Three ways to build an ISA portfolio from scratch

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Putting together a portfolio to weather different conditions is no easy task, even in calmer times. For beginner investors it can be particularly puzzling, given there are thousands of funds to choose from.

To help cut through the noise interactive investor’s Dave Baxter has put together three hypothetical portfolios for different risk levels: cautious, balanced and adventurous.

Dave joins Kyle to explain his choices and how he arrived at the mix of assets. The duo also discuss ‘hands-off’ funds for investors on the lookout for low maintenance options.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly show that aims to help you make the most out of your savings and investments.

The focus for this episode is on how to approach building a portfolio from scratch, and joining me to discuss this topic is Dave Baxter, senior fund content specialist at interactive investor. Dave, welcome back to the podcast.

Dave Baxter, senior fund content specialist at interactive investor: Thanks for having me on.

Kyle Caldwell: So, Dave, you’re going to run through three hypothetical portfolios that you put together for three different risk levels. So low risk, medium risk, and high risk.

Before we delve into those, what would you say are the main considerations when starting to build a portfolio from scratch?

Dave Baxter: I’m going to make two related points. One thing to consider is your time frame and your circumstances, which of course is related. So, say you have 10 or 20 or more years to ride the ups and downs, then really you should be taking maximum levels of risk because you can tolerate that volatility and you’re going to maximise the growth that you can get.

Whereas if you’re, in retirement, for example, or if you for some reason would need your money soon, you need to be a bit more cautious.

The other thing I would highlight, which again is linked, is your appetite for risk and that’s quite interesting because sometimes that can contrast a bit with your actual circumstances. So, you might have time to ride out the ups and downs of markets, but if you’re particularly squeamish and freaked out about a big fall in your portfolio, then maybe just for your own peace of mind, you might take off a bit of that risk.

Kyle Caldwell: I completely agree with everything you’ve just said. I think also when you’re starting out, how much you’ve got to invest is a big factor, and that can help dictate how many funds or investments you choose.

If you’re just starting out with £1,000, you could feasibly just buy one fund, a global index fund or a global exchange-traded fund (ETF), for example, and that’ll give you ready-made diversification, as those types of funds own thousands of shares across the globe, and it gives you lots of exposure to different areas, different countries, different sectors, and different industries.

Whereas as your portfolio hopefully grows over time, or if you do have a larger initial investment amount, you can then consider holding more than one fund, maybe holding several and spreading diversification out even wider.

Dave Baxter: I guess there’s also the question of how interested you are in your investing point. Because perhaps you kick off and, like you said, you’re having a broad tracker and nothing else. Then over time, perhaps you’re watching what it does and then perhaps you go down the rabbit hole of studying a bit more about investing and then you can pick some of your more individual holdings.

Kyle Caldwell: In terms of what to think about when constructing a portfolio, I think the core and satellite approach is a really good rule of thumb for people to consider.

The theory is that if you have around 80% in core holdings, such as a global fund, which you can build a portfolio around, and then the remainder of 20% in more satellite positions, potentially in more adventurous areas such as funds investing in smaller companies or funds investing in the emerging markets or Asia-Pacific region.

A core/satellite approach helps give you a diversified portfolio and plenty of balance.

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Dave Baxter: Yeah, definitely.

Kyle Caldwell: So, let’s move on to the three hypothetical portfolios that you have assembled.

We will put links to each article in the podcast episode description, which will contain the tables of the funds that you’ve selected for each of these hypothetical portfolios. But for those who are listening and watching on YouTube, we’re also going to show the tables during parts of this podcast recording.

Let’s first get into the lowest-risk portfolio or the cautious portfolio.

In terms of asset allocation, talk us through how you decided how much exposure to dedicate to shares, bonds, and alternative investments in this one.

Dave Baxter: To be frank, I’ve been very cautious, very conservative, and just put 20% in shares, and that’s a very diversified exposure. Some people who are cautious investors would have more in equities because even if you’re in retirement, you probably still want to keep growing your portfolio.

