Join our community of smart investors

Diversify your holdings with exposure to different investment styles

These readers should have exposure to more than just large-cap growth stocks
October 29, 2020 and Ben Yearsley
  • Readers want investments to generate £50,000 a year
  • Could be taken as a mixture of income and capital gains 
  • Need to diversify their investments by investment style 
Reader Portfolio
Mike 48
Description

Isa, trading account and pension invested in funds, cash, residential property. 

Objectives

After tax income of of 7 per cent or more – at least £50,000 a year – from investments, prevent investments' value from falling more than 10 per cent a year.

Portfolio type
Investing for income

Mike is 48 and has recently left his job. His wife doesn't work and their child has just started university. Their home is worth about £900,000 and is mortgage-free.

“I plan to do some part-time, project and voluntary work, only some of which I will be paid for," says Mike. "I have a defined benefit pension that will pay me £17,000 per year from age 65 or less if I start to draw it earlier. I also have a personal pension worth £350,000 with the same investment allocation as my individual savings account (Isa) and general investment account (set out below).

"But until I start drawing from my pensions our other investments will be our only source of income. So I would like the non-pension investments to generate enough income for me not to have to work just for the money. We would like to have a 'passive income' so we can get involved in some interesting projects and learn new skills.

"I estimate that our annual income requirement is around £50,000. A 7 per cent annual return from the investments that we can currently access, which are worth £850,000, should provide that after tax. A return greater than 7 per cent a year would be nice but I am more concerned with mitigating downside risk.

"I have also £100,000 in cash to cover two years of living expenses so that I do not need to draw from our investments during periods of poor performance.

"We hold as much of our non pension investments as possible within Isas.

"I have been investing for 25 years and would say that my risk tolerance is conservative when it comes to income, although I am less concerned about the investments’ capital value. As long as they generate an income of 7 per cent a year I do not mind if their value fluctuates. That said, I would not wish for my investments’ value to fall by more than 10 per cent in poor market conditions and would be willing to sacrifice some upside potential to prevent that from happening.

"I don’t think that our investments can generate an annual income of 7 per cent or more without taking undue risk, so I also plan to crystallise some of our capital gains on a quarterly basis. I will put any gains in excess of our required income in a cash reserve. And if the investments’ value falls I will use this excess cash to top them up once a quarter. I may also put excess cash into momentum trades, takeovers and stock tips I like the look of.

"I prefer funds to direct share holdings as I would stress more over the latter. I recently bought AA (AA.) but sold it two days later for a 10 per cent gain. 

"To provide the growth we require, roughly 75 per cent of our investments are in funds with a proven track record – especially in down markets. I hold the remaining 25 per cent in funds with low equity market correlations. For example, I have recently added BH Macro (BHMG), whose returns have shown a negative correlation to our holdings in equity funds and which has a good record of delivering positive annual total returns.

I also hold some renewable energy infrastructure investment trusts that provide reasonable dividends. They also have a good record of making positive total returns, and low or negative correlations with my growth funds.

But I don’t like bonds at current levels.

"Based on history, I would expect this portfolio to provide an average annual return of around 10 per cent, and up to 15 per cent in a good year. It could also fall 10 per cent in a rather bad year and do even worse in a catastrophic one.

"My heart says buy value funds but my head looks at their performance overall and – more importantly – in bear markets. I am having trouble finding value funds that have not performed poorly in such conditions. The growth funds I hold have made good returns in poor markets."

 

Mike and his wife's portfolio
HoldingValue (£)% of the portfolio
Fundsmith Equity (GB00B41YBW71)        160,00012.31
Lindsell Train Global Equity (IE00BJSPMJ28)        160,00012.31
LF Blue Whale Growth (GB00BD6PG563)        160,00012.31
LF Miton European Opportunities (GB00BZ2K2M84)          95,0007.31
Lindsell Train Japanese Equity (IE00B7FGDC41)          65,0005.00
BH Macro (BHMG)        142,00010.92
Renewables Infrastructure Group (TRIG)          34,0002.62
Greencoat UK Wind (UKW)          17,0001.31
Bluefield Solar Income Fund (BSIF)          17,0001.31
Personal pension        350,00026.92
Cash100,0007.69
Total     1,300,000 

 

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

 

INCOME STRATEGY

Rachel Winter, associate investment director at Killik & Co, says:

I completely agree with taking money you need from capital as well as income, rather than just relying on dividends. This combined approach will lead to you having a much more diversified portfolio. However, a return of 7 per cent a year plus inflation is ambitious. Although your investment allocation could have returned 10 per cent a year over the past decade, this time period has been particularly strong for global markets. Falling interest rates, quantitative easing, and the rapid expansion of the technology sector all played their part, and it’s unlikely that the next decade will yield the same level of return. Multi-decade studies suggest that long-term equity returns are closer to 5 per cent plus inflation.

