How to invest £500 per month in your ISA

Regular investing is the best way to build a nest egg, but how should you choose where to invest?

Part of the challenge of becoming a regular investor is simply making the decision to allocate spare cash to a suitable account each month - an ISA being the obvious choice, in that your money grows free of income or capital gains tax, and there’s no tax to pay on withdrawals either.

But another big challenge is the question of how to invest the money in the ISA. It’s all too easy to feel like a rabbit in the investment headlights: there is just so much choice.

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More than 600 investment trusts are available on the ii website, for example, while according to the Investment Association (IA) almost 4,000 open-ended funds are available to retail investors in the UK. So, what should you be thinking about as a regular investor?

When you’re starting out with a relatively small monthly investment, there are obvious ‘one-stop shops’ to make use of. You could choose a cheap index tracker fund, which aims to do as well as the benchmark stock market index – the FTSE All-Share, for example – but won’t outperform it.

A more robust option is along the lines of interactive investor’s low-cost, mixed-asset Quick-start range of individual funds. Choose from the passive Vanguard LifeStrategy choices, or the actively managed alternatives from Columbia Threadneedle.

Both ranges invest in bonds as well as equities to help manage risk, with different options according to how much risk (in terms of exposure to equities) you are comfortable with.

Merits of diversification

Funds such as the ii Quick-start choices are inherently well-diversified, in that they provide a good geographical spread of equities (different stock markets have different strengths, and not all are equally impacted by wider events) and and also include bonds, which have historically performed relatively well when stock markets fall.

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Nonetheless, if you invest in just one fund, your investment is entirely dependent on its fortunes. As and when you’re able to increase monthly contributions, therefore, it makes sense to reduce that level of vulnerability and potentially enhance returns by branching out to include other asset classes, equity markets and company sizes, and other managers with different investment styles.

Ben Yearsley, director at Shore Financial Planning, explains: “It’s vitally important to have different types of equity with different drivers - you want growth, value and defensive stock exposure, as well as different asset classes such as infrastructure, commodities and property. What you don’t want is all your investments pointing in the same direction or being driven by the same factor – low interest rates, for example.”

Routes to diversification

One way to diversify is by adding exposure to more specialist investments focusing on, say, biotech, emerging markets or a thematic approach. Such funds tend to be more volatile in the short term, but can boost returns over the longer term.

Smaller companies are another attractive proposition as you rethink your portfolio. Although they are by definition less well-established or far-reaching than large companies, small-caps have the potential to grow much faster from a low starting point. They’re adaptable, focused, and also tend to be concentrated in forward-looking industries where demand is increasing generally.

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To put that potential for faster growth into context: the Association of Investment Companies UK All Companies investment trust sector has seen an average share price increase of 122% over the past 10 years (to 20 February), compared with 149% for the UK Smaller Companies sector. That’s despite the fact that the latter had a particularly tough time in the pandemic during 2020, and again as inflation bit and interest rates rose last year. 

Especially in these more specialist parts of the investment universe, investment truststend to come into their own over the long term. AIC research shows that over the 10 years to end January 2023, investment trusts outperformed open-ended funds in 10 out of 16 leading sectors.

Trusts are structured differently from funds, and as a consequence have certain features that add some risk in falling markets but help to boost their long-term returns. For instance, unlike funds they are allowed to borrow money to invest, which helps enhance returns when times are good but makes market declines more painful.

In addition, as Yearsley mentions, there’s a diversification role for alternative investments such as renewable energy, commodities, property and infrastructure.

Investment trusts are a natural home for this type of illiquid investment because their closed-ended structure means that when the fund’s value has fallen and investors want their money back, they sell their shares in the stock market rather than the manager having to liquidate holdings at short notice to provide cash.

However, it is also possible to find open-ended funds that invest in alternatives.  Yearsley suggests funds such as VT RM Alternative Income F GBP Acc (BGV7K90), ARC TIME UK Infrastructure Inc II C Acc (BP5GQC1) or Janus Henderson Diversified Alternatives.

Overall, he says: “For most investors I’d still be looking at 75% or more in equities, because most people need their pot to carry on growing and only real assets let you achieve that.”

So, how can you go about gaining that broader exposure?

Core and satellite approach

One option is to keep ahead with the cheap ‘core’ exposure you’re building up, but allocate a part of each month’s contribution to one or two ‘satellite’ or specialist options.

Yearsley says another way of keeping it simple is to use multi-asset funds such as Troy Trojan or trusts such as Ruffer Investment Company (LSE:RICA), which hold a broad mix of assets including equities, bonds, gold, commodities, property and private equity. The mix is adjusted by the manager according to the economic backdrop. “You could have one of these as your core holding then build more specialist equity funds around the edges,” he says.

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He recommends “a good 60% in core funds and the rest in more specialist”. As a relatively steady alternative to multi-asset investments, he likes equity income funds, which tend to hold shares in larger, more robust companies and also benefit from reliable dividend payments even if capital values are falling.

Multi-manager funds

Another possibility is to make use of an actively managed multi-manager fund or trust, where the manager builds and manages a portfolio of specialist funds rather than individual equities, bearing in mind the combination of investment styles, market capitalisation and geographical focus.

These come in different guises: some use only or mainly in-house funds, while others aim to identify ‘best in class' boutique managers. Many are run primarily for use by professional investment advisers for their clients (fund houses including Barclays, Jupiter, Premier and Vanguard are widely used), but some cater for retail investors.

Alliance Trust (LSE:ATST) is an interesting example of the latter, with different parts of the portfolio allocated to specialist managers with very divergent styles and focuses. The Unicorn Mastertrust fund is a readymade portfolio of investment trusts in open-ended fund form.

Readymade portfolios

If you’re prepared to put together a portfolio yourself from scratch, brokers including interactive investor offer so-called model portfolios with suggested weightings for each fund.

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These are particularly useful because they are designed specifically to cater for the needs of growth or income investors. Even if you don’t stick rigidly to the suggested funds or allocations, they’re useful as a blueprint and source of investment ideas.

If you want to stick closely to the model, you will need to divide your existing ISA across the funds according to the proportions specified, and also set up regular payments from your monthly £500 contribution. Regular investing is free with ii, and you can invest across up to 25 different holdings.

The ii portfolios are also monitored regularly, so it’s possible just to adjust your holdings in line with the models. If you’ve followed a portfolio that is not being monitored, you’ll need to be prepared to check each fund is still performing as it should on a regular basis.