Getting asset allocation right in your Isa

More than 20 years since their inception, investors require little encouragement when it comes to the take-up of Isas. Like pensions they have become an established feature of the personal finance landscape.

Yet success can breed proliferation, and complication. A confusing array of different Isas have cropped up over the years, all with different potential uses. To make matters worse it can be easy to make the most of generous Isa allowances without thinking about the exact purpose of your holdings – and how your goals and circumstances should guide what sits in the tax wrapper. As Seven Investment Management (7IM) private client manager Michael Martin puts it: “What we do with Isas is work out people’s objectives. People don’t really have an objective – it’s something to do.”

All this means it can be useful to reassess the type of Isa you use, and the rationale behind it. Some rules of thumb can apply when it comes to asset allocation, holding selection and even portfolio management techniques to suit different Isas and financial objectives.

Stocks and Shares, and the income love affair

Stock-and-shares is by far the most popular investment Isa of recent years (See chart), and the approaches taken within it can differ vastly depending on your objectives.

It should first be noted that this can be an extremely useful vehicle for those who are taking income, and for those investors looking to sell down investments. As with other Isas, you do not pay capital gains tax (CGT) or dividend tax – making it an efficient source of retirement income of extra cash. Because Isas count as part of your estate on death – leaving them vulnerable to inheritance tax (IHT) bills – it can make sense to use up this pot and preserve any pension savings, which escape the IHT net.

Asset allocation will always be driven not just by your personal circumstances and goals, but also by individual attitude to risk and other investment preferences. In the case of income portfolios, a balance has to be struck between the level of yield you target and your attitude to risk.

Laith Khalaf, an analyst for platform AJ Bell, argues that a retirement income portfolio would be “largely an equity portfolio giving an income”, mixed with a few other asset classes such as bonds and property. The latter two can also provide yield as well as some diversification, although higher-yielding bonds can potentially offer equity-like risks without the full upsides seen in the stock market in good times.

Here, it depends on what you are comfortable with. Equities remain a good source of income even after the brutal dividend cuts of 2020 and diversification across regions can offset some risks. The UK and Asia tend to offer the most promising yields.

It is possible to generate a good income without being too reliant on stocks, as suggested by a look at some of the higher-yielding multi-asset income funds in the market. Premier Miton Multi-Asset Monthly Income (GB00B7GGPC79), which listed a historic yield of 5 per cent at the end of January, had 32.7 per cent of assets in UK equities, with 44.4 per cent of assets in equities altogether. A similar allocation was made to different sources of bond exposure, including floating rate credit funds, high-yield bonds, emerging market debt and convertible bonds.

Fidelity Multi Asset Balanced Income (GB00BFPC0725), with its historic yield of 3.73 per cent at the end of January, had a 36 per cent allocation to equities, with a 60 per cent weighting to various bond exposures, the majority of which in high-yield corporate debt.

Finally, it should be reiterated that income does not need to come via dividends or bond coupon payments. Investors can always run a balanced growth portfolio and sell down assets as a source of capital.

Going for growth

Growth investing comes with different levels of complexity, again relating to factors such as one’s attitude to risk. Here, it is important to ask how long you can go without needing, or wanting to use, the money.

Extremely long-term investors are arguably the easiest to satisfy. Rob Morgan, an analyst for Charles Stanley, notes that there is “nothing wrong” with a 100 per cent allocation to equities for anyone with an investment horizon of 20 years or longer. This applies to adults who have an very long-term view and see the Isa as a patiently managed growth vehicle to sit alongside their pension. It is likely, in this case, that they will need both the willpower not to touch the Isa and separate financial means to deal with emergencies or unexpected life events as they arrive.

The all-out growth mindset should also apply to those setting up Junior Isas, especially for newborns or very young children, given the lengthy time frame involved.

However, asset allocation is just one part of the equation. Within a 100 per cent equity allocation a good deal of diversification – across funds, stocks or both – is still needed. A good spread of geographical exposures would be useful, again without an investor picking up so many holdings that the portfolio becomes unwieldy. Targeting growth markets such as Asia could be productive, and investors would do well to resist any temptation to cling too closely to their home market. That said, some level of UK exposure can be useful to offset the effects of a strengthening in sterling, which would erode the value of overseas gains. Over time, different currency shifts can effectively cancel each other out.

As with exposures to the likes of Asia, investors may be tempted to make some investments that look volatile over a few years but appear promising in the longer term. Rory McPherson, head of investment strategy at Psigma, notes Pacific North of South EM All Cap Equity (IE00BD9GKZ43) as one potential option.