 

Ben Yearsley, director at Shore Financial Planning, says:

You are in a great position. You don't have a mortgage, and have money in the bank and two different types of pension. However, you want to basically retire now and live off your capital – which is where the problem begins.

For most people £850,000 would be a big pot of money to live off. But you want it to generate £50,000 a year after tax. You are right in thinking that you can’t generate this from income alone. This would require a pre-tax yield of around 6 per cent if all the investments you were drawing from were held within an Isa, and maybe up to 9 per cent if they were not, depending on your tax position.

Very few investments, except high-risk bombed-out ones are paying close to this. To put this into context, the FTSE All-Share index's yield is somewhere in the region of 3 per cent. So to achieve that annual return you intend to strip income from capital.

This is a pretty tax-efficient way to draw income. For investments held outside Isas, you have an annual capital gains tax allowance, which for the 2020/2021 tax year is £12,300 per person. And any gains over this amount are taxed at 20 per cent if you are a higher-rate taxpayer or 10 per cent if you are a basic-rate taxpayer. These rates are far lower than the equivalent ones for income or dividend tax.

So stripping capital is a pretty efficient way of generating an income. But whether it is a good idea depends on your time scale, tolerance for risk, desired level of  income, and whether you want any money left over after you stop drawing from it.

You understand risk, but have you considered other factors such as the impact of inflation and need to grow the pot to provide a higher level of income in the future?

To generate 6 per cent after tax and investment charges, each fund you hold would have to deliver around 10 per cent gross every year. Fund and platform charges will eat up, say 1.25 per cent to 1.5 per cent, and you will have to pay some tax.

But gross returns of 10 per cent a year are very unlikely in my view. So lower your expectations of what you will take as the returns you need just seem too high. If you have a couple of stagnant years and still draw the same amount from your pot of money, the required gross return would need to be greater – maybe 12 or 15 per cent – as your pot would be smaller. And if the down years come around the time you start drawing from the money, it’s even worse.

That said, you have thought of this and have two years' expenditure in cash. Maybe you should draw on some of this first, and only realise gains up to the value of your annual allowance for the next few years to build a buffer and achieve some growth.Your investments need to grow because £50,000 today does not have the same value as £50,000 in a decade. But when you start to receive your workplace pension at age 65 this will help to meet your annual income requirements.

 

HOW TO IMPROVE THE PORTFOLIO

Rachel Winter says:

Diversification is a great way to manage risk, and funds are an effective way of achieving diversification without having to monitor a portfolio of direct equity holdings. A portfolio can be diversified in many different ways, for example, by sector, asset class, and geography. And when investing in funds you could also diversify by investment style.

Most of your funds focus on large-cap global growth companies so some market sectors, such as mining, do not feature in your portfolio at all. Although shares in mining companies have historically been volatile, large mining companies have spent the past few years strengthening their balance sheets by selling off non-core assets and many of them now offer attractive, well-covered dividends. The International Monetary Fund (IMF) has also recently encouraged governments around the world to boost their economies by taking advantage of record-low interest rates and borrowing money to spend on infrastructure projects. If this happens it would be good news for the mining sector.

The non-equity proportion of your investments is heavily exposed to renewables infrastructure. Although the income from these types of investment trusts is attractive, their current value is based on assumptions of the future power price. Historically it has been assumed that power prices will rise, but more recent trends suggest they could fall due to rapid advances in the development of new renewable power generation facilities. So even though renewable infrastructure funds are largely locked into long-term contracts, a fall in the power price could still harm their valuations. Therefore rather than holding three of these types of funds, consider a real estate investment trust (Reit) that invests in logistics warehouses as these are benefiting from the growth in online retail and also paying attractive levels of income.

 

Ben Yearsley says:

This just doesn’t look like a portfolio of investments. What’s the point in having six funds accounting for 92 per cent of your investments [minus the cash], and the other three of them only accounting for very small proportions?

You have put nearly 60 per cent of your investments [minus the cash] into  three excellent funds – Fundsmith Equity (GB00B41YBW71), Lindsell Train Global Equity (IE00BJSPMJ28) and LF Blue Whale Growth (GB00BD6PG563). But they are managed in a very similar manner to each other. It seems to me that you may have been overly influenced by the past performance tables when deciding what to add to your portfolio.

I have no issue with any of the funds you hold – I hold some of them in my own portfolio. But where is the diversity of style? If you are wrong about growth style investing and value style investing makes a resurgence, you will be left high and dry. So diversify the holdings into more styles.

Where are the funds that invest via a value style such as AVI Global Trust (AGT) or Schroder Global Recovery (GB00BYRJXP30)? Where is the exposure to long-term growth in Asia via such funds as FSSA Asia Focus (GB00BWNGXJ86) and Matthews China Small Companies (LU2075925870)? Or even some something managed a bit differently, such as Monks Investment Trust (MNKS) or Personal Assets Trust (PNL).