How to Storm-Proof Your Portfolio using Alternative Investments

Is recent market volatility a mere blip? 

[I wrote this in 2018, but clients appear to find it helpful, so I thought I'd put it here on LinkedIn. Case studies are not real people... and I'm sure you'll let me know if it is out of date!]

Should savvy investors hold their nerve and resist changing their portfolios in light of the storms? No. Volatility is here to stay. It’s now vital to diversify your portfolio with investments that do not move in lock-step with stock-markets. 

What’s more, the returns associated with ‘traditional’ bond-and-equity have fallen dramatically in the past two decades; investors need to take more risk than before.

“ ... investors now require meaningful allocations to alternative asset classes in their portfolios in order to maintain a 7.5% nominal rate of return, a level that was attainable with just bonds and cash as recently as 1995! And even today’s much more diversified portfolios, Callan17ii estimates that the level of risk an investor must take on in order to achieve that 7.5% return has nearly tripled over that time period.”17i 

In the graph, standard deviation measures volatility. Adding (20% in this example) alternatives will reduce the risk and raise the return of your investment portfolio.

So, what are alternative investments?

These simple represent an ‘alternative’ way for investors to diversify their investment portfolios away from their long-standing reliance on traditional stocks, bonds and cash. Alternative investments can be used to potentially generate higher returns, to dampen volatility, aiming to preserve capital for the long-term.

Alternative investments have developed since the Global Financial Crisis of 2008/9 to provide more choice of assets and liquidity in strategies.  

Leaving aside equity investment via collectives, we’ll focus on strategies for high earners and those with existing investments, aiming to maximise tax-efficiency and growth while balancing liquidity with risk. And some passion on the side. 

Martin,

an engineer aged 52, earns ￡230,000, has a pension worth ￡1m and has paid maximum contributions for the last 3 years. As an additional rate tax-payers he is feeling the tax-relief tapering changes that began in April 2016. Anyone earning up to ￡150,000 a year can save ￡40,000 into their pension, getting tax relief of up to 40%, or ￡16,000. As he earns above ￡210,000, his allowance has slipped from ￡40,000 to ￡10000. He’s down by ￡13,500 - 45% of the ￡30,000 he’s lost, because saving ￡30,000 into his pension would previously only have cost him ￡16,500. 

He plans to increase his pension up to the ￡1,030,000 limit over the next 3 years, to use his remaining tax-free allowance. He also holds ￡50,000 in Premium Bonds, giving him tax-free prizes of varying amounts every year, without eating into his Personal Savings Allowance, and near-instant access to his cash. He has largely finished paying for his children’s education, and now seeks to grow his capital for 6 years or so before gradually moving his gains into fixed-interest bonds before retiring.  

For the last 15 years Martin has let residential property, because its low correlation with other financial assets has diversified his portfolio. In May he sold his buy-to-let property as the tax-breaks he had enjoyed on the mortgage interest had decreased, while management charges from his letting agent will rise imminently to cover a ban on letting fees charged to tenants. He is not alone in this decision. Quoted in the Financial Times, George Bull of accountants RSM prophesied that HMRC’s coffers would be increasingly filled next year:

Martin feels secure enough now to take on some risk associated with more interesting investments, as his standard of living will not be affected. After associated fees and maintenance costs, his net gain on the property sale is ￡70,000. Using his annual exemption of ￡11,700, and being taxed at the higher rate gives him a CGT liability of (￡59,300@ 28%) = ￡16,604.

“Far more individuals will have got out of buy-to-let following the tax changes. Other people have sold property to crystallise values before an anticipated decline in property values, particularly in parts of London”19

Martin wants to use his ￡70,000 gain, plus the ￡16,500 he would have put into his pension to recoup both his old pension tax-relief (￡30,000x45%=￡13,500) plus his CGT liability, a total of ￡33,464. 

He investigates 3 schemes offered by HMRC. Venture Capital Trusts and Enterprise Investment Schemes both offer him tax-free growth and point-of-investment tax-relief of 30%, with EIS also giving CGT reinvestment deferral, IHT exemption and some protection against losses, with investment limits of ￡200,000pa (VCT) and ￡1m (EIS). He’s tempted, but his criteria are not yet satisfied.

