Make the most of tax breaks

Last updated: Aug 24th, 2011
Feature

Cash is no longer king, it appears. A recent Moneywise poll revealed that 40% of users are looking at low-risk investments as well as keeping some of their money in cash savings.

When it comes to ISAs, taking a racier approach increases your risk but also offers longer term returns. Each tax year you can invest up to the full £7,200 into a stocks and shares ISA, minus anything you might have put into your cash ISA that year. You can choose from a wide variety of different assets, including shares, gilts, corporate bonds, investment trusts, unit trusts, open-ended investment companies and exchange traded funds.

As well as enabling you to take advantage of your full ISA allowance, there are a number of reasons why you might want to invest in a stocks and shares ISA. First, returns can be higher.

Inflation erodes the real value of cash over time,” says James Davies, investment research manager at financial adviser Chartwell. “However, you can avoid this if you invest in stocks and shares.”

Although the value of shares can go up as well as down, their performance will normally outstrip that of savings accounts over time. For instance, according to figures from Lipper, over a 20-year period to the end of October 2008, a £1,000 initial investment, followed by a top-up of £100 a month, would have returned £42,228.38 in the average UK All Companies fund. The same money going into a building society account would have amounted to more than £10,000 less, at £31,293.10.

Although the stockmarket might look pretty hairy at the moment, as it has fallen so much over the last few months, many experts are saying that it could be one of the best times to invest. “Equities are very cheap now,” says Darius McDermott, managing director of Chelsea Financial Services.

“They could get cheaper still, of course, but if you’re going to be investing for the long term, at current valuations, it’s a good time to invest.”

You might also decide to invest in a stocks and shares ISA because you’ve already built up plenty of savings. “Everyone needs a rainy-day cash fund, but if you’re saving for something further in the future you could benefit from a stocks and shares ISA,” explains Davies.

Ideally, you need at least three months’ income set aside in a savings account or cash ISA before you even consider a stocks and shares ISA, to ensure you have sufficient cash readily available should you lose your job.

But while the higher returns available on stocks and shares are attractive, it’s important to remember that their value can fall as well as rise. This means you need to be able to leave your money invested for the long term – experts recommend at least five years – without needing to dip into it during that time. This will lessen the risk of being stung if the stockmarket does take a tumble.

Where to invest

Once you’ve decided that a stocks and shares ISA is right for you, you need to decide the type of investment you want. There are thousands of ready-made collective investments, including unit trusts, investment trusts and open-ended investment companies, that you can hold in an ISA.

These funds work by pooling the money you contribute with that of other investors and then using it to buy suitable investments, which could be shares in companies, government bonds (gilts), corporate bonds, derivatives or even other funds. A fund can hold anything from 20 or so different underlying investments through to 200 or more.

Taking the ready-made option is a good way to start investing. You’ll benefit from the experience and expertise of a professional fund manager who will decide where your money should be invested.

Furthermore, because your money is lumped with that of other investors, you’ll be able to get a more diversified portfolio than if you invested on your own. This helps to spread the risk – one or two of the companies might perform badly, but it’s unlikely that all of them will.

It will also be cheaper than building your own portfolio. If you had £3,000 to invest in a stocks and shares ISA and wanted to buy shares in 50 different companies, it would cost you 50 times the dealing charge – say, £10 per trade – which would equal £500. However, with an ISA fund, you could get exposure to the same companies at no more than 5.5% of your initial investment (£165), depending on where you buy your ISA from – in many cases, the initial charge is much lower or even zero.

Once you’ve decided to start with a fund, you need to consider what type of assets you’d like to invest in. There are three main asset classes: fixed interest, equities and property. Each behaves slightly differently. Although you can invest in just one asset type, if you spread your investments across all three classes you can reduce the risk to your overall investment of massive losses in one particular market.

Fixed-interest

As the name suggests, fixed-interest investments pay you a fixed (or in some cases index-linked) level of interest in much the same way as you would receive interest from a fixed-rate savings account. But, unlike savings accounts, there is some risk involved.

Interest is generated by investing in a bond, which is effectively an IOU issued by a company (a corporate bond) or the government (a gilt). The issuer agrees to pay a level of interest throughout the term and at the end repays the capital.

