Since our last review at the beginning of September, our ‘income biased’ portfolio of shares has continued to perform, bringing home a return of a return of 15.77%!

As expected, in a rising market, it has given back a touch of its outperformance. In this period, we have seen a rebound in ‘materials’ as commodity prices recovered, continued enthusiasm for banks and Telstra, and a reasonably lacklustre performance in most other sectors.

It’s worth restating our expectation that this portfolio should moderately underperform in a rising market, and moderately outperform in a falling market. After all, we have constructed it for tax-effective income and are underweight the typical ‘growth’ sectors.

To recap, last December we introduced our ‘income biased’ portfolio of stocks. The portfolio is forecast to generate a dividend yield of 5.82% pa, which given it is 97% franked, translates to a forecast of 6.87% a year after your tax income return in accumulation, and for a fund in pension phase, 8.08% per annum.

Some of the key construction rules we applied:

• a ‘top down approach’ to the sectors, with biases that favour lower price to earnings ratios (PE) and higher yielding sectors;
• in the major sectors, our sector biases are not more than 33% away from index;
• to balance the need for diversification with a manageable number of stocks to be monitored, we sought 15 to 20 stocks; and
• we confined our stock universe to the ASX100, avoided chronically underperforming industries and looked for companies that pay franked dividends and have a strong record of earnings consistency.

The ‘sector bias rule’ in the major sectors is critical. If we had just been seeking tax effective income, we may have selected a higher bias (such as 50% or 67%). However, we were concerned about the risk of an underperforming portfolio in a rising market and selected a lower bias of 33%.

Keeping the portfolio within these parameters led us to do some minor rebalancing on 31 August, where we reduced our exposure to Consumer Staples and increased our exposure to Materials. We also marginally reduced our exposure to Health Care by taking profits on Ramsay Health Care, and replaced with the much cheaper Primary Health. The changes were:

Our income biased portfolio (per $100,000 invested) and its performance from 15 December 2011 to 26 October is shown in Table 1.

Total return

When the dividend income of $4,559 received during the 10 months is added to the nominal profit of $11,212, the portfolio is up $15,771 – a return of 15.77%!

ANZ, NAB and WBC are yet to pay their final dividends, which are due in mid December. As there are unlikely to be any surprises here, our portfolio should generate an income return of 5.74% for the year, pretty close to its forecast of 5.82%. The only disappointment has been with David Jones.

Performance

So, how has it done on a relative basis?

As income is such a critical component of performance, we track the performance against the S&P/ASX200 Accumulation index rather than the normal price index. Further, as the accumulation index doesn’t take into account the taxation benefits of fully franked stocks for SMSFs, we have included the value of the portfolio ‘grossed up’ for this benefit in Table 2.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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