A well diversified portfolio, subject to income tax and CGT

Brendan and I have discussed this subject many times so I decided to set myself a challenge:

To create a portfolio of less than 10 positions which is "appropriately" diversified but which gives up nothing in terms of the tax efficiency of a direct share portfolio that Brendan is looking for.

Important: The following is intended for educational purposes only and does not represent a recommendation for a particular portfolio of investments for any particular investor. To avoid the risk of anyone buying a potentially unsuitable portfolio without advice I have therefore left out the specifics of the underlying investments.

Note that although we have clients invested in portfolios substantially the same as described below the data described is "backtested" using a system from Morningstar, the actual results an investor might have achieved over the same time period could vary significantly due to transactions costs, fx costs, personal taxation and other factors.

However, the portfolio is comprised of just 9 positions and has the following characteristics:

Categorically subject to Income Tax and Capital Gains Tax - tick
Exposure to underlying positions in 1290 individual companies - tick
Market Cap weightings so 50% USA 20% Greater Asia etc - tick
Beta vs FTSE All World Index over 3,5 and 10 years 1.03, 1.02 and 0.99 so looks and feels like the index - tick
However, Alpha over the same periods vs the same index 1.68, 0.81 and 1.70 so you were getting about a percent a year over the market for the same risk - bonus

We can test that by looking at the sharpe ratios
3 years
portfolio 1.08 vs benchmark 0.97
5 years
portfolio 0.79 vs benchmark 0.75
10 years
portfolio 0.46 vs benchmark 0.37

Average annual returns to end of Sept 2015

1 year 8.95%
3 year 14.94%pa
5 year 12.91%pa
10 year 7.73%pa

These figures are total return numbers and include dividends

Valuation multiples

P/E
Portfolio 16.94
Benchmark 15.98
Price/Book
Portfolio 2.16
Benchmark 1.88

Geometric Avg Capitalization (Mil)
Portfolio 26,930.18
Benchmark 35,416.32


Source: All data and analysis source Morningstar

The performance data quoted represents past performance and does not guarantee
future results. The investment return and principal value of an investment will fluctuate
thus an investor's shares, when redeemed, may be worth more or less than their original
cost. Current performance may be lower or higher than return data quoted herein.


So, historically at least, we are getting more return for each unit of risk taken than the Index

For those of you worried about short term performance records, one of the investments in this portfolio launched in 1868.

So, my conclusion is that since it is possible to make just 9 trades and give up nothing in terms of the tax benefits of a more concentrated share portfolio and still retain all of the benefits of a more diversified portfolio then surely the rational thing to do would be to hold the more diversified portfolio?

Some caveats:
This portfolio is designed to have a beta of 1 against the FTSE All World benchmark index ( a globally diversified index of both developed and emerging markets) and it isn't therefore necessarily looking to outperform the index.
I have also created a value weighted and smaller companies portfolio which enables investors to tilt their portfolio away from the benchmark and towards a higher expected return.

Hi Marc

Thanks for the detailed post. I have moved it from the original thread, as I think this deserves a separate discussion.

I don't understand why you need 9 separate funds? If you can set up this for America, surely you can set up a worldwide fund which puts 50% in America, 20% in Greater Asia etc.

You don't mention costs? What are the annual costs, initial and exit costs?

You don't mention how it's done. Subject to income tax and CGT? So these funds pay dividends? If one of them does not pay dividends but the gains are subject to CGT, then it would be of great interest to those who have unused CGT losses.

And, of course, I have no idea of how you constructed these funds. You don't seem to have selected them at random.

Marc said:

Brendan and I have discussed this subject many times so I decided to set myself a challenge:

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So I will set you a challenge.

Publish the full details and names of these funds including the costs.

If they meet the criteria you say, I will consider investing some money in them and I will report on my experience. (Having said that, I don't want to manage 9 different funds, so I might just choose one or two of them.)

Let's look at how they perform over the next 10 years.

Brendan

I wonder does the Foreign & Colonial Investment Trust (established in 1868) form part of Marc's portfolio? It's a very well diversified trust but it's certainly not an index fund - for starters it employs leverage.

I looked at these trusts like the one you mention sarenco , the problem for me was they are all in GBP (if I'm correctly remembering ) so there is significant cost getting in and out of them.