But one thing I wanted to explore is the dilemma with the defensive or the cautious side of a cautious portfolio. Because in the past you might simply have held a bit of equities and then put loads of money into bonds because, in theory, bonds should gain in value when stock markets fall.

But we’ve seen some challenges there. In 2022, when we saw interest rate rises, you saw bonds falling in tandem with equities and we’ve had a weird throwback to that with the conflict in the Middle East.

So, you’d be hoping that things like government bonds would be gaining in price while equity markets struggle, but they’ve also fallen because bonds hate the prospects of inflation and rate rises. So, rather than going all-in on bonds, we’ve split it up, as you mentioned.

So, we’ve got 40% in bonds, some government bonds, some corporate bonds, and some inflation-linked bonds. Then we’ve got some gold, some commodities, a bit of property, and also a so-called absolute return fund.

Kyle Caldwell:And the final 20%, is it in equities?

Dave Baxter: Yeah, it’s 20% equities. There we’ve gone for one really diversified fund, F&C Investment Trust Ord (LSE:FCIT), which doesn’t stray too far from the MSCI World Index. I’ve also gone for a MSCI World ex USA tracker, just because F&C is very heavily weighted to the US and, as investors learned or remember from last year, there’s a lot going on beyond the US and there are a lot of returns to be had beyond the US, so I just wanted to give that spread.

Kyle Caldwell: You’ve arrived at 10 different funds, and they’ve all got a 10% weighting. Those listening in and watching the podcast on YouTube will now be able to see a table of your choices.

You’ve already explained F&C Investment Trust. Are there any others that you want to talk through?

Dave Baxter: A lot of these are actually ETFs. I think six of the funds are ETFs or passives of some form because we wanted some very straightforward exposure.

For gold, we simply wanted a physical gold ETC. With bonds, we’ve gone to some broad bond trackers. But perhaps to touch on a couple of more interesting options, you’ve got Schroder Real Estate Invest Ord (LSE:SREI), which is focused on physical property. Property can be a diversifier against equities and it might hold up better if we did see that inflationary environment that is going to threaten bond investors.

One other to highlight, and this might be a controversial take, is the Janus Henderson Absolute Return I Acc fund. A lot of people now probably pretty much hate absolute return funds because they haven’t done that well in recent years. But this one has quite a good record of protecting your capital. It’s a so-called long/short fund, so it does have some exposure to just buying equities, but it also does shorting, so betting on the price of a share falling.

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Kyle Caldwell: Personally, I’m not a big fan of absolute return funds. I think many of them are too risky. If you see that an absolute return fund has, over a one-year time period, delivered a return of 20%-plus, then it’s not really doing its job. These funds are supposed to provide steady returns in a range of different market conditions. If a fund can go up 20% in one year, it can also go down 20% in one year as well.

Now for each hypothetical portfolio, you’ve also come up with some more hands-off options for people who might want to outsource the decision-making on a cautious portfolio. You’ve mentioned that wealth preservation investment trusts are a potential good option. Could you explain why?

Dave Baxter: Yeah, so these are names like Ruffer Investment Company (LSE:RICA), Personal Assets Ord (LSE:PNL) and Capital Gearing Ord (LSE:CGT). They do have some equity exposure, I can’t remember the levels off the top of my head, but it’s relatively moderate. They also use things like bonds, kind of some derivative instruments, exposure to gold, that kind of thing, to try and protect you when stock markets fall out a bit.

So, if you’re a pretty cautious investor and you want a bit of growth but you also want to protect what you’ve spent decades building up, then these trusts should hopefully do that job, and give you a bit of a steady option. But it’s really worth examining the different kind of levers that they use.

Some, like Ruffer, are actually a bit more complicated. They use more esoteric things. And the different funds have very different exposures to different sorts of bonds, to gold, and so on.

Kyle Caldwell: Each of those three wealth preservation investment trusts are potentially really good options for a defensively minded investor. However, the thing to bear in mind is that if you dedicate too much of a portfolio to that type of strategy, you’re potentially going to do that at the expense of long-term capital growth.

Dave Baxter: Yes. That’s the big risk that we overlook with cautious investors, that you are being too cautious and you’re, like you say, giving up growth. Also, you just need to remember that inflation is a thing and you need to keep protecting your portfolio against those rising costs.

