Isa investment strategies for uncertain times

With the tax environment growing increasingly hostile for investors, shovelling as much money as possible into individual savings accounts (Isas) and pensions seems to be a straightforward choice. Unfortunately, the no-brainers end there: whateverthe goal, choosing the best mix of investments has always been the most challenging task. It’s one that has been amplified by recent uncertainties: high inflation and rising rates continue to worry away at markets, while a global recession remains a possibility. What’s more, many of the funds and shares that have graced the top of the performance tables for many years suffered a horrendous 2022 – prompting valid questions about their prospects and on how to assemble the best combination of holdings.

Tricky as it is to build the right Isa portfolio, certain rules of thumb can prove useful. Knowing your goal, and the best approach to asset allocation, can at least set your Isa on the right path.

Starting with the easy part

It’s important to first identify the targets set for your Isa based on your circumstances, risk tolerance and general preference. Some individuals are simply looking to grow their wealth and can leave their investments alone for 20 years or more – thanks perhaps in part to them having a separate rainy-day fund for emergencies. This category could capture all manner of scenarios, from parents looking to get the most out of a Junior Isa to Lifetime and stocks and shares Isa users playing the long game.

Those seeking all-out growth tend to embrace so-called ‘risk’ assets by investing predominantly or totally in equities – with possible room for small exposures in other areas that might deliver strong returns over time, from private equity to property. Here it’s important to maintain a long-term mindset, especially in a year like 2022 when indices can fall steeply and most asset classes take losses. “You can have a bad year and re-emphasise that it doesn’t matter – your objectives are longer-term,” says Alex Brandreth, chief investment officer at Luna Investment Management.

Certain good practices can help investors ride out the ups and downs of markets, and making regular monthly investments is one discipline that can be especially useful at points of volatility as it allows investors to buy in ‘cheap’ when valuations are low. That can offset the expense of buying into a rising market, and more generally leaves investors less exposed to the risks of market timing.

All-out growth investors should also remember that diversification still serves a purpose. There are a few elements to this. Some investors will have discovered lately that they are insufficiently diversified by style: growth investments, exemplified most obviously by the likes of US tech stocks and many of the funds run by Baillie Gifford, dominated for much of the past decade until a bout of high inflation and rising rates brought them crashing down. To look at some prominent victims of this reversal, Baillie Gifford’s flagship vehicle, Scottish Mortgage (SMT), left shareholders sitting on a 45.7 per cent loss last year, with unlisted growth play Chrysalis Investments (CHRY) down by nearly 70 per cent. The more sedate but nevertheless growth-minded Fundsmith Equity (GB00B4Q5X527) was down 13.8 per cent.

Many investors are likely to have found that their portfolios had become overly skewed towards the growth style, with little in the value stocks that have underwhelmed for much of the past decade. A glance at 2022 returns from funds in the Investment Association’s UK All Companies sector shows value portfolios such as Invesco UK Opportunities (GB0033031153), Jupiter UK Special Situations (GB00B4KL9F89) and Man GLG Undervalued Assets (GB00BFH3NC99) ranking highly, with similar trends elsewhere. Contrarian fund Lightman European (GB00BGPFJN79) bested most of its peers, with names such as Ninety One Global Special Situations (GB00B29KP103) and Schroder Global Recovery (GB00BYRJXL91) faring much better than many of their growth-focused rivals.

The growth funds that suffered so badly in 2022 have at least recovered some ground in the very early weeks of this year, but it is possible that a longer period of outperformance awaits some of the classic value stocks of the past decade, such as energy names. The important thing, however, is to remember to stay diversified across styles and not lean too much on the current winners. “Stay balanced, even if a style does badly for 10 years,” says Downing fund manager Simon Evan-Cook. “In 2022 people had abandoned value almost completely. There’s a danger that reverses for the next decade [with investors abandoning growth].”

It’s therefore worth holding a mixture of different styles – and this can be done in a few ways. You could pair up growth and value funds within an allocation to the same geographical region (over the page we have listed some funds in different regions broadly known for having a distinct style bias). You can also back certain stock markets as a proxy for different styles via passive funds.

The FTSE 100 still serves as a play on some very cyclical companies and can offer value exposure, while the S&P 500 still stands out for the presence of the big tech stocks. Using markets as style proxies can, however, be a blunt instrument: the European market is also viewed by some as a ‘value’ region but had an especially tough 2022 due to idiosyncratic issues including the energy crisis.

Diversifying by geography and looking beyond UK shares alone can also make sense, although choosing the best allocations here can be tricky. “Regional allocation is one of the hardest things for DIY investors to approach,” says Laith Khalaf, head of investment analysis at AJ Bell. “One option is to go very active – say you really like Europe and the UK but not the US and emerging markets, so you tilt your portfolio that way. That could go wrong very easily and unless you have a reliable crystal ball you might struggle to determine the direction of markets.”