Seed Enterprise Investment Schemes (SEIS)

- high-risk/high potential return investments in early-stage unlisted companies - more than tick his boxes. In order to make the tax-efficiencies Martin must hold his SEIS’s for at least 3 years, but can then sell them when he wants, so he can access his capital sooner than he could in his pension. He’s allowed to invest up to ￡100,000pa. 

He gets 50% income tax relief so Martin only needs to invest ￡15,000 to have a ￡30,000 holding. Additionally, he gets CGT ‘Reinvestment’ relief, as he can invest his ￡70,000 capital gain and only pay half of the CGT, saving ￡8,302. SEIS gains and losses are also protected. There is no CGT to pay on gains, and loss relief of 45% is given on Martin’s real investment amounts. This means that, should his ￡30,000 investment fail altogether, he can claim 45% of ￡15,000, so his loss is reduced to ￡8,250. Should his other investments (spread over several early-stage businesses, to alleviate risk) lose value, his losses are mitigated. 

Further, Martin enjoys assessing the potential in start-ups, backing enterprise, and following their progress. A final benefit is that his SEIS investments are protected from Inheritance Tax (IHT) should he die before he crystallises his investments, which saves his inheritors a maximum bill of 40%.

Lastly, Martin has always loved to tinker, has a good eye for a bargain, and is plain wistful for bygone days. He collects classic motorbikes - closely correlated with classic cars - and HMRC classify also these under the ‘wasting asset’ rule. Indeed, bits have dropped off his Italian bikes, but he now keeps his passions under wraps, they have appreciated substantially, and all his gains are free from CGT. Richard Dyson says in the Telegraph (27.10.2015):

“ ... vintage cars have been one of the most rapidly appreciating of all collectible investments. Coutts puts the rise in classic car prices between 2005 and 2014 at 400 per cent.”18. 

Although not liquid - it takes enjoyable time to find the right buyer for his bikes - Martin has made money every year through his bike sales. 

What other alternatives are available?

 Meet our investment club: Denise, Sally and Rita. While Denise and Sally are still paying into their pension plans, they reason that in a volatile market they must diversify; each also hold growing alternative investment portfolios. Each member researches different areas, then share their findings, while cooking (and increasingly, thanks to Denise, drinking) together once a month. While their liquidity needs and risk profiles are different, they share a desire for minimum management fees, maximum tax advantages and capital growth.

Denise, 35, divorced at 29, has a 10-year-old daughter Iona, owns their home (worth ￡640,000), has a pension worth ￡330,000, and stocks-and-shares ISA holdings worth ￡120,000. She earns ￡85,000 as Vice-President in a Brand consultancy, and rents a room in her London flat for ￡625/month to Sally, which earns her an annual ￡7500 tax-free under HMRCs rent-a-room Scheme. Denise has decided to triple this, maxing her ￡20,000 ISA allowance to create an alternative, higher risk portfolio but held for the long-term. In 10 years she intends to release ￡45,000 over 3 years, to pay for Iona’s college rent and tuition, keeping and adding to the remainder for a further 10-15 years.

Denise bought Iona a case of wine on her 1st birthday. This has sparked a growing interest, and this year Denise will become a Master of Wine. Offering her friends a glass each, she tells them about her ‘cellar plan’. With a reputable dealer, she invests ￡200 a month, intending to sell most of it. She will diversify with unopened wooden cases of different provenance and vintage, and it will be kept in bonded warehouses in perfect conditions so that sale value is maximised. As her expertise grows, she invites sally and Rita to join her ‘en primeur’ - buying low-yield wines from well-known vineyards during a good vintage. She quotes Simon Lambert in thisismoney.com (3.4.2018):

“The long-term returns on investing in wine certainly look decent enough and it can be tax-friendly; keep your cases ‘in bond’ in a proper warehouse and it will be free of duty and VAT, while profits are also capital gains tax-free. The Liv-Ex Fine Wine 100 index, which tracks 100 of the most sought after wines, has more than trebled since its launch in 2003.”20

With ￡1666 a month Denise will build an ISA holding infrastructure projects outside the U.K.; as infrastructure growth precedes economic growth in a region, so her investments should build the long-term capital growth she requires.

