Effective Investing

by Mark Dampier

  Fast forward and it is hard to see how, apart from very short-dated issues, government debt could do as good a job today if we were to have another big stock market setback. Cash probably remains the best general portfolio diversifier in today’s markets, although interest rates are very low. It is also possible to have some diversification within each broad sector. For example, you can see from the table that UK gilts have a very low correlation with another type of fixed interest security, so-called high-yield bonds. The latter are bonds issued by companies (or countries) with relatively poor credit ratings. As such they pay a much higher rate of interest, but being much riskier than high-quality government debt behave more like equities when share prices move up and down. As a result they offer much less diversification value in a portfolio with high equity weightings, but can be a useful source of income and diversification within a bond-heavy portfolio.

  Diversified and model portfolios

  Everyone needs to have an element of diversification in their portfolio, to spread the risks and prepare for a range of uncertain outcomes. How you go about achieving this depends on where you are in the investment and savings spectrum. You may be just making a start on your investments and either building a portfolio gradually or looking to make a one-off initial investment which you may not be in a position to add to for a couple more years. Sometimes you may find yourself with a lump sum to invest: more common is to settle for a regular monthly or quarterly investment plan.

  If you are making a one-off investment, you really want to be looking for a broad-based fund that covers all the main geographic markets. If you are starting off your investment portfolio and hope to add to it over the years, I believe that you should probably start off with a mainstream UK based fund as a core holding. You can always add a global equity fund, and the appropriate fixed-income funds for balance, at a later stage. With a more mature investment portfolio, it is easier to achieve better diversification from the beginning, even if it means reorganising what you already have. It makes sense as time goes by to look to blend one or more funds within each broad asset class that have complementary rather than identical strategies.

  It is no coincidence, incidentally, that very few asset management companies have been able to add value consistently for their clients by making frequent asset-allocation decisions from one period to the next – in other words, changing the mix between shares, bonds, property and so forth on a regular basis. I see little evidence that most investment groups add value this way, and I certainly would not encourage you to do so. There are always some exceptions to this rule, but in my experience not many. For example, most professional investors were selling their bonds in 2010/11, yet bonds continued to be a great place to be right up to 2015.

  As a general rule I believe that your bias should be towards making as few big calls as possible. Most big asset-allocation moves by investors tend to be knee-jerk emotive reactions to headline-grabbing events that are either happening elsewhere in the world, such as Greece or China, or are political rather than financial in nature, such as general elections. Most of the time these ‘critical’ events turn out to be more benign than they seem at the time. If anything, widespread fear of this kind of event can provide good entry points for topping up your holdings. They reflect emotions, not fundamentals. Sharp stock market falls are normally best seen as opportunities to buy, not to sell.

  It is true that from time to time asset classes do become very expensive or very cheap when measured against their long-term history. It is here that knowing and understanding a bit of its history can help in terms of the valuation of a major asset class. But this only happens once or twice in a decade. The majority of the time asset classes are in no man’s land. This means they can move either up or down by 20%, but nobody really knows which way and trying to guess is more akin to gambling. It is better to sit still instead. Go and play a round of golf, go fishing, sailing or whatever your pastime is!

  Without knowing each individual reader’s personal circumstances, it is impossible for me to give specific advice about which individual funds are right for you. However, it may be worth taking a look at some of the starting model portfolios which I have designed for clients of HL. There are five main types in all.14 The key determinants are how much an investor has to invest, whether they are investing a lump sum or on a regular basis (so much a month, quarter or year) and crucially their time horizon and tolerance for risk. While each individual case is different, these are designed to be benchmarks against which you can usefully measure your own situation. The minimum requirements are either a lump sum of £100 or a regular monthly investment of £25. To keep things consistent, in the examples I have gone for similar investment assumptions in each case – a lump sum of £10,000 a year, or £500 a month.

  Figure 6.1: Conservative portfolio

  This is the portfolio I might suggest for someone who is not able or willing to take on much investment risk – perhaps because they have little money to spare, or because they feel they will need the money they have invested in a relatively short period of time. The portfolio consists of four very conservatively managed funds which will never make huge positive returns, but are likely to suffer much less if and when the stock market turns down. The money is split equally between the four funds. (Note how the class of units mentioned here all have different letters, even though they are all directed at ordinary private investors – an example of how the industry continues to confuse people needlessly!) If you drilled down into what these four funds own, you would find a high percentage in bonds and fixed-interest securities.

