Who wants to be a millionaire?

What’s the secret to becoming a millionaire? The answer may just lie in the investment companies industry – and some valuable help from the taxman.

New research from the investment platform AJ Bell considers how investors would have fared if they had made full use of their tax-free individual savings account (ISA) allowance in every year since 1999. One in six investment companies available back then would have turned such investors into millionaires by now, AJ Bell concludes.

The analysis found that 22 investment companies around in 1999 would have pulled off that trick by the start of this month – that’s 17% of all the investment companies in business at the time. To put that number into context, only 14 open-ended funds around in 1999 would have done the same – just 4% of the funds available back then.

Investment companies versus open-ended funds

Both investment companies and open-ended funds aim to do the same job: they pool the savings of investors, and a professional manager then invests the money with the goal of achieving the best possible return. Often, the two different types of savings vehicle invest in very similar assets.

That should mean similar returns, so why have investment companies been so much more likely to get investors to millionaire status?

Well, we should point out that the comparison isn’t entirely fair. Investment companies largely invest in the stock market and other asset classes that have a long-term record of superior returns, as well as higher risk. Many open-ended funds do that too, but some of these vehicles invest in assets with a lower risk and return profile, such as bonds. A like-for-like comparison of the average performance of the two is therefore misleading.

Nevertheless, even stripping out bond funds and similar vehicles, there were many more open-ended funds in 1999 than investment companies. So, the fact that 50% more investment companies would have turned Isa savers into millionaires is still very striking.

Investment companies’ advantages

In practice, there are several explanations for investment companies’ outperformance. One is that for large parts of the past two decades, investment companies consistently charged lower fees, so costs dragged less on performance. The gap has closed in recent years, but this will have been a factor.

Also, unlike open-ended funds, investment companies are allowed to take on gearing – that is, they can borrow additional money to invest on top of what savers have put in. When stock markets rise, this gives investment companies an advantage since they have more money invested. It also exaggerates losses, of course, but over long-term periods, stock markets have, at least in the past, consistently delivered positive returns.

There are other factors at play too. Investment companies differ to open-ended funds in that they are independent companies – rather than investment products – with boards who are legally accountable to shareholders. Arguably, this forces them to focus on delivering performance. Also, investment company managers have a fixed pool of assets to look after, whereas the size of open-ended funds increases or falls, depending on investor demand, which can make life more difficult for the manager.

Winning big

There is no guarantee that investment companies will repeat their success over the next 20 years. But it’s worth noting that ISA savers should have an easier time getting to the magic £1m mark in future, since the £20,000 annual Isa allowance available today is much higher than in the past. AJ Bell calculates that had the allowance been £20,000 since 1999, 70% of open-ended funds and 86% of investment companies would have performed well enough to be worth more than £1m today.

Still, even in the absence of that larger allowance (the ISA limit was £7,000 a year between 1999 and 2009), some investment companies have done remarkably well. For example, if you had invested your full ISA allowance in Scottish Mortgage Investment Trust each year, you would now have a savings pot worth £1.8m.

It’s food for thought as the tax year comes to an end on 5 April. If you’ve not yet decided how to use your ISA allowance for the 2021-22 tax year and you’re focused on long-term savings goals, an investment company might just give you the best shot at achieving them. And remember, all income and profit earned on investments held inside an Isa are completely tax-free