The pace of change has left many companies such as media agencies, oil companies, retailers and fund managers gasping for breath.

The equity funds you hold are relatively underweight the US and Asia, and relatively overweight Europe. Many of the strong growth companies changing the way we live are listed in the US, although not necessarily US-focused. Visa (US:V), for example, is a global company whose fortunes are not tied to the performance of the US economy. 

Your target return of 5 per cent a year is not overly aggressive. But in a low interest rate world where risk-free returns have all gravitated to zero, achieving it is likely to require you to take more risk than you have so far. This would mean having less exposure to cautious managed or distribution funds.

So I would suggest spreading your equity investments better in terms of style and geography, to boost the return potential of your Isas.

You could hold low-cost ETFs such as HSBC MSCI World UCITS ETF (HMWO) or iShares Core S&P 500 UCITS ETF (CSP1), which you already have, and Invesco EQQQ NASDAQ-100 UCITS ETF (EQQQ). Alongside these you could have more adventurous funds such as Baillie Gifford American (GB0006061963) and more steady funds such as SPDR S&P US Dividend Aristocrats UCITS ETF (USDV) to give you broader exposure to the US market.

I would also suggest investing in Asia via a mixture of passive and active funds. This region has weathered the Covid-19 pandemic pretty well. For example, Japanese companies generally have rock-solid balance sheets and would help to further diversify your portfolio.

Infrastructure and property funds can also provide greater diversification.

Freddy Colquhoun, investment director at JM Finn, says: 

Investing in funds can be a sensible approach when trying to construct a diversified portfolio, but their charges can often be detrimental to long-term returns. So consider incorporating some direct equity holdings.

Also consider selling some of your smaller holdings.

In light of the current market environment and reduction in dividend payments, it may be worth investing on a total return basis rather than just for income, so relying less on income funds. This would involve replacing some of them with growth stocks. To supplement your dividend income, you could sell some of your holdings in these when they grow.

Infrastructure funds could help maintain your level of investment income and increase diversification, something we have been using to complement the usual income generators for years.