  Figure 6.2: Medium-risk portfolio

  Here is an example of a medium-risk portfolio for an investor looking to invest a lump sum of £10,000. This one has five funds in it. Two of those five, Newton Real Return and Artemis Strategic Assets, are also found in the conservative portfolio. The other three funds inject more equity exposure into the portfolio. Woodford Equity Income, Old Mutual UK Alpha and Lindsell Train Global Equity all invest in shares of companies, though mostly in the largest companies in either the UK or global markets. The other two funds invest in a mixture of shares and bonds, with the primary aim not of maximising returns but seeking to perform steadily through all kinds of market conditions. Because of the large number of holdings which each of the five funds has, the portfolio is very well-diversified, both geographically and by type of asset, even though there are only five names in it.

  Figure 6.3: Adventurous portfolio

  For someone with a greater appetite for risk, a more appropriate starting point might be the adventurous starter model portfolio, which looks like this (as of May 2015). Again, two of the funds are the same as those in the medium-risk portfolio, but now there is a much greater exposure to emerging markets and smaller companies, which tend to perform better over longer periods of time, despite their higher risk. The Marlborough Micro-cap fund, which invests in quoted companies drawn from the smallest segment of the market by value, has only a 10% weighting for that reason. As the markets ebb and flow, you would expect this fund to move higher and fall further than the other two portfolios.

  Figure 6.4: A portfolio for children

  This portfolio is one designed specifically for children whose parents have decided to put aside money on their behalf. The logic here is that children have a long investment life ahead of them, so it is appropriate to take a maximum amount of equity risk, as we have seen how the passage of time increases the likelihood that equities will deliver strong positive returns. Children probably won’t have access to these investments until they are 18 or 21, and potentially their investment horizon could be even longer. They have plenty of time to let their investments mature. As a result the portfolio includes a much higher weighting in emerging markets (40% in the Newton and First State funds) and also 20% in one of my favourite small-cap investment funds.

  Figure 6.5: A portfolio for regular income

  The final
portfolio is designed for those who specifically want an income from their investment portfolio, with capital growth as a secondary objective. The bulk of the portfolio is made up of the HL multi-manager income and growth trust, which invests in 11 of the equity income funds that the firm rates most highly. (This is a fund that I also own in my personal portfolio.) The other two funds invest exclusively in fixed-interest securities, though their investment approaches are different. The Royal London fund pays out more in income, and is consequently higher risk, than the Artemis Strategic Bond fund, which has more flexibility to protect its capital if the bond markets turn down – provided the manager makes the right decisions of course. This is a good example of how it is possible to achieve diversification within particular asset classes, and not just between them. Together they provide a more rounded exposure to the fixed-interest market.

  Going back to the medium-risk portfolio, it is worth pointing out that while it has no bond funds as such, that does not mean that there is no diversification protection built into it. You always have to look deeper into what a fund owns to discover its real nature. The Newton Real Return fund, for example, has 37% in bonds and 7% in cash, while Artemis Strategic Assets has about 25% in cash and equivalents. In reality the Artemis fund is heavily shorting government bonds across the developed bond markets like the US, UK and Japan, which means it will do well if those bonds start to fall in value.

  You will notice that I have mostly used the same funds as building blocks for all these portfolios. They happen to be the ones that I have researched very thoroughly and know very well. My analysis also suggests that they will blend well together, which is another crucial factor. Other professional investors and advisors might well recommend different funds as building blocks. There is nothing to say that only these specific funds will do the job required of them. I could suggest one or two credible alternatives for most of the portfolios. However, the important point is that the great majority of actively managed funds will not beat the market averages: and unless they do, you might as well as use a series of cheaper index funds instead. The challenge – and the rewards – come from finding the small number of exceptional fund managers in each of the main sectors.

  Weightings and fund numbers

  It is important to emphasise that you do not have to be bound by the precise weightings I suggest for each portfolio. You can choose to keep some money back as cash, or change the weighting given to each fund in your portfolio – which you might want to do in order to change the overall risk of the portfolio. The same is true of the number of funds you invest in. For portfolios of £10,000 you won’t benefit from having more than three or four funds in your portfolio. With larger sums you can afford to spread the money across more funds, which has the effect of reducing your specific fund manager risk. So for example, for a medium-risk portfolio of £200,000 I suggest increasing the number of funds from five to seven, as shown in figure 6.6. With larger sums you might want to up the number to the 15–20 range, but you will rarely need more than that number, even if you have millions to invest.

