My wife has recently received a substantial inheritance and, having put some money aside in the building society for a rainy day and bought some National Savings Certificates, we are wondering how to invest the balance.

We have considered approaching a stockbroker to run a share portfolio, but really don’t know how to go about this or even how to choose one. We are also concerned that, having appointed someone to manage our money, we will not know whether we are getting a good or bad service. Can you please give us some guidance?

A

This is a subject upon which you really need to take some professional advice from an investment adviser (see Yellow Pages) - but here are some very general guidelines.

First, you need to decide if you want “active” or “passive” management. An active manager has available a wide range of securities (subject to any restrictions imposed by you) and uses his judgment to select the split between asset classes (equities, bonds, cash etc), geographic sector (UK, Europe etc) and also the individual stocks within the class or sector. This gives rise to a number of risks, namely, that the manager might choose the wrong asset class andor geographic sector andor individual stocks.

A passive manager aims to mitigate these risks by an investment technique known as “indexing”. An indexed fund aims to produce the same performance in terms of capital and income (taken together) as a specified index. For example, the aim of an indexed portfolio of UK shares would normally be to produce the same overall performance as the FT All Share Index.

Such an approach avoids the risk of bad stock selection by the manager and rests on the belief, supported by statistical evidence, that it is difficult for a diversified portfolio of securities to outperform the relevant indices, after incurring the costs of switching.

There remains the risk of bad asset or sector selection. This can be removed by the adoption of “consensus asset allocation”, which extends the concept of picking shares in a passive way to asset allocation. In essence, a consensus portfolio tries to replicate the asset allocation of a “typical” investment fund.

The objective is that through a combination of asset allocation in line with the typical fund plus indexation of each of the main sectors the portfolio can be expected to achieve returns close to average over the long-term.

Broadly, active management will suit investors with a relatively higher risk outlook whilst passive management will suit a more cautious investor. You really need to visit both types of manager before making up your mind.

The second step, having chosen your manager, is to consider the investment objectives of your portfolio. Investment portfolio objectives are usually loosely defined as “income”, or “growth”, or “total return” (sometimes called “balance”). Income and growth are, I hope, self-explanatory. Total return has the objective of maximisation of return through a combination of income and capital appreciation and generally results in managers managing portfolios more actively between asset classes to obtain the best overall return.

You must then establish benchmarks against which the investment performance can be measured.

Benchmarks come in four parts. First there is the asset allocation benchmark. This could be based on equities and bonds, but the allocation can be amended to suit your investment requirements. The benchmark does not, of course, preclude the manager from investing in, say, cash or index-linked gilts.Second, there is the investment return benchmark which is derived from the relevant index return on the asset classes in the asset allocation benchmark.

Third, there is the income benchmark, which is derived from the gross yield on each of the constituent indices. I have summarised this below: At current index yields this would give the overall portfolio an income benchmark of between 3.5 and 4 per cent gross per annum.

The fourth step will be to determine a performance objective. This might be to produce a total return on the portfolio which is 2 per cent per annum greater than the total return (gross income plus capital returns) on the benchmark portfolio over a rolling three-year period.

This would be a very demanding benchmark. (I suggest that you discuss “risk” with your manager so you can agree a suitable objective with him.) Finally, your manager will want you to sign a client agreement. Read this carefully and ask him to explain anything that you do not understand. You must also ensure that it incorporates your objectives and all the relevant benchmarks.

Andrew Warwick-Thompson is a lawyer who works for Bacon and Woodrow, the international firm of actuaries and consultants. Readers who wish to put questions to him (no names will be published) should write to the Personal Finance Desk, The TES, Admiral House, 66-68 East Smithfield, London E1 9XY.No personal correspondence will be entered into and no legal liability will be accepted for the advice offered.