One approach mooted by Khalaf is to either simply buy a global equity tracker or an active fund roughly in line with its allocations, or to actively allocate your money based on the make-up of the MSCI World index. A problem here, however, is that MSCI World remains heavily tilted towards US stocks, which made up nearly 70 per cent of the index at the end of January. Successful as the US market has been in recent years, investors might be tempted to have a good allocation here but spread the money out more broadly. “You could just pick five major markets and put 20 per cent in each,” Khalaf suggests.

For those wondering when to back active or passive, the MSCI World conundrum highlights some important dividing lines between the two. A global tracker will often be very US-heavy, something that a handful of active funds deviate from. In the UK, active funds tend to focus more on small- and mid-cap stocks than a typical tracker, while Asian and emerging market indices tend to be very heavily exposed to China.

Some active Asia funds including the Pacific Assets Trust (PAC) tend to look past China, while a few emerging market exchange traded funds (ETFs) that exclude the region, such as the Lyxor MSCI Emerging Markets ex China UCITS ETF (EMXC) have launched in recent years.

We’ve noted before that investors with a long time horizon might also be tempted to focus on promising investment themes rather than simply going for funds with geographic remits. The options are numerous here, from dedicated thematic ETFs focused on trends such as the energy transition, the digitalisation of everyday life, and ageing populations to funds focused on future developments, such as Scottish Mortgage. More established sector funds can also play a role: Evan-Cook highlights the Polar Capital Global Insurance Fund (IE00B61MW553) as his favourite thematic portfolio of the past decade despite it being “possibly the most boring theme”. “That is a real tortoise of a fund, and insurance seems to me to be a win, win situation,” he adds.

We have previously discussed the drawbacks of thematic funds – from the risks of hype and market timing to issues with portfolio construction. For those who nevertheless want exposure, it might make sense to restrict the size of such positions.

Balanced portfolios

Many investors will wish for capital growth, but with less risk and some element of capital preservation. That can certainly be the case for those approaching or in retirement, but younger investors might also have reason to have a shorter timeframe than 20 years plus. “You need to look at the financial goal and see how far away you are from needing the money,” Khalaf notes.

Assembling a balanced growth portfolio can be challenging, but rules of thumb do apply. Much as it has been derided in recent years, the traditional 60/40 portfolio does have merits. Bonds finally offer higher yields that are attractive in their own right but also have room to fall (meaning prices rise) if investors get spooked and seek out a safe haven. Luna’s Brandreth, for one, has spent recent years using a ‘60/30/10’ approach, with the lion’s share in equities but a 30 per cent allocation to alternatives and 10 per cent in bonds. The bond allocation has now risen to 20 per cent to reflect the fact that bonds “do offer a return”.

An alternatives bucket in your portfolio can contain all manner of options: think property, generalist and renewable energy infrastructure and more esoteric asset classes such as music royalties and even ship leasing. Alternatives have plenty to offer; infrastructure, for one, has a huge following thanks to the high yields on offer, a degree of inflation linkage in some cases and the theory that such assets are not reliant on the economy doing well.

Appealing as alternatives seem, lessons about diversification and position sizing apply here, too. The risks can be both highly idiosyncratic and difficult to anticipate with specialist assets, as highlighted by the recent problems of the once highly popular Home Reit (HOME). The diversifying credentials of alternatives have also faced some questions after the likes of property and infrastructure trusts sold off in line with the spike in gilt yields in late 2022. Others have their own doubts: one professional investor who wished not to be named notes: “I’m not convinced on most of the alternatives being able to prove defensive in a sell-off. Quite often in the alternative asset area people have carved out a niche of what would be an equity anyway and positioned it as an alternative asset class. For example music rights – it’s a good asset class but why should it be an alternative asset class when you have companies like Sony (JP:6758)? I don’t see how carving out small parts of companies makes them defensive.”

Investors therefore have a few choices. They could go for a spread of alternatives alongside traditional diversifiers such as bonds and gold, and perhaps consider those few names that have proved truly differentiated in market crises such as hedge fund vehicle BH Macro (BHMG). Position sizing is also important: some specialists, for one, would not have an allocation of more than 5 per cent in a given specialist vehicle.

The professional investor quoted above would instead turn to cash. “With a balanced growth portfolio I would go with equities but less in them,” they say. “If I have £100,000 to invest and I’m an all-out growth investor I put all the money into equities. If I have less time to stay invested or a lower appetite for risk I put 50 per cent in equities and 50 in cash.”