Hi Fella

How significant would the cost be?

If you are holding them for say 10 years, then the currency exchange fees would be insignificant in the context of the overall costs and the performance.

I presume that there would be 1/2% stamp duty which is less than the 1% charged on buying shares.

Brendan

I didn't look too hard at the currency conversion fees even if it's 1%-2% on a lump sum of 200k I would want to invest it's significant then the other problem is I have a fair portion of my wealth on a foreign currency which doesn't feel right .

Fella said:

I have a fair portion of my wealth on a foreign currency which doesn't feel right .

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Most of my shares are quoted in euro. But that is not particularly relevant. It's where those companies earn their revenues and profits.

If I invest in a euro denominated fund which has 50% in North America, it's the same as investing in a sterling fund which is 50% in North America... I think.

Brendan

I do like the idea of the investment trusts and if they where available in euro I would be up more keen on them. I do understand your point that most of the companies in the trust probably earn money in euros and dollars but I am not 100% sure this is the only factor and would need to do more research.
Another negative was they all paid dividends , I wanted dividends reinvested , to do this myself would be additional costs.

Fella said:

I do like the idea of the investment trusts and if they where available in euro I would be up more keen on them. I do understand your point that most of the companies in the trust probably earn money in euros and dollars but I am not 100% sure this is the only factor and would need to do more research.
Another negative was they all paid dividends , I wanted dividends reinvested , to do this myself would be additional costs.

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Well, currency conversion costs are fairly trivial in the grand scheme of things. Degiro only charge €10.00 + 0.02% per trade for currency conversion and you could probably do better again by using a specialist online conversion company.

An investor’s currency exposure is to the currency in which the underlying holdings are denominated – not to the currency in which the shares of the fund or trust are denominated. So, if a fund only holds securities denominated in US dollars, your currency exposure is to US dollars – regardless of the currency in which the fund shares are denominated.

To be honest, I think investors with a long-term investment horizon get far too worked up about currency risk. Currency movements have historically been uncorrelated to movements in stock prices. As a result, over time, currency movements actually help reduce the correlation between securities denominated in different currencies, thus contributing to the benefits of holding a geographically diversified portfolio. As such, currency exposure should be seen as a positive – not a negative.

I’m a big fan of investment trusts (ITs) – particularly for investors with a low marginal tax rate or that are sitting on capital losses that they can carry forward. Yes, unlike investing in a fund, UK stamp duty (technically, stamp duty reserve tax) at a rate of 0.5% applies to the purchase of shares in an IT but you should bear in mind that IT’s commonly trade at a discount to the NAV of their underlying holdings (unlike ETFs).

Having said all that, ITs are all actively managed and typically more volatile than funds (partly because they typically employ a modest degree of leverage) so they won’t suit everybody.

I take the point that there is a cost associated with reinvesting dividends, although these days Degiro only charge €4.00 + 0.04% commission, which is pretty reasonable. Also, bear in mind that accumulating funds also have costs associated with re-investing dividends received on their underlying holdings and this will be reflected in their NAV.

Thank you Sarenco , great post as usual , I don't understand the NAV why is it trading at a discount to the holdings in the first place? And surely this can go against you as well as go for you. I was reading about this particular investment trust and the trust itself has to buy back shares just to keep the NAV discount under control . This seems concerning to me although it is probably common practice , but why don't investors value the trust as much as it actually worth.

I am also a big fan of these investment trusts, saxo will let you operate multi currencies , I am already with them and having no problems so will likely stay there , my intention was to move to trusts after an initial lump sum in ETF's .

Well, it's pretty common for ITs to employ a discount control mechanism but you're absolutely correct that a discount to NAV could widen or narrow during a holding period.

There are any number of reasons why shares in an IT might trade at a discount to NAV. Investors might not like a change of manager or investment approach, the IT might hold assets that are not publicly traded and investors may take a different view on the real value of those assets, or investors might simply be taking a view on the direction of a particular market that is not (yet) reflected in the value of the underlying assets. In fact, if the discount to NAV grows too large an active investor might seek to take over the IT to realise the value of the underlying investments.