More thematic options may also fit the bill, especially for ESG-minded investors. He notes that options such as UK equity fund Royal London Sustainable Leaders Trust (GB00B7YH3F12), Pictet Global Thematic Opportunities (LU1437676809) and Liontrust’s Sustainable Future products might appeal. These could in theory expose investors to trends that may come to fruition in the coming decades. Similar thinking can apply to other names such as Scottish Mortgage Investment Trust (SMT), with its focus on major future trends.

What is a balanced portfolio?

If being an all-out growth investor is relatively simple, finding a suitable middle ground is much trickier. This applies to income investing, discussed above, and to balanced growth investing. ‘Balanced growth’ may be your objective if you expect to need the money, or put it to work elsewhere, in 10 years or so. This could apply to those approaching retirement or younger individuals building up a house deposit, either via a stocks-and-shares Isa or a Lifetime Isa.

Morgan suggests that a well-worn approach could still succeed – with caveats. “A traditional 60/40 portfolio could work well for 10 years, with investors progressively tilting bond and alternatives exposure the shorter [the time] you have, down to a minimum of five years to maybe a 40/60 mix,” he says. 

“The problem is currently that bond yields are very low so the offsetting effect you get from bonds [against stock market falls] is potentially more limited.”

A mix of diversifiers may instead be wise. Gold may continue to act as an effective safe-haven asset when equity markets fall, for example. But most diversifiers come with potential problems, and investors may wish to use a few rather than relying on one. Investors who are happy to outsource their decisions may wish to use the so-called ‘wealth preservation’ investment trusts to some extent. Names such as Personal Assets Trust (PNL) take some equity market exposure but also use the likes of gold and bonds for protection. It is important to check how the investment manager is steering the portfolio and why – Ruffer Investment Company (RICA), which recently made headlines by dabbling in bitcoin, has long been fixated with the threat of resurgent inflation, something currently viewed in some camps as a real possibility in coming years. We discussed their approaches in greater depth in the issue of 19 February.

Lifetime Isa users looking to save for a house deposit should exercise caution if their timeframe is shorter than five years. McPherson suggests an allocation to fixed income via funds like Allianz Strategic Bond (GB0031383408). But sticking with cash can be an equally valid strategy.

On the subject of cash, it is important to put it to work over a longer time period. Cash Junior Isas have taken on more business than their stocks-and-shares equivalents in recent years – suggesting a mountain of money has been earmarked for a long period but left open to the ravages of inflation.

Talking tax

With the CGT regime likely to grow more punitive in the future and dividends already vulnerable to tax, Isas continue to stand out. As Martin notes, the fact that Isas and pensions are immune from CGT makes them a good home for volatile assets that could make significant gains. If they do – as with stocks such as Tesla (US:TSLA) and funds including Scottish Mortgage Investment Trust in 2020 – selling them outside a tax wrapper could incur a significant bill.

As such, it could make sense to make sure you buy riskier assets such as stocks, investment trust shares and higher-octane open-ended funds within a tax wrapper. Conversely, any losses you have incurred outside of a tax wrapper could be offset against your CGT allowance. This can sometimes be a small solace in the case of an investment going awry. Investors in Neil Woodford’s doomed equity income fund could potentially have taken advantage of this, for example.

When it comes to picking a tax wrapper, investors should be extremely wary of the Lifetime Isa, given the punitive measures applied to those who exit 'early'. The wrapper gives a 25 per cent bonus to first-time buyers who use it to purchase a property worth £450,000 or less, at least a year after setting up the Isa. You can also safely withdraw – and take the bonus – if you are aged 60 or over, or if you are terminally ill with less than 12 months to live.

But life circumstances and objectives can get in the way of meeting these strict criteria: the property you buy may exceed the £450,000 limit, or you may unexpectedly need the money in the long wait to the age of 60. If a customer does breach the terms, they will be slapped with a 20 per cent penalty.

Stocks and Shares is a much simpler, more flexible vehicle, and this is reflected in take-up over recent years. However, as EQ Investors chartered wealth manager Freddie Cleworth explains, the Lifetime Isa can still pay off over time and will serve a purpose for a small cohort. “For any high earners maxing out pension contributions and able to fund their full Isa allowance as well, this is another tool in the kit for helping eke the most out of savings and investments,” he says.

Isas: investors' route to riches