What is an Investment ISA - the basics
Whether you want a potentially higher return than you get from your cash ISA; you'd like a more tax-efficient way to invest in the stockmarket; or you'd simply like to make full use of your annual ISA allowance, a stocks and shares ISA is worth considering.
These allow you to invest in a wide variety of stockmarket-related assets, including shares, government bonds (gilts), corporate bonds, investment trusts and unit trusts - and pay less tax than if you held the same assets outside of an ISA.
Stocks and shares ISAs are exempt from capital gains tax (CGT). Outside of the ISA wrapper, you would have paid CGT on any profits in excess of the annual tax-free allowance (£10,600 in 2011/12) at 18% if you're a basic-rate taxpayer or 28% if you're a higher-rate taxpayer.
Higher-rate taxpayers additionally benefit from paying less tax on any dividend payments they receive. Outside of an ISA, they'd have to pay 32.5% tax on dividends but within an ISA wrapper they don't have to pay any tax, bar the 10% tax deducted at source. But for basic-rate taxpayers, who would only have to pay 10%, there are no further savings.
The income tax position is slightly different for fixed-interest investments such as gilts and corporate bonds. With these, because the income is classed as interest, it is treated in the same way as interest paid on a cash ISA, meaning that all taxpayers are better off investing within the wrapper.
You can invest your full ISA allowance in a stocks and shares ISA, although this will be reduced by anything you put into your cash ISA. With the cash ISA allowance of £5,340 in the 2011/12 tax year, the maximum you can invest in a stocks and shares ISA is anything from £5,340 to £10,680. From the start of 2012/13 tax year on 6 April, the allowance will increase to £11,280, of which up to £5,640 could go into a cash ISA.
CASH VERSUS STOCKS AND SHARES
While some investors save into a stocks and shares ISA to take advantage of their full ISA allowance, others do so because of the potential for higher returns. "Over the long term, the additional risk you take with stocks and shares should be rewarded with higher returns," says Jason Witcombe, director of Evolve Financial Planning. "Over most five-year periods you would be better off investing in the stockmarket than in cash." But there is a price to pay for this additional potential return.
Stocks and shares ISAs are more risky and, unlike cash, the value of your investment could fall rather than increase. There are ways to reduce the likelihood of this happening.
First, it's essential to give your money sufficient time to ride out the ups and downs of the stockmarket. As a minimum you need to be able to leave your money for at least five years, ideally longer.
Additionally, as stockmarkets can behave unexpectedly, it's important that you're not relying on the money. For instance, if your stocks and shares ISA is worth £5,000 and you know you need it to pay off a car loan in a year's time, it may be sensible to move it to less risky assets or move it into cash rather than run the risk of its value falling.
Diversification is also important. If you only invest in the shares of one company, the performance of your money is completely dependent on that company's fortunes. If it goes bust, you could lose the lot. By spreading your money across a number of different companies and investments, if one goes under you won't be as badly affected.
You may also want to mix up the types of investments you hold. There are four main asset classes: cash, which you can hold through your cash ISA; property; equities; and fixed interest. Witcombe explains why it's good to have a mix: "In 2011, equities performed badly, while the top performers were fixed-interest funds. It could be the other way round this year so it's worth having exposure to more than one asset class."
While it's possible to diversify your investments yourself, the easiest way to do this is through a collective investment.
As the name suggests, these are ready-made portfolios of investments with each unit or share you buy giving you exposure to all of the underlying investments. Depending on the collective investment, this could mean an instant portfolio of anything from 20 to 250 companies for an investment of as little as £50 in some cases.
The collective approach can also work out to be more cost-effective for investors with smaller pots. Even with a relatively concentrated portfolio of, say, 20 shares and a modest share dealing charge of £7.50, you'd rack up dealing charges of £150 to replicate a fund's portfolio yourself. Conversely, a fund would levy a charge of up to 5.5% of your investment to get the same exposure, which on an investment of £1,000 would equal a less costly £55.
There are two distinct types of collective investments - open-ended funds, which include unit trusts and open-ended investment companies (OEICS), and closed-ended funds, which include investment trusts.
Although both invest in the same way, there are important differences. While an open-ended fund can issue more units as demand increases, a closed-ended fund has a limited number of units. This means that as well as being influenced by the performance of the underlying shares, the price of a unit in a closed-ended fund will also be affected by supply and demand.
As an example, if you invest in a closed-ended fund, for instance an investment trust, and it performs strongly or is in a sector that is particularly attractive, demand for units will increase.
This will mean your investment is worth more than the value of the underlying assets. This is an advantage of closed-ended funds but, unfortunately, it can also work against you when a fund or sector falls out of favour. If this happens you could find the price dragged down, so the units are trading at a discount.
Whether you choose to invest in closed-ended or open-ended funds, you'll face a number of charges. As closed-ended funds are bought and sold through the stock exchange, you'll pay a dealing charge when you buy. This varies but many of the investment trust companies have arrangements, especially on their ISAs, where they pool all their investors' money to enable them to negotiate a discount on dealing costs.
Open-ended funds are more straightforward, but potentially more expensive. These have an initial charge, which could be anything up to 5.5%, and an annual charge of up to 2%.
BUILDING A PORTFOLIO
With so much choice available, it's important to have an idea of where you would like to invest. This will come down to your risk profile, which takes into account factors such as your time horizons and how you feel about your investments losing value.
For example, if you're saving for your retirement in 30 years' time you can afford to take plenty of risk as your investments will have ample time to recover from any losses. So you might want to consider spicing up your ISA with investments in emerging markets, smaller companies and specialist sectors such as technology and commodities.
But, whether you go high risk or invest in something more pedestrian such as fixed interest, while there may be plenty of funds to choose from, it isn't necessary to hold hundreds to get a well-diversified portfolio. If you're starting out with a stocks and shares ISA, one global fund may be sufficient. Then, as the value of your ISA grows, you can add more specialist funds to pep up your portfolio.
Once it's up and running, it's sensible to keep an eye on your ISA but, because stockmarkets fluctuate on a daily basis, it's best not to become obsessive about this. "Obsessively monitoring and adopting a strategy that involves a knee-jerk response to the 10 o'clock news will almost always result in investors losing money," warns Rebecca O'Keeffe, spokesperson for Interactive Investor.
"In addition, if you're constantly trading, unless you're underlying investment is large, the commission costs involved might well erode the benefits." A monthly check will usually suffice, with a more thorough annual review to rebalance your portfolio and ensure it's delivering the best possible performance.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.