Kyle Caldwell:Let’s move on to the medium risk/balanced hypothetical portfolio that you came up with. To start, could you talk us through the asset allocation?

Dave Baxter: So often, again, this is very subjective, but the idea of a balanced portfolio has in the past tended to land on this idea of 60/40, which traditionally was 60% in equities, and 40% in bonds. I’ve done a slightly different version of the 60/40 because of those concerns we discussed earlier about bonds and their outlook.

So, we’ve got 60% in equities but 20% in bonds and then we’ve got 20% split between a gold exchange-traded commodity (ETC) and a commodity ETF. So, hopefully, if bonds do have a rougher period, then those other assets will pick up some slack in terms of protecting investors from equity market volatility.

Kyle Caldwell: With the medium-risk portfolio, you went for 15 holdings, and you’ve dedicated 30% to the iShares Core S&P 500 ETF USD Acc GBP (LSE:CSP1). Talk us through your thought process.

Dave Baxter: I still, like everyone, slightly fear and respect the world’s biggest market. I don’t want to completely bet against the US, but I’m still going sort of underweight the US with some exposure because, as I mentioned before, lots of markets have done really well beyond the US.

There are still these questions about the outlook for the US now, and, obviously, the current president is causing a lot of headaches for markets. So, I’ve got that US exposure, and I’ve got one other US fund to give a different form of exposure, and then beyond that what I’ve done is taken exposures to the main equity markets.

So, we’ve got the UK, Japan, Asia emerging markets, which are kind of bunched together, and Europe. Rather than just picking, say, a fund for the UK and a fund for Europe, I’m trying to be aware that investment styles can wax and wane. So, of course, as we know, value funds have done pretty well in recent years, but before that, so-called quality and growth funds were doing really well. So, I’ve tried to mix or pair a growth fund with a value fund.

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Kyle Caldwell:You’ve got a number of holdings that are a 3% weighting. Do you think that’s sufficiently high enough to do justice in terms of performance?

Dave Baxter: That’s an interesting critique. I mean, you could argue that you might want to be, say, 5% or higher in order to move the dial a bit better. What’s interesting about these pieces is it just really highlights how difficult it can be to build your own portfolio because you’re trying to juggle the different percentages.

I didn’t want to go too wildly underweight the US, but in my quest to do that and have diversification, it means you need to end up with some relatively small fund sizes.

Kyle Caldwell: For me, if you’ve got a holding that’s less than 1%, it’s going to be very, very difficult for that to move the performance dial even if it has spectacular performance. But we are going to come back in a year’s time to review how these portfolios have fared, both on the website and in a podcast episode. So, we will see in a year’s time how much of a difference those 3% weightings have made.

Dave Baxter: Yeah, fingers crossed 3% is the magic number.

Kyle Caldwell: So, for a hands-off investor, which type of funds fit into the category for a balanced investor? The one that springs to mind for me is something like Vanguard LifeStrategy 60% Equity A Acc fund given that it has 60% in shares and 40% in bonds?

Dave Baxter: Yeah. That’s the big beast, isn’t it? It’s a nice no-stress option. It’s very simple. They don’t move those allocations around.

I guess, though, given that I was talking about the question marks around the reliability of bonds, a big criticism of that whole LifeStrategy range is that their only diversifier is bonds.

There are rivals to LifeStrategy, for example BlackRock MyMap and a few others. They do delve a little bit into so-called alternative assets, so they try and diversify a bit differently beyond bonds.

There’s a whole universe out there, but there are also active multi-asset funds, which should try and give you that mix.

Kyle Caldwell: And, of course, at interactive investor we also have our own Managed ISA range.

Let’s now move on to the adventurous portfolio. So, if you’re investing in an adventurous manner, you could in theory have 100% of your portfolio in shares. Is that what you’ve chosen to do?

Dave Baxter: I’ve done 100% in so-called risk assets, but it’s not all shares. Obviously, that’s a very big bit of industry jargon, but it’s 92%, I believe, in equities. Then I’ve chucked the remaining 8% into different forms of private asset exposure.