She quotes Jason Hollands, Managing Director at Tilney Group (Money Observer, 3.1.2018)21:

“Infrastructure projects typically involve long-term contracts of 20 to 30 years and these contracts often include an element of inflation-proofing, so that revenues rise incrementally in line with inflation. These provide investors with a relatively secure and predictable revenue stream that is less sensitive to the economic cycle.”

Sally, 33, saving to buy her own home, earns ￡90,000 as an Ethical Hacker.

She chooses a Lifetime ISA, investing ￡333 monthly with ￡83 monthly from HMRC (until she is 50) which can be used (after 12 months) as part of a deposit for a house in the U.K. In the event that she does not use it towards a house purchase, she will keep it until she is 60 rather than paying the 25% penalty charge for withdrawing it sooner.

Sally also tells the group about her gold research, pointing out that nervous investors usually wish they’d bought gold sooner, but are hesitant about buying ‘now’. Her research shows her that gold is for the long term, generally outperforming equities. Rather than buying bullion, she quotes MoneyWeek:

“[Gold Sovereigns] contain the intrinsic security of bullion or precious metal in a pure form and can also offer additional profit potential due to their aesthetic and historical appeal.”22

 2018 is the 65th year of Queen Elizabeth’s reign and the gold sovereigns minted will become collectors pieces. As they are legal tender, they are exempt from VAT and CGT. To diversify, Silver Brittania coins are also CGT and VAT free. Holdings are liquid and coins can be traded on the open market.

Rita, 55, a CIO earning ￡140,000, is a widow. Her understanding of technological markets, fast-growth companies, and the security of her late husbands savings, held in NSandI bonds, lead her to investigate the high-risk Innovative Finance ISA available since 2016. It’s a tax-free wrapper for her savings income. An ex-colleague who has successfully built and exited from two businesses using both crowdfunding and peer-to-peer lending, both of which can be included in an IFISA. 

Currently she can find returns on between 4% and 7.5% on 3 and 5-year IFISAs. Rita will mitigate the amount of risk she takes by investing in at least 4 different companies each year as she builds her portfolio. When she decides to liquidate her investments, all gains are tax-free. However, her returns are not guaranteed, nor are her savings in any way protected by the Financial Services Compensation Scheme, so the risks are high if her chosen firms fail.

Rita finds that the IFISA also ticks the clubs ‘low-or-no management fees’ criteria:

“Peer-to-peer lending is similar to crowdfunding, in the sense there are no financial middlemen (such as banks) between lender and borrower. As a result all of the interest paid on the loan as well as the original capital goes directly to the lender, with the platform taking a small fee.”23

Knowing that the government backed up to ￡1million in their NSandI one and three-year guaranteed growth and guaranteed income bonds, Rita was shocked to discover this June that this amount has been reduced to ￡10,000. She is therefore looking at gilts, bonds, and fixed-interest investments, aware that she will pay no CGT if she holds such investments directly rather than in a fund. 

Sensing a sluggish U.K. property market, and in the light of Brexit uncertainty, she has dismissed both Real Estate and Property Authorised Investment Funds. The only way she could enjoy tax-free investing in a REIT would be through an ISA wrapper, which would protect her from having to pay a tax on dividends. She prefers the IFISA opportunities.

So, is recent volatility just ‘white noise’ from the markets?

The current bull market has had a long run. It’s time to batten down your hatches and seek more investments that move inversely to the public markets. We’ve looked at some of the alternative investments you might chose, and further liquid alternatives become increasingly accessible through collective investments and financial strategies, which are out of our scope in this article. 

Rita, Denise, Sally and Martin are re-weighting their investments to improve the performance of their portfolios in stronger winds. Are you? 

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