Investing Your Capital - Obvious & Hidden Risks

As we have said consistently for many years, we favour passive funds and tracker funds when investing clients' capital. The evidence for actively managed funds where the Fund Manager stock picks, and perhaps tries to time the markets leading to consistent long term performance above the average is thin on the ground.

Especially so when you take into account the higher costs usually associated with active fund managers.

So, in our opinion, the decision for canny investors using passive and tracker funds is beyond doubt.

However, there are various types of tracker/passive funds, and this is what we would briefly like to look at here, as well as to remind ourselves how to go about building your portfolio.

So, how is an investment portfolio built?

The vast majority of new clients we meet usually have a collection of funds that has been sold to them over the years.

It's also unlikely they will have a formal investment philosophy (as normally their previous financial adviser has not implemented one for them), so to create order from this chaos is one of our principal objectives.

So how do we go about helping a new client?

Let's say Dr Smith and his wife are in their 50s and have £250,000 invested in ISAs with various investment companies (87% of which is invested in equities).

After discussing their planning, Dr Smith agrees that they are now entering their wealth preservation years (as opposed to wealth creation).

They will be relying on their capital over the next 20 years to fund lots of holidays and travelling. They don't like volatility, but like the idea of these investments growing a bit better than what they'd receive if they had it in cash with the bank.

After analysing their risk profiles, we agree that no more that 60% of their money should be in growth stocks like equities.

So the 'obvious' risk to them is that their asset allocation (how much they hold in stocks, bonds, property and cash), is totally out of line with their comfort zone.

So we recommend that they reduce their allocation of equities to 60% (from 87%), with the remainder in fixed interest investments.

Clearly risk and return are linked, but the good news is that The Smith's cash flow forecast has shown that this lower level of risk/return portfolio will still allow them to achieve their goals in life.

So, so far so good!

We then come to how the equity part of the portfolio is arranged - the strategic allocation. This means how much is invested in the UK, and how much globally?

To keep things simple, let's say this is 50/50. So 50% UK, and 50% global. This is key, as we shall see below.

Concentrating here on the UK, you then decide how do you get exposure to the stocks you want - i.e. what fund?

A tracker or passive fund is the sensible answer, but which type and what fund do you choose that does the job?

This is where the 'hidden' risks come in.

What we mean here is that if you choose a FTSE 100 tracker, you have to understand that the top 10 companies account for around 47% of the value of this index.

Why is this significant?

Well, for example, we have seen the BP share price massively hit recently because of the problems they have had, and we all remember Northern Rock. BP has halved in value this year.

In fact, BP was the largest value company in the index until recently, but is now number 4 in the list.

(A new client we've recently met has many 10s of thousands of pounds invested with BP, and to see this value halved over just a short period of time is uncomfortable to say the least).

So, a FTSE 100 tracker has these 'hidden' risks of a small number of 'super companies' dominating the index. One way of alleviating this risk is to use an All Share tracker instead, made up of over 600 companies.

Crucially, as mentioned, we have also bought into global stocks, and therefore this reduces risk as it gives further diversification as the FTSE companies make up just 9% of all the world's quoted companies.

Finally, as to which fund you use, it really boils down to finding a passive fund that does the job and is as inexpensive as possible, and how well it tracks its index.

We have recently looked at a Fund Manager called Vanguard, and will be using them for part of our portfolios.

Why?

They are cheaper then the alternatives and track the respective indexes better than other alternatives, and so we can improve the investment experience for our clients.

The Financial Tips Bottom Line

Understand why you have the investments you have. What investment philosophy do you and your adviser have? What strategic decisions were made regarding your UK/Global exposure and asset allocation? Do you have active, tracker or passive funds?

ACTION POINT

These decisions are absolutely vital to get right for your future wealth. Ask your adviser these questions, and if the answer is that he/she picks the 'best funds', get a second opinion.