Constructing An Investment Portfolio In Today’s Market – An Overview

Constructing an investment portfolio to deliver the medium to long term retirement income an investor may require has never been easy but given today’s economic climate (especially post Brexit) it has perhaps never been so difficult. We review the situation and suggest a possible way forward.

The Safe Option

Investment has always been based on balancing return vs risk. Of course, it would be possible to take the safe option of relying on Bank interest or an annuity.

Mark Carney, the Bank of England Governor delivered good news to the markets with his recent cuts in interest rates (and further quantitative easing). It may have been good news to the markets but was it such good news for people trying to generate income from their investments? It was certainly not good news for those relying on bank interest.

To generate £10,000 of income (less than half the average national wage) with a maximum interest rate of 0.1% you would have to deposit £10,000,000. This is over ten times the maximum an investor is allowed to have in their pension fund – let alone the fact that the vast majority of people will get nowhere near the maximum allowed.

Annuity rates vary according to post code, the type of annuity and several other factors but as a rough guide assume a available pension pot of £1m (the current lifetime allowance) and annuity purchase at age 65. In the current market (August 2016) this would generate a yearly income of approximately £25,000p.a for life. £25,000 is below the average UK salary and as most individuals are somewhat short of a £1m pension fund at retirement they should expect a significantly lower annual sum.

So what can an investor do? How can they be sure they have a sustainable income in the long run?

A History Of Income

20 years ago designing an income portfolio was reasonably straightforward;

  • Gilts (UK Government Bonds) were paying a healthy return and were low risk
  • Equities had a lower dividend yield but offered some growth potential and protection against inflation.
  • Property was somewhere in between.

So a “sensible” long term portfolio would have say 50-60% in Gilts, 20-30% in equities, 10-20% in property and some cash.

Starting today that portfolio would be yielding less than 2% (and that is before charges).

Gilts

The Brexit uncertainty, the cuts to interest rates and the quantitative easing outlined above have driven down Gilt yields. Many would argue that with Gilt yields so low by historic standards they are much higher risk than many realise (if the yield rises on a bond the price falls).

So when constructing an investment portfolio what might an investor do? One solution would be to move out of Gilts into other bonds. Corporate bonds, high yield and emerging market debt all offer higher income but at what capital, liquidity and exchange rate risk? Once again, the fact that many investors have been chasing these higher yields has pushed prices up and up – this may well all end in tears.

Equities

While bond yields have fallen, dividend yields from equities (UK equities at least) has stayed much more consistent – The yield on the FTSE all share is currently 3.5%. Dividends have long been a key element of the return that investors receive for holding equities.

According to the Barclays equity Gilt study 2016 the value of £100 invested in UK equities since 1945 would be worth £251 if dividends had not been re-invested. With dividends re-invested (in real terms – after inflation) the £100 initial investment would now be worth £5,115. Compare that with Gilts at £220.

In more recent times (1989 to the trough in 2009) if no dividends had been re-invested an investor in the FTSE All Share would have seen a return of 66% (Source: Premier Asset Management). To try to capture these facts many managers launched Equity Income Funds during the 1990’s and it has worked.

According to the Investment Association the UK Equity income sector average (in which funds must pay a yield at least 10x higher than the FTSE All Share) has outperformed the wider UK All Companies (Growth) sector average by over 70% in the last 20 years.

So perhaps a range of Equity Income Funds would give us a higher income and some diversification but a word of warning. According to Capita just 20 companies generate 70% of the dividends paid in the UK market by value – so most Income Funds holds the same stock – so much for diversification!

An Investment Portfolio For Today’s Markets

Given the above, if today we held a portfolio of 40% UK equity income, 20% Global Income, 20% UK Corporate Bonds, 15% Commercial Property and 5% cash the yield would be close to 3.7%p.a.

As long as there is no need to access the capital this should also give good protection against inflation and has a reasonable asset class diversification. Notice the change around between Gilts and Equity compared to the historic perspective. However, given the historic perspective (above) it should be obvious that what works today will not necessarily work well in future. Stay close to those advisers who know the market and its risks.

Conclusion

When constructing an investment portfolio the key point that should be obvious from the above is there is no reliable, consistent formula that will guarantee the best mix of assets to deliver long term income. Economic conditions change, businesses rise and fall, Governments (and banks) intervene and tax laws change. The only advice that does remain true is diversify, make tax efficiencies, keep costs low and stay close to advisers.

 

With thanks to our associate D. A. Norman of TCF Investments.

The information in this article does not constitute financial or other professional advice. You should not take action on the basis of this article without seeking regulated independent financial advice that addresses your specific circumstances.