The level of interest charged will depend on the risk of the borrower defaulting. So, for example, the safest type of bond, a government bond or gilt, pays between 4% and 5%, while a small company at greater risk of struggling to repay its debts might pay 9% or 10%. In other words, you might receive 10% from a small company, but there’s a greater risk you’ll lose your initial stake.

Another factor also affects the return you’ll receive, and that’s demand for bonds. Although the bond is redeemable at the end of the term for a set amount, if investors want to hold it, the price on the market will increase in the meantime. This means the yield (the interest received as a percentage of the price paid) will be lower for buyers, as it will cost more to generate the same amount of income from the bond.

As well as corporate bonds and gilts, a fixed-interest fund could also hold preference shares. These are a class of share that pays a fixed dividend.

Whichever type of fixed-interest fund you pick, it has a tax advantage over other income-generating ISA investments. Instead of dividend income, it produces interest, which is paid tax-free and doesn’t lose the 10% tax credit taken off dividends.

So would fixed-interest suit you? This depends on the type of investment you select, which range from low-risk for gilts through to high-risk for some corporate bonds. Additionally, because of the preferential tax treatment, fixed-interest investments can be a good option if you’re seeking income.

Equities

The second asset class is equities (also known as stocks or shares). These are issued by companies and entitle you to a stake in the business. As the company’s fortunes rise and fall, so will the value of your investment.

As you can invest in any share that’s quoted on a recognised stockmarket anywhere in the world, there are thousands of options available, from the shares of large UK blue-chip companies through to small companies in emerging markets such as China and Latin America.

Index trackers are often touted as a good way to get diversified exposure to the whole of a particular stockmarket. They track all sorts of indices, although most commonly UK trackers follow the FTSE All-Share or the FTSE 100. Because they are run by computer, tracker funds are cheaper than actively managed funds. Typically, they won’t have an initial charge, compared with a charge of up to 5.5% on an active fund, and the annual charge is generally less than 1% a year, compared with up to 1.5%.

However, Ben Yearsley, investment manager at Hargreaves Lansdown, isn’t convinced. “Although there’s criticism of active managers for underperforming the index on many occasions, trackers will always underperform the index,” he says. “Tracker funds may be cheaper, but I’d rather find a good manager and pay for their services.”

Property

The third asset class you might want to consider for your ISA is property. Since December 2005, it has been possible to invest in commercial property funds within your ISA.

Funds can invest in property either through the shares of property companies or directly into bricks and mortar, or a combination of both, so be sure to check exactly what you’re buying before you commit yourself. For example, Aberdeen Property Share invests in the shares of property companies, while L&G UK Property Trust invests in actual buildings.

While both routes give you exposure to commercial property, they behave differently. “Shares are more volatile because they are affected by the performance of the stockmarket,” says James Davies. “But, with bricks and mortar, there can be problems with liquidity – the manager might need to sell a property if there’s a run on the fund.”

This risk of illiquidity means that property investments should only be held for the long term. But if you’re able to commit yourself in this way, they can form part of a well-diversified portfolio and help to reduce risk.

Buying funds

There are a number of ways to buy funds for your stocks and shares ISA. It’s worth going through a fund supermarket or discount broker. They have special deals with the fund management groups and they rebate the commission they are offered on sales, so they will be able to offer you the best value.

For example, Hargreaves Lansdown Vantage Supermarket will discount the 5.5% initial charge on some funds by as much as 100%. On an investment of £7,200, this could save you £396.

Although they won’t give you advice, fund supermarkets and discount brokers can also help you research the market. As well as producing ratings and research on individual funds, some of these services have online tools to help you determine your risk profile and find the most appropriate funds.

But, if you would like advice, an independent financial adviser can help. An IFA will assess your attitude to risk, investment objectives and financial situation before recommending suitable funds. Also, as many IFAs use fund supermarkets, you should benefit from reduced charges.

Ironically, the worst way to buy a fund for your ISA is direct from the fund manager. This is because they will levy the full initial charge, even though you won’t have had any advice or support in your selection.

On top of this, as you can only have one stocks and shares ISA each tax year, you’ll be restricted to the funds of that provider. With a fund supermarket, in contrast, you can hold funds from several different managers within a single ISA wrapper.