  Figure 6.6: A medium portfolio for investors with larger sums to invest.

  There is nothing to stop you adding more risk by adding new funds later on. For example, if you wish to make the medium-risk portfolio more aggressive, you could increase exposure to the Far East and emerging markets yourself. Alternatively you could switch the UK allocation towards smaller companies or specialised funds that focus on particular sectors, such as financials, technology and healthcare. For those seeking a more cautious approach, you could increase the amount dedicated to fixed interest. An allocation of 15–20% to bonds will tend to reduce the volatility of the portfolio.

  However, you will also need to look at what level of income you are getting. If yields on corporate bonds are down to low levels historically, you may do better to retain a higher cash position, switching a bigger chunk of your money into your bank or building society account instead. I should stress again that these model portfolios are suggestions to help investors to get started. You will see similar models on other websites and platforms. They are best used as a baseline. Add or subtract other funds according to your personal tolerance for risk.

  Rebalancing

  An important issue that you need to think about is whether or not to rebalance your portfolio at regular intervals. Rebalancing is a term that means taking steps to ensure that your asset allocation – how your portfolio is made up as between different asset classes or types of fund – remains the same over time. For example, suppose that you set out with the aim of creating a portfolio that is 60% invested in equities and 40% in bonds. A year later, equities have gone up by 20% while your bond funds have produced a 5% return. The relative weights of the two types of investment in your portfolio have therefore changed too.

  The following table shows how the figures would now look. As you can see, even without you doing anything, the equity portion of your portfolio has risen from 60% to 64.3%, purely as the result of the difference in performance between the two categories. The greater the number of years that you leave your portfolio to take its own path without rebalancing, the further away from your original target it is likely to take you (although some years the process will even out if the performance gap between equities and bonds reverses).

  Start of year

  End of year

  Holding

  Invested

  Weighting

  Return

  New total

  Weighting

  Equity funds

  £6,000

  60.0%

  20%

  £7,200

  63.2%

  Bond funds

  £4,000

  40.0%

  5%

  £4,200

  36.8%

  Total

  £10,000

  100.0%

  £11,400

  100.0%

  Table 6.2: How your asset allocation can change as time goes by.

  The question is whether it makes sense to return your portfolio to its original target weights, or whether you simply let things take their natural course. If you decide to rebalance, you would look to take something from the equity side of your holdings and increase the bond allocation with the proceeds. You would sell enough units in the equity holding to reduce them to an amount equivalent to 60% of the new overall total of £11,400. This would leave you with £6,840 in equities and £4,560 in bonds, as per the table below. The following year you would repeat the exercise.

  End of year

  Holding

  Units

  Value

  Per unit

  Required

  Action

  Holding

  Weight

  Equity funds

  6,000

  £7,200

  £1.20

  £6,840

  Sell 300

  5,700

  60%

  Bond funds

  4,000

  £4,200


  £1.05

  £4,560

  Buy 342

  4,342

  40%

  Total

  10,000

  £11,400

  £11,400

  10,042

  100%

  Table 6.3: An action plan for rebalancing your portfolio.

  Rebalancing can be done at any time, but many investors who follow this course typically do it once a year. The first advantage of rebalancing is that you know that your risk profile will stay broadly the same from one year to another, something that becomes more important as time goes by. At the same time, you are selling the funds or asset class which have done best and buying the ones which have not done so well. Surprising as it may sound, this is a second reason why rebalancing might be a good idea. Selling outperformers and buying underperformers is not at all a bad investment strategy, although my experience is that investors often do the opposite. I remember one portfolio review meeting with a client. Having congratulated myself on how well his portfolio had done beforehand, I imagined that our meeting would be quite congenial. Far from it. He berated me for the funds in the portfolio which had done poorly and wanted me to sell these and buy the ones that had done well.

  As I tried to explain to him, doing what he was suggesting is almost always a mistake, because loading up on past winners destroys the diversification value that comes from owning a balanced portfolio when things go ugly. Many people found out the dangers at the height of the internet boom in February 2000. I remember one client who rang our office and insisted on selling all his equity income funds in order to switch into the TMT (technology, media and telecom) funds that were all the rage at the time. We said: “Are you sure?” His reply was, “I have a strict discipline of selling my losers and buying the winners”. Of course, it all then went horribly wrong and he lost a packet when just a few months later TMT funds dropped like a stone and equity income funds soared.