Investing your ISA: Market Trends, Investment Guidelines and Fund Suggestions
Updated: Mar 16
As the ISA investment deadline of 5 April approaches, investment management consultant MATTHEW FEARGRIEVE explains some important market dynamics and trends, and suggests some investment funds for your ISA portfolio.
It’s that time of year again. The deadline for making the most of your £20,000 tax allowance (£40,000 for couples) is midnight on 5 April 2021. Like many savers and investors, you will be pondering which investment funds to buy for your ISA portfolio this time around.
In this blog, I suggest some investment products in key asset classes and sectors for you to consider, and point out others that you should think about avoiding at the current time.
But first, I start with an overview of the current state of play in the key parts of the financial markets.
March 2021: Market Overview
The stock markets continue to show signs of returning to something approaching pre-pandemic “normal”, with the ongoing roll out of Covid-19 vaccines.
In addition, governments in the developed world are committed to their programmes of fiscal stimulus, with the Fed in the US and the European Central Bank (ECB) leading the way. This is giving an added confidence boost for markets and investors alike.
It has come as no surprise that there as been some correction of the sky-high valuations of Big Tech companies listed on the S&P500. February saw some sell-off of Tech stocks, together with some devaluation of the pandemic winners that were always due for a slow-down once the virus started to wane. That said, prices of Big Tech and Pharma on US and other exchanges remain buoyant – and high, with some analysts predicting further downward correction.
The key troublesome asset since the start of the year has been debt, or bonds. Bond valuations (and, therefore, funds that are invested in bonds) are currently subject to two discrete market pressures that are negatively impacting debt as an attractive investment option right now: inflation and government fiscal stimulus.
First, inflation. Many commentators now agree that inflation is on the visible horizon. Conditions for an inflationary economic environment look right: fiscal and monetary stimulus packages are on their way, like President Biden’s whopping US$1.9 trillion package, and the ECB has similarly reiterated its commitment to providing monetary support to the Eurozone; furthermore, these government initiatives are combining with widespread pent-up demand on the part of hundreds of millions of consumers who have saved money over a year of lockdown. These are factors that normally usher in a period of price inflation.
Inflation is problematic for bonds. When prices rise at a rate greater than the interest earned on a bond, it follows that the value of the fixed income delivered by the bond will fall in real terms. Consider a five-year bond paying 2% nominal interest. If inflation rises to 2.5% for those five years, the income paid by the bond won’t be able to keep up.
The second economic dynamic that is impacting bond markets right now is the rise of bond yields (the return on a bond), triggered by the roll-out of worldwide stimulus packages, particularly in the US and Europe.
When governments pump out debt, the price of bonds falls, whereas the yield (which is inversely related to price) rises. US and European governments have been spooked by the recent emergence of so-called bond vigilantes, bond investors who want to discourage monetary or fiscal policies by selling bonds in large amounts, thus increasing yields. This in turn makes borrowing more expensive for governments.
The 10-year US Treasury yield has risen from around 0.9% at the start of the year to 1.6% at time of writing, while the so-called five-year break-even rate, which indicates the outlook for prices in five years’ time, recently hit 2.5% for the first time since 2008, notwithstanding expectations that official short rates will stay low and inflation forecasts are still at acceptable levels, despite the market forcing interest rates on longer bonds up.
There has also been a modest rise in bond yields in Japan, the Eurozone and the UK, even though these economies are not announcing big new stimulus measures on top of previously-announced anti-pandemic spending.
Rising yields in turn depress bond prices, making investment products in this asset class less attractive. These two market forces – looming inflation and rising yields – have caused the market value of bond funds to fall in recent weeks.
For more about the bond markets and their impact on your investment portfolio click here.
As you know, traditional investing wisdom dictates that you should hold higher proportions of bonds in your personal portfolio as you get closer to retirement, based on the premise that bonds are less risky than equities (stocks and shares) and pay a steady income.
That wisdom is being challenged right now, given the difficulties in the bond markets. Nevertheless, bonds can and should feature in the portfolios of most investors, and I will explain precisely how, when I come to suggest some bond funds for your ISA (below).
Investment Ideas for your ISA
Let’s forget the complexities of the bond markets for the moment, and focus on the mainstay of your ISA portfolio: equities. Weakness in the bond markets traditionally signifies recovery and strength in the stock markets, and for the majority of investors who are not yet nearing their personal retirement age, investments in shares are needed for higher returns.
Inflation isn’t all bad news for equities, although inflation expectations have impacted the US Nasdaq index, dominated by Big Tech as it is, which has fallen by more than 8% in the past two weeks alone, heading towards a correction of the pandemic-long over-valuations in the order of 10%.
This correction will, however, leave much promising and good-value stock in the Nasdaq, along with exposure to some great companies whose share price should do well as markets and economies recover post- covid. So I personally decided to brave the recent Tech sell-off, by buying for my ISA Invesco EQQQ Nasdaq-100 UCITS ETF , a fund rated by Morningstar with Five Stars and attractively costed with an OCF of 0.3%.
Turning to the UK, and mid-cap companies listed on the FTSE250 are looking like good value. As deal-making has resumed post- covid, with debt financing being dirt cheap, UK mid-cap companies are at the centre of interest from overseas strategic buyers like private equity firms. FTSE250 companies will be of interest to buyers like these, given their low valuations (post- covid and post- Brexit) and the fact that they are not too big, but still sufficiently large to make a difference to the global strategies of interested bidders.
So, with the FTSE250 hopefully set for some M&A activity over 2021 and 2022, I chose for my ISA the X-Trackers FTSE250 UCITS ETF. For an annual fee of just 0.16%, this well priced index-tracker will give your portfolio affordable exposure to these interesting developments in the UK mid-cap space.
Given the uncertainties in the bond markets, many investors will prefer to move some of their debt investments into cash, whilst we wait to see where longer-term bond rates end up.
You can still buy bond funds for your ISA, though; just make sure that you follow two protective rules: first, avoid bonds with longer maturities, say, anything over three to five years. Bonds with longer maturities are more exposed to changes in interest rates, meaning they have more to lose if rates rise (which they invariably do, once inflation kicks in).
Second rule: use inflation-linked bonds as a way of keeping your money in fixed income whilst protecting against inflation risks. The coupon offered on these bonds is linked to a rate of inflation, meaning the interest they pay rises as inflation goes up.
The iShares USD TIPS 0-5 UCITS ETF (GBP Hedged) combines both protections, by investing in index-linked US Treasury Bonds with short maturities (0-5 years). With a respectable performance history, a low buy price (around £5 per unit at time of writing) and an annual charge of 0.12%, this product allows you to include bonds in your portfolio and hedge against possible losses due to inflation.
A suitable bedfellow for this fund could be the Lyxor Core UK Government Inflation Linked Bond UCITS ETF, providing access to UK government bonds with in-built protection against inflation, for an OCF of just 0.07% (upside) and a rather high per-unit buy price of around £20 (downside).
Finally, a fund providing access to global government bonds with index-linked protection against inflationary pressure: the iShares Global Inflation Linked Government Bond UCITS ETF , a fund with a Morningstar rating of Four Stars, and an OCF of just 0.20%.
Important: this blog contains the author’s opinion only, and does not constitute professional investment advice, nor should it be relied upon when making investment decisions, for which you should always consult your own financial adviser.