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Isa asset allocation for unsettling times

Market turbulence highlights the importance of diversification
Isa asset allocation for unsettling times
  • Recent market shifts will test portfolios that have leaned too heavily into growth investments
  • Diversifying is essential but do this in moderation

The UK is now home to more than 2,000 'Isa millionaires'. That’s testament to a good degree of patience, substantial individual savings account (Isa) contributions and some great investment returns.

That said, markets never go up in a straight line. That has become abundantly clear in the opening months of 2022, with markets tanking and many former investor favourites, from tech stocks to various popular Baillie Gifford funds, racking up alarmingly high paper losses. Initially sparked by concerns relating to inflation and interest rate rises, this panic had ramped up at the time of writing with the Russian invasion of Ukraine sending markets further into tailspin. 

Isa investors surveying the sea of red may well be tempted to panic sell, overhaul their portfolio or simply ignore the problem. But there is a more prosaic solution. With monetary tightening testing the former market winners and geopolitical strife heightening equity volatility, now is the time to consider how diversified your Isa really is and where it is appropriate to tinker.

With regard to monetary policy, some investors may have found themselves overly exposed to the US and highly valued tech stocks, or funds that have heavily invested in them over the years. And this may have resulted in their portfolios being overly exposed to growth assets. But if a remedy is required for inadequately diversified portfolios, the asset allocation rules of thumb we outlined in Getting asset allocation right in your Isa (IC, 11.03.21 ) should still hold.

Rob Morgan, chief analyst at As Charles Stanley, says that investors should also avoid "getting carried away" with portfolio inflation-proofing or style rotations. He argues that we could well enter a more deflationary environment within a couple of years, reinforcing the argument for balance rather than one-way bets.

 

All out growth and the road to diversification

If the opening weeks of the year have been deeply unsettling, investors with a long time horizon should be able to stay the course. If you can stay invested for the next 20 years or longer, and are willing to ride out the ups and downs of markets, you can still target all-out growth by backing 'risk' assets. You could even top up on the likes of beaten-up tech names where appropriate. But smoothing out the ups and downs by making regular portfolio contributions and staying properly diversified is still important.

An all-out growth mindset could apply to an investment Junior Isa set up for children or grandchildren, or a stocks and shares Isa run by an adult looking to maximise their assets either indefinitely or ahead of retirement. Likewise, those using a Lifetime Isa as a means of maximising long-term gains for retirement, rather than for a house deposit, would fall into this category.

Whichever of those boxes you tick, the asset allocation calls remain relatively simple. Provided you can withstand the volatility, allocating predominantly or exclusively to equities is a reasonable approach, with an added caveat about the need for diversification. As Jean-Paul Jaegers, head of asset allocation at Barclays Wealth and Investments, puts it, "diversification is a lot like a healthy diet" and portfolios need a little of everything. 

Within equity portfolios, this has applied to investment styles in recent history. Fans of growth and quality investment styles, including many Baillie Gifford fund managers, Nick Train and Terry Smith, have hit bumps in the road after multi-year successes, while 'value' plays have fared better. Take the strong returns made by commodities in recent months or the more promising outlook for banks if interest rates rise.

Some investors may have loaded up on the obvious winners of recent years such as Fundsmith Equity (GB00B41YBW71), US equities and tech. Or they may have allowed allocations to drift to the extent that their portfolios are too heavily weighted to one style. While piling fully into value is not advised, it makes sense to have a foot in each camp. For investors who seem overly reliant on the growth style, it would make sense to buy into value with future contributions to reset the balance, rather than selling out of growth names and crystallising recent losses.

Diversifying by style can take different forms. Especially when it comes to using passive funds, some of the major equity markets can act as proxies on these investment styles, from the energy and financials-heavy FTSE 100 index to the dominance that the FAANG tech stocks, stalwarts of the growth styles, have maintained in the US. But diversifying within individual regional allocations can make sense.

As we explained in Funds to hold alongside Fundsmith Equity and Scottish Mortgage (IC, 29.10.21), positions in growth-minded global equity funds such as Fundsmith Equity, Scottish Mortgage Investment Trust (SMT), Lindsell Train Global Equity (IE00BJSPMJ28) and Rathbone Global Opportunities (GB00BH0P2M97) could be offset by exposure to value plays such as Ninety One Global Special Situations (GB00B29KP103) and Schroder Global Recovery (GB00BYRJXL91). Similarly, dividend plays such as M&G Global Dividend (GB00B39R2Q25) can work as a counterbalance to the big growth funds.

There are multiple fund options for exposure to each of the main geographic regions. To give a very basic sense of which funds and investment trusts might have contrasting approaches, I have singled out some of the best active performers of 2020, a year when growth and quality investors prospered. For the value options, I have identified some of the leading funds so far this year, given that cyclical assets have until now fared better than the growth plays. But this approach can be a blunt tool. For example, the performance of Asia and emerging market funds depends in large part on their exposure to Chinese equities, which strongly outperformed in 2020 before running into trouble. And the list does not include funds from income or small-cap sectors.