You should certainly be comfortable that you fully understand the discount/premium dynamic before investing in any IT - they are quite different animals to index funds.

Fella said:

Thank you Sarenco , great post as usual , I don't understand the NAV why is it trading at a discount to the holdings in the first place? And surely this can go against you as well as go for you. I was reading about this particular investment trust and the trust itself has to buy back shares just to keep the NAV discount under control . This seems concerning to me although it is probably common practice , but why don't investors value the trust as much as it actually worth.

I am also a big fan of these investment trusts, saxo will let you operate multi currencies , I am already with them and having no problems so will likely stay there , my intention was to move to trusts after an initial lump sum in ETF's .

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This comes from notes I have made on Investment company's, NAV and buying at a premium/discount....

INVESTMENT COMPANIES ...are LISTED...(investment trusts or closed end funds)......Low cost and risk controlled. Active not passive. Closed end means they initially issue say 1000 units (pieces of a puzzle or shares) and no more. From these a portfolio of stocks are bought. The net asset value NAV of the fund is the assets minus the liabilities divided by the number of outstanding shares. For example 2000 Euro net assets/1000 outstanding shares gives a NAV/share of 2 Euro. If you buy 1 piece of the puzzle (1 share) and pay 2.2 euro for it. The fund is trading at a premium, 2.2/2 represents a 10% premium. However if you pay 1.8 euro it was trading at a 10% discount (written -10%). If the share price is below its net asset value one needs to investigate why there is less demand for this share before buying it. Analogy......1000 seat concert hall may be sold out and the tickets might be sold at a premium, I.e. Above face value.

Thanks Landlord , I do understand the NAV just don't understand why it is trading at such a big discount and the investment company has to buy back funds to keep the NAV under control , this fund had performed well but people don't value it for some reason.

I start looking at funds with huge discounts thinking I could buy them in the hope they break up like Sarenco said and you get some arbitrage that would interest me a lot but its seems a lot of these funds invest in other sub funds so breaking them up won't be much use as if the sub funds are also trading at a discount you would have to hope they break up also , I doubt the companies are going to be keen to break any funds up anyway unless there is significant pressure. I don't see much benefit to buying at a discount to NAV if this discount to NAV has always been there and is likely to always be there in the future or potentially grow larger , I actually see trading at a discount or a premium as a negative thing compared to trading at market value. The only positive I could see is investing for income it could push the dividend yield higher as a % .

Fella said:

it seems a lot of these funds invest in other sub funds so breaking them up won't be much use as if the sub funds are also trading at a discount

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That is interesting.

Say Fund A is trading at 80% of Net Asset Value.

Fund B is also trading at 80% of NAV but its only asset is Fund A.

That means that Fund B is trading at 64% NAV.

I was reading a review of John Kay's new book Other People's Money

"Industry insider John Kay argues that the finance world’s perceived profitability is not the creation of new wealth, but the sector’s appropriation of wealth – of other people’s money. The financial sector, he shows, has grown too large, detached itself from ordinary business and everyday life, and has become an industry that mostly trades with itself, talks to itself, and judges itself by reference to standards which it has itself generated."

This looks like an example of it. The managers of Funds A and B are getting big fees and so are the professional advisors who advise people to invest in them. All of which go to reduce the return to the ordinary investor who could have bought the shares in the companies directly.

Brendan

Being a value gambler the idea of getting something at 10% 20% 30% of a discount excites me , I am not naive enough to believe that I can make money here where others can't but I am going to start buying stuff at a heavy discount , if the market is efficient why not , its probably possible to buy the fund at a discount and short the index its tracking or buy the index its tracking and short the fund. I'll allocate a few thousand to this and see how it goes , looks like there's a possibility for arbitrage , initial thoughts is to avoid companies that use gearing. I'll start with buying a few companies trading at a 20%+ discount , likely will end up with lots of sub funds.

One of the positive effects of a discount to NAV is that as an investor you are gearing your exposure to the underlying investments.

If a trust is trading at a discount of 10% to NAV for every unit of investment return you are only paying for 90% of the NAV.

Comparing a Mutual Fund or ETF (which generally trades at NAV) with an Investment Trust on the same set of assumptions except higher fees for the trust yields a higher IRR for the investor in the Trust all else being equal.