ISAs: use them or lose them
Time is running out to make the most of this year’s ISA allowance. David Prosser explores why investment companies could be a good choice.
With less than a month to go until the end of the 2017-18 tax year on 5 April, have you used your individual savings account (ISA) allowance yet? ISAs are now more generous than ever before; this year you can use them to put up to £20,000 of assets – including a very wide range of individual investments and funds – out of the reach of the taxman. No matter how much income and profit you earn on these assets, you’ll never have to pay income or capital gains tax on them. But once the tax year ends, unused ISA allowance is gone for good.
The important point to grasp about ISAs is that they’re not investments in their own right. Rather, they are shelters within which you may hold other assets to avoid a tax bill. You should choose those investments to reflect your individual financial circumstances – your investment objectives, your attitude to risk and your time horizons – rather than getting caught up in the blizzard of ISA-related advertising that takes place at this time of year.
How as well as where
When thinking about where you will invest your ISA allowance this year, think about how you will invest it too. The conventional approach to investment in times gone past has been to invest through a fund such as a unit trust – some £230bn is already invested in ISAs through these vehicles. More recently, however, investment companies, which are structured a little differently, have become increasingly popular – around £14bn of ISA money is held this way.
Both unit trusts and investment companies invest in similar assets. The difference is how they are set up. The former are open-ended funds – that is, they grow or shrink in size as investors put money into them or make withdrawals. By contrast, investment companies are closed-ended – they are a fixed size and investors buy exposure to the underlying assets through shares in the fund, which are traded on the stock market.
The structure of investment companies offers one advantage in particular: the manager only has to worry about managing the fund’s assets. By contrast, in an open-ended fund, the manager has to invest with one eye on fund inflows and outflows – as new investors join the fund, there may be large sums of money to invest at any given moment; or, when investors leave in sizeable numbers, their withdrawals may add up to large sums, possibly even forcing the manager to sell assets.
Why investment companies outperform
Financial advisers regularly compare the performance of open-ended funds and investment companies investing in similar pools of assets. In most of these comparisons, investment companies tend to come out on top, delivering higher returns, particularly over longer-term periods. There are several good reasons for this.
The first is that investment companies, unlike their open-ended counterparts, are allowed to take on gearing. This means they borrow money to invest alongside investors’ cash. When financial markets are rising, the effect of gearing is to enhance the returns the fund earns, though there is also a risk of exaggerated losses during falling markets.
It’s also the case that the closed-ended structure of the fund means investment company managers can put more of investors’ money into the assets in which the fund invests. An open-ended fund manager has to keep some money in cash in order to be able to repay investors who want to make withdrawals and this can be a drag on performance.
One final advantage of investment companies is also worth considering this ISA season. These funds are allowed to keep back some income payments when they’re earning good dividends from their investments; this money can then be used to continue income in leaner times. For income-seeking investors, this is really valuable – a number of leading investment companies have a track record of raising their dividends every year for several decades.