Contrasting fund options by equity region
MarketPossible growth/quality options which were 2020 winnersPossible value options which have been 2022 winners, as at 24/02/22
UKMarlborough Special Situations, Baillie Gifford UK Equity Focus, Slater RecoveryInvesco UK Opportunities, Schroder Recovery, Jupiter UK Special Situations
USBaillie Gifford US Trust, Morgan Stanley US Advantage, BNY Mellon US OpportunitiesFidelity American Special Situations, BlackRock US Opportunities, M&G North American Value
GlobalScottish Mortgage IT, Marlborough Global Innovation, GAM Star Disruptive GrowthJupiter Global Value, Schroder Global Recovery, Ninety One Global Special Situations
AsiaPacific Horizon IT, BNY Mellon Oriental, Allianz Total Return Asian EquityInvesco Asian, M&G Asian
Emerging marketsBNY Mellon Global Emerging Markets, Aubrey Global EM Opportunities, Polar Capital EM StarsM&G Global Emerging Markets, Lazard Global Emerging Markets
EuropeBaillie Gifford European Growth Trust, Premier Miton European Opportunities, BlackRock European DynamicLightman European, Schroder European Recovery
JapanJPMorgan Japanese IT, Nomura Japan High Conviction, Martin Currie Japan EquityMan GLG Japan CoreAlpha, Polar Capital Japan Value, M&G Japan
Source: FE. Mainstream IA and AIC growth sectors used. Income and small-cap sectors not included

Geographic diversification still matters, and ties in with not relying too heavily on 'market darlings'. Dean Cheeseman, multi-asset fund manager at Janus Henderson, notes: “Over the last two years, a period dominated by quantitative easing but also complicated by Covid and the structural challenges posed by lockdowns for more cyclical industries, US growth stocks have massively outperformed. Entering that market now as the tailwinds are beginning to recede may incur elevated volatility.”

He argues that long-term investors who can tolerate ups and downs should turn their focus to emerging markets, an area he views as promising after some disappointing years.

All-out growth investors can afford to be ambitious, and this could include backing some riskier funds and regions, and taking a punt on promising themes. This could be done via broader thematic funds such as Pictet Global Thematic Opportunities (LU1437676809). Or, if relevant, diversified environmental, social and governance investing funds such as those in the Liontrust Sustainable Future range. But if the themes of the future, such as battery technology and clean energy, appeal it is important to remember that more targeted funds are highly vulnerable to the risks of market timing (see Further Reading: The drawbacks of thematic ETFs, IC, 25.02.21).

Like many asset classes, equities can struggle in the face of inflation. Morgan therefore warns investors not to write off other options if they can generate similar returns. “At the moment I think some of the inflation friendly income oriented areas look quite interesting, such as infrastructure investment trusts,” he says. “Private equity would be another diversifier, though – arguably – it’s not a different asset class as it’s still equity.”

 

The challenge of 'balanced' growth and 60/40

Asset allocation gets trickier for those not far from or already in retirement. The level of risk you take at this stage depends heavily on circumstances. Morgan notes that those with substantial resources beyond their Isa, such as defined benefit pensions, may maintain an aggressive growth approach to maximise their Isa assets. But circumstances, and the fact that pensions can be worth preserving for as long as possible because they can be passed onto beneficiaries without incurring inheritance tax, may result in you being more reliant on your Isa and more risk averse.

Some old rules of thumb still apply. Morgan and Cheeseman point to a '60/40 portfolio' – 60 per cent invested in equities and 40 per cent in bonds – as a starting point. But Morgan also suggests adding an element of inflation protection. Options include infrastructure investment trusts, property, gold and commodities. A mixture could be a good bet in times of uncertainty, although a few defensive investments had held up well between the start of the year and late February.

Government bonds, in particular, are worrying some investors, given their high valuations and exposure to both inflation and interest rate rises. This has led to some notable calls: Peter Doherty, head of fixed income at Sanlam, declared in early 2022 that it made sense to “mininimise holdings of government bonds in favour of cash”, as sovereign bonds were more at risk of losing their nominal value. Cash could form part of your arsenal and even allow you to top up holdings when markets fall, but it is undeniably vulnerable to recent high levels of inflation.

Others have turned to previously out of favour sub-sectors as a defensive play. Sam Dovey, group head of fund research at Ravenscroft, has been looking to increase allocations to global equity income, arguing that quality and near-term cash flows tend to be highly valued at times of elevated uncertainty. Yet she is also sticking with some classic safe-haven assets including conventional and index-linked government bonds.

 

Income

Generating income without taking too much risk is also a tricky undertaking, although you could run a balanced portfolio and take capital gains where needed instead. Equities are likely to be a big component of income portfolios – the UK market has made a strong recovery following cuts, cancellations and suspensions after the outbreak of Covid in 2020. But diversification is still key. Asia, for example, has strong income prospects and global equity income funds can offer a mixture of exposures.

Other options include infrastructure investment trusts which offer equity-like yields and often have inflation protection. But these trade on hefty share price premiums to net asset value. Riskier bonds also offer reasonable yields and some of the riskier strategic bond funds such as Royal London Sterling Extra Yield Bond (IE00BJBQC361) and Artemis High Income (GB00B2PLJN71) offer substantial yields.

And loan funds such as CVC Credit Partners European Opportunities (CCPE) generate attractive levels of income via debt with a link to inflation.