Should our focus remain on funds rather than direct equities?

“We would like to retire on an income of about £30,000 each per year,” says Jeff. “So we would like our investments to make a total return of 5 per cent a year for the next 20 years. We would also like to help our children buy homes in about 25 years’ time.

"We have workplace stakeholder pensions worth about £500,000 and £250,000, invested in passive global equity and bond funds. We have invested as much as we have been able to in our pensions, and are mindful of the lifetime allowance, which we really don’t want to exceed.

"We have been investing for 15 years, and fully use our own and our childrens’ annual individual savings account (Isa) allowances. We are investing for the long term, so would be prepared to lose up to 30 per cent of the value of our investments in any given year. We also aim to use our capital gains tax allowances each year. 

"We try to hold about a quarter of our investments in low-cost exchange traded funds (ETFs) and tracker funds, and invest the rest in active funds with ongoing charges of under 1 per cent. We choose funds with good ratings and records and, for example, have recently invested in Baillie Gifford Emerging Markets Growth (GB0006020647), LF Miton European Opportunities (GB00BZ2K2M84) and BlackRock World Mining Trust (BRWM).

"Although we want our investments to be well diversified, we minimise the number of active funds we hold to avoid significant overlap of underlying holdings. But we find it hard to strike a balance between being diversified and not duplicating underlying holdings as several of our active and passive funds hold some of the same companies, such as Amazon (US:AMZN), Microsoft (US:MSFT), Alibaba (US:BABA) and Tencent (700:HKG).

"We also try to have about a quarter of our investments in smaller and medium-sized companies, and 15 per cent in in bonds, property and gold. We try to spread our investments geographically and hold a few specialist sector investments. We have also invested in venture capital trusts (VCTs) for tax reasons. 

"We have bought and sold small stakes in direct equity holdings, but do not consider that we have the expertise to pick the right ones, hence our preference for funds. We would still like to invest directly in shares, but have not found a reliable strategy via which to do so."

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:

It’s good that you're making use of tax allowances such as Isas. But I'm not sure about buying VCTs for their tax breaks. Imagine you had two assets with identical risk and expected return, and the government imposed a tax on one but not the other. The price of the taxed asset would be likely to fall and the one of the untaxed asset rise, as investors sold one to buy the other. After the prices had changed, the pre-tax expected return on the taxed asset would be higher because its price is lower. And the pre-tax expected return on the untaxed asset would be lower. But after-tax returns should be the same.

So you get what you pay for. You should in theory pay for a tax break with lower pre-tax returns.

But there is a case for holding VCTs and private equity. What growth we get in coming years might come from unquoted companies – young companies that will undergo the best of their expansion before being listed on public markets. And VCTs can give exposure to such growth.

But you should hold several such funds because returns vary a lot across different managers. This is because returns on unquoted companies are massively skewed – there are many failures and one or two great successes. One or two good or bad decisions can generate big differences in the returns of one fund compared with another.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

It's good that you're trying to minimise the amount you pay for funds. But over the long term even small extra charges compound horribly. For example, a fee that is 0.5 per cent more per year over what an ETF charges could easily mount up to a cost of well over £20,000 on a £100,000 investment over 20 years. So be very selective about which funds you buy.

Longer-term investors need to diversify their equity exposure internationally as returns across markets can vary a lot over that kind of time frame. And you are right to regard gold and bonds as diversifiers against equity risk. However, these are unlikely to deliver such good returns in future.

But I’m not sure that property is a great diversifier. Like equities, it does badly in recessions and over the next 20 years we can expect another two or three of these. In such circumstances property also becomes illiquid. If you are genuine long-term investors, however, these defects should in theory become advantages as the sector should offer decent returns as compensation for such risks.

You find it difficult to be well diversified and not hold funds that have some of the same holdings as each other. One reason for this is that a few big global stocks have done extraordinarily well in recent years, such as PayPal (US:PYPL), Amazon, Tencent and Tesla (US:TSLA). Funds that held these have a good track record and ones that didn't don't. So recent best performing funds tend to have similar holdings to each other.

Also, large funds that don't want to overdiversify and become closet trackers can only invest in big stocks. For example, a fund with assets under management worth £2bn and 40 holdings will have, on average, £50m in each holding. And you can only invest those sorts of amounts of money in large stocks. As there are few attractive large stocks, this causes funds to cluster into the same ones.

There is now a risk that investors are overpaying for past winners and companies with monopoly power. But you are doing pretty much the only thing one can do about this – diversifying into smaller companies and private equity.

Nick Astley, investment manager at Progeny, says:

The issue of investment holdings overlapping with each other is topical. The phenomenal growth of US tech companies means that you can hold different funds in a portfolio, but the US and global ones are likely to have considerable holdings in stocks such as Apple (US:AAPL), Amazon, Microsoft, Alphabet (US:GOOGL) and Facebook (US:FB). These five stocks alone make up around 12 per cent of stock markets globally, according to financial website Forbes. And the value of US tech stocks' market caps, in aggregate, eclipsed that of the entire European equity market, including the UK and Switzerland, as of 28 August.

Using both passive and active investments is a sensible approach. You could also invest in specific regions via passive funds. You could decide on which ones by looking at the probability of outperforming individual markets, and using passive funds where that probability is less likely. Identifying the probability of alpha generation in different regions could also be a better way of deciding what proportion of your investments to allocate to passive funds than a set 25 per cent allocation. After all, why pay higher fees if there is a greater likelihood of better performance at a lower cost via a passive fund?

An example of an area where passive funds tend to do better is the US, an efficient market where only a small number of active managers have outperformed the overall stock market. As you want sufficient diversification and to minimise duplication of underlying holdings, consider steering away from active funds that may be largely overweight in US tech. Instead, invest in a passive fund that tracks the entire US market, including smaller and medium-sized companies. Passive US funds can cost as little as 0.05 per cent and there are ones that track this market really well.

Doing this could help you reduce the overall amount of fees you pay and bring down your investments' average level of ongoing charge.

It could also enable you to hold some active funds that have an ongoing charge slightly above your 1 per cent limit [while overall still paying less in fund fees]. In the UK, for example, there is a greater likelihood of being able to outperform the market. So we invest our clients' money in this area via active funds, which may have an ongoing charge of more than 1 per cent, but have solid track records and investment approaches, generate significant outperformance over the UK stock market over a fixed period, and dilute their higher costs. If you take a similar holistic approach you could potentially improve the structure of your portfolio.

You could also invest in the UK by investing directly in equities as these do not have a management charge. You should try to identify quality companies that compound their growth annually, and achieve both diversification and compound growth.

This year has shown that diversification is key. If you had put all your eggs in one basket this could have been very costly. A portfolio construction approach that involves worldwide exposure can help to reduce country-specific risk.