There’s this argument that listed or public equity markets are shrinking and we’re no longer seeing some of those great growth stories - the most obvious example at the moment being SpaceX - and that they get a lot of their growth before they actually list on to the stock market.

So, I just wanted to spice things up a bit by giving some of that exposure and interestingly, again, it is a dilemma because perhaps some people would argue that an adventurous portfolio now needs to have more in private assets and less than I’ve put into listed.

Kyle Caldwell: And with this adventurous hypothetical portfolio, you’ve once again opted for 15 holdings, and you’ve also again selected iShares Core S&P 500 ETF as the biggest weighting - it accounts for 35% of this portfolio. Could you talk us through the rest of the line-up and how the adventurous portfolio differs from the medium-risk portfolio?

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Dave Baxter: Yeah. So, I’ve tried to have a string of continuity between the three funds. In this case, I’ve stuck with the whole S&P as a core and then paired funds with different styles for given regions. To give an example, we have BlackRock European Dynamic A Acc, which is flexible but can be quite quality growthy, with WS Lightman European R Acc - that’s a value fund. So, that’s how it’s similar to the balanced portfolio.

How it’s different is that I have put in a few punchy satellite funds. So, we’ve got Scottish Mortgage Ord (LSE:SMT), the future trends investment trust. We’ve got AVI Global Trust Ord (LSE:AGT), which is an interesting one because it’s kind of a value fund, but it also holds things like holding companies and it has a lot in Japan. So, it’s offering you access to growth opportunities that you’re not really getting elsewhere. So, that could have some potential.

And then we’ve gone for some private exposure, as I mentioned. So, we have HarbourVest Global Private Equity Ord (LSE:HVPE), that’s one of those big, sprawling private equity trusts. It has exposure to so many different funds and hundreds, I think, of underlying companies. So, that’s a well-diversified PE option.

I’ve also gone for quite a fashionable fund at the minute, which is Seraphim Space Investment Trust Ord (LSE:SSIT). It’s catching that really exciting trend, again predominantly in private assets, and also riding the defence spending trend too.

Kyle Caldwell: And for a more hands-off option, which types of funds would you say fall into the adventurous category?

Dave Baxter: So, you’ve got your simple global trackers, and you can have different mixtures in terms of what exposure you have to the US. LifeStrategy has its own 100% Equity fund and that is much more UK-focused than, say, the MSCI World index.

But don’t forget the active fund because there are some global funds - I mentioned F&C before - which are quite diversified and they can try and act as a one-stop shop.

I would caution that perhaps with some of the really popular names like Scottish Mortgage and Fundsmith Equity I Acc, they can actually be quite focused funds. So, I don’t know if you would necessarily put all your money in those. You probably want to go for a wider spread.

Kyle Caldwell: Yes. Because in the case of something like F&C or Alliance Witan Ord (LSE:ALW), they own hundreds of companies. That does give you greater levels of diversification, and they are a bit more ‘Steady Eddy’ than, say, a Scottish Mortgage or a Fundsmith Equity, which while they do have more potential to outperform an F&C or an Alliance Witan, at the same time, they are more likely to give you more of a volatile ride at certain points.

Dave Baxter: Yeah. It depends on your belief in those stock pickers, doesn’t it, as well, and how much risk you want to take and how much of a bet you want to take on, say, Terry Smith or the Baillie Gifford team.

Kyle Caldwell: Dave, thank you for running through each of those three hypothetical portfolios. As mentioned earlier on in the podcast, we’ll put links to each of the articles and the tables in the episode description. That’s all we have time for today. So, thanks Dave for coming on.

Dave Baxter: Thanks for having me on.

Kyle Caldwell:And thank you for listening to this episode of On The Money. We love to hear from you, and the way to get in touch if you have an idea for a future episode or you have a question that you’d like one of the team to tackle is to email us at: OTM@ii.co.uk.

In the meantime, you can find lots of analysis related to funds, investment trusts, and ETFs on the interactive investor website, which is ii.co.uk. I’ll hopefully see you again next week.