Fund Manager’s Response

A client in his mid-thirties, with substantial capital and income sources, a medium/long-term perspective and a reasonable tolerance of risk, is ideally placed to reap the benefits of investing in equities. So we agree with the heavy emphasis on equities and, in principle, with the attempt to achieve portfolio diversification. However, whether a 20% holding in a single hedge fund represents diversification (therefore risk control) or an acceptance of higher risk in exchange for enhanced capital appreciation is an issue for debate.

Looking specifically at the UK portion of the portfolio, we accept the basis assumption about continued low inflation (and low interest rates). We certainly recognise the validity of including equity income funds even in a portfolio with no specific income objective. However, two points stand out.

First, we reject the assumption about a low-growth background made by the broker. The UK economy has enjoyed a long period of uninterrupted expansion and seems set to enjoy sustained annual growth averaging 2.5% or more over the coming decade. Our second point relates to the importance of dividend growth as an indicator of healthy growth. Many companies with strong dividend growth prospects would not typically qualify for equity income funds because their yields are too low. They are more properly the type of stocks to interest managers of growth funds.

These assumptions lead us to advocate a bigger exposure to UK growth funds, both those that target companies with the potential to increase profits at well above the market average and recovery/special situations funds. Well-managed recovery funds have a proven record of delivering impressive returns over the long term. Recovery managers target companies that have suffered temporary setbacks or those that have simply fallen out of fashion.

This contrarian approach avoids the temptation to chase overvalued stocks. Instead, problem companies are all too often abandoned by conventional investors and can be bought on valuations that take little account of their potential. Special skills are required to distinguish recovery candidates from lowly rated businesses in terminal decline.