How to build a passive portfolio for a Lifetime ISA

A Lifetime ISA is designed to help you save for your first property, but it can also be used to help boost your retirement savings, too.

Whatever the reason for using a Lifetime ISA, you’re more likely to be looking to grow your money rather than investing for income, and passive funds are one option for your portfolio.

These types of funds track a specific stock market, industry sector or a certain characteristic such as high-quality companies. They are typically lower cost than an actively managed fund because there isn’t a person making investment decisions, instead the portfolio is based on pre-defined rules.

The popularity of passive investing shows no signs of waning. Active fund managers have seen record outflows over the last three years with a significant proportion of that money being reinvested into passive funds.

Nine of the top 10 funds bought by AJ Bell customers in 2024 were passive:

Source: AJ Bell. Most popular funds by net number of trades in 2024, excluding AJ Bell funds. *Active fund.

Passive investing is used to describe both index funds and exchange traded funds (ETFs). There’s little to choose between them for long term investing, other than how they are bought and sold.

ETFs can be traded throughout the day like shares (in market hours) and you’ll know what prices you are buying and selling at. Index funds are traded like other funds – they are valued and traded once a day at what is known as a forward price. The price is based on the value of the fund’s assets, but you won’t know exactly what price you’ll get when you place a deal. Because of the way they’re traded, you might pay different dealing charge for an ETFs vs an index fund.

There are hundreds of passive fund options available, so we’ve broken down what you need to consider into four easy steps.

1) Your investing goals and risk level

Your goal and timeframe will influence how much risk you can potentially take. This should be balanced with how you might feel if investment markets go and up and down a lot in the meantime.

For retirement saving in a Lifetime ISA, you’re probably aiming towards your 60th birthday. You might be willing to allocate most, if not all, of your portfolio towards shares, rather than bonds.

If you’re using a Lifetime ISA to help buy your first home, your time horizon might be much shorter, so you might not want to have as much exposure to shares compared to retirement saving. There are also passive options across different asset classes such as gold and property.

2) Where and what to invest in

Passive funds can help you diversify by holding a basket of investments rather than just one or two company shares or bonds. But you still need to decide what country, region and/or type of industry you’d like to invest in, and in what proportion.

For shares, a simple way to get invested is to use a global tracker fund. This would buy shares in companies all over the world, according to their size and value. This has served many investors well over the last five to 10 years, but you should be aware that close to two thirds of the value of a global tracker will currently be invested in US stocks. You might feel that’s putting too many of your eggs in one basket and want to spread your risk more evenly.

An alternative is to pick your own weightings by region and allocate your money to passive funds that focus on these regions. This is more of an active stance (as you’re making a call on your allocation across different regions) while still using passive funds to build your chosen portfolio.

Diversifying across different regions means that if one region underperforms, hopefully the others will soften the impact of any downturns and smooth the returns you get overall. You’d need to make regular checks on the weighting across the regions and potentially rebalance back to your original allocation if things get out of kilter in the long run.

3) Choosing the funds

Once you have chosen your asset mix and where you’d like to invest, you can choose which funds to include in your portfolio.

It’s usually straightforward to research what index a particular tracker fund is following, but you’ll still need to do a bit of fine tuning. For example, you might decide to allocate 20% of your portfolio to tracking the UK stock market. But would you like to concentrate on the wider FTSE All-Share index rather than pick a fund that tracks the FTSE 100 – restricted to the top 100 shares listed in the UK?

If you’re considering more niche or thematic ETFs that focus on market trends in spaces like artificial intelligence and ESG investing, then you should take care to look under the bonnet and at exactly what index the fund is tracking as these funds can be far from simple.

4) Keep an eye on charges and tracking differences

Even in an area famous for low costs, it’s important to pay attention to what you’re paying. You aren’t going to outperform the market – because you’re simply tracking it – but the return you get should be the market return minus the fund costs.

You’d think passive funds tracking a well-known index would all come in at a similar cost. But that isn’t always case, as the table below illustrates.

Source: AJ Bell, Morningstar to 30 November 2024

Take global tracker funds where the least expensive option comes in at 0.12%, close to the 0.14% average, but the most expensive is 0.57%. The differences are even more stark in the UK space where the least expensive fund has an ongoing charge of 0.08% versus an eye-watering 1.02% at the top end.

Higher fund costs for the same investments will eat into the return you achieve and mean less in your Lifetime ISA pot over time versus a better value option.

Also keep an eye on tracking differences, which is the gap between a fund’s performance versus its benchmark index over a specific period. There will always be a small tracking difference, mainly due to fees and transaction costs.

While differences are measured over specific time periods, tracking error looks at how the differences have varied over time, giving you an indication of the consistency of the fund performance versus its benchmark. A higher number would indicate significant variations in the tracking difference over time.

Ready to research investments for your Lifetime ISA? AJ Bell has a fund screener tool that you can use to filter through index fund and ETF options once you’ve got a plan in mind.