How to build a properly diversified investment trust portfolio

Max King explains how to build a well diversified portfolio using one of our favourite tools – investment trusts.

The number of investment trusts may be dwarfed by the number of open-ended investment companies, but there are still more than 200 trusts investing in equities, and a further 130 non-equity “alternative income” trusts listed by investment trust specialist Winterflood Securities.

Their sizes (in terms of assets under management) vary from a few million pounds to Scottish Mortgage’s £8.5bn, and their ages from freshly launched to F&C’s 152 years.

So if you want to build a portfolio of investment trusts, the question has to be: “where to start?”

The true nature of risk

Wealth managers ask prospective clients for their appetite for risk. The answer is usually in the middle of the range. Most investors would be happy to sacrifice some upside to their investments for less risk, but it’s all too easy to accept sluggish performance on the way up only to find that performance on the way down hasn’t been well protected.

Conventionally, portfolios mixed bonds with equities to lower risk, but yields on government and quality corporate bonds are now so low that bonds offer, at best, a miserable return. Wealth managers have been substituting alternative income trusts for bonds, but a growing number of these have tripped up, showing that the returns they targeted were too good to be true.

Professional investors tend to confuse risk with volatility (the number and size of ups and downs a given asset class tends to experience over time). But risk is best defined as the possibility of a permanent loss of capital, not to be confused with the gyrations of the market.

For a private investor, the best way to reduce the volatility of an investment portfolio is simply to look at it less often. Arguably, for those with a long-term perspective, a good strategy is to seek the best returns from an equity-only portfolio and accept the ups and downs around a long-term upwards trend.

Income is also a key issue. For those who don’t need it, the accumulation of cash from dividends still provides an opportunity to make new investments while the payment of healthy dividends shows that the trust is investing in profitable companies.

High yields, however, usually involve a disproportionate sacrifice of capital return and may not be tax efficient – less pleasant than the receipt of dividend income is the resulting receipt at the end of the tax year of a demand for higher-rate income tax. Sipps and Isas (Individual Savings Accounts) provide protection against this, but more capital gains tax may be saved by putting high-growth trusts into an Isa instead.

Most investors will seek a diversified portfolio, well spread across asset classes, geographies, sectors and size segments (large, medium and small-cap stocks). But putting all of your eggs into the one basket of a high-quality, medium-risk international investment trust such as Monks, Alliance or F&C is fine for small investors.

Easy and low-cost dealing makes chopping and changing a portfolio tempting, but it’s rarely a good idea. Recognising mistakes and selling before they get worse is important, but there is great satisfaction from seeing a share price multiply in value over time.

Where low-cost dealing is useful is as an alternative to investing for income; selling a few shares each year of a high-performing but low-yielding trust such as Scottish Mortgage, can generate the same cash flow as an income trust but with a much better total return.

Four of the biggest diversification mistakes investors make

The fault of many UK-based investors is to diversify badly. Common mistakes include:

  1. Too much in the UK. The UK accounts for well under 10% of global equity markets by value and is dominated by poorly performing mega-caps. Its earnings may be international (70% of revenue is derived from outside the UK) but it has been no substitute for a truly international spread.

  2. Too little in the US. The US now accounts for more than half of total global equity market valuation, and much more of the healthcare and technology sectors. Many of these companies are relatively new but are already global household names. The US market may look relatively expensive in price/earnings terms (and it has done so for a generation) but high growth and high quality has consistently made fools of the bears.

  3. Focusing on discounts to net asset value. High discounts (where the share price of the investment trust is trading at well below the value of its underlying portfolio) usually reflect a problem, whether it is due to poor performance, a distrust of the manager or a flaw in the asset type. The key to the long-term performance of a holding in a trust is its underlying investment performance, not any change in its discount.

  4. Too many eclectic holdings. It’s easy to get enticed into a Vietnamese, Indian or Brazilian trust by an effusive article about the country and its economy accompanied by a photo from the travel pages, or into esoteric funds investing in uranium mining, timber or Berlin property. One or two of these investments may be justifiable – but it’s best to stick to the mainstream for at least 90% of a portfolio.

A good portfolio will have a sizeable core of global trusts whose managers can focus on the best opportunities, regardless of geography or sector. Regional trusts can bring in areas such as Japan or emerging markets which are not well covered by global trusts, and a greater focus on mid and small caps.

Specialist trusts, such as private equity, technology and healthcare, give exposure to expertise in complex areas beyond that of the global investors. Alternative income trusts provide income and, if well chosen, reduce risk and volatility.

If the result is more than ten holdings, then that’s far from being the worst lapse of judgement you can make.

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