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Who wants to be a millionaire?

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28 February 2020

David Prosser explains why investment companies are a good option for your annual ISA allowance.

As time begins to tick down towards the end of the tax year on 5 April, new research from Interactive Investor makes interesting reading for anyone wondering how to make the best use of this year’s £20,000 individual savings account allowance. When II took a look at the portfolios of the 395 Isa millionaires on its books, it noticed something striking: such investors have disproportionately made use of investment companies.

The typical savers with Isas held with II holds 28% of their tax-free savings in investment companies, the company explains. But amongst those who have built portfolios within their Isas worth £1m or more, this figure rises to 46%. In other words, amongst savers whose Isas alone make them millionaires, almost half their money is held in closed-ended funds.

The statistics reflect two realities. First, given that investment companies have consistently outperformed other types of collective fund over the 20 years or so that Isas have been in existence, it makes sense that the most successful savers have been more likely to choose them. And second, that outperformance has automatically increased the proportion of savers’ portfolios held in investment companies; as investment companies have grown more rapidly than other funds, they’ve accounted for a larger slice of the pie.

Why have investment companies outperformed? Well, gearing has certainly been an important part of the explanation. During the extended bull run of recent years, the fact that investment companies are uniquely able to take on gearing, which boosts returns in a rising market, has been a significant advantage.

The investment company industry’s critics rightly point out that gearing works both ways – that in a declining market, funds with borrowing will underperform those that don’t have debt. This is true, of course, but it would be a mistake to exaggerate the extent to which investment companies use gearing. Data from the Association of Investment Companies reveals that the average fund currently has gearing of just 7% - and that this figure is barely changed on a decade ago.

In practice, it’s important to recognise that a variety of factors have come into play in investment companies’ outperformance. For example, savers using investment companies have often benefitted from lower charges. They enjoy the advantages of strong governance structures, with an independent board charged with safeguarding the interests of the fund’s shareholders. Investment company managers are free to focus single-mindedly on the portfolio, with no inflows and outflows of investors’ cash to worry about as demand waxes and wanes.

Income is a consideration too. New figures just released by the AIC show the typical investment company today yields 3.98%, more than double the average figure of 1.72% two decades ago. Investment companies have focused on delivering income during a period of exceptionally low interest rates, but it’s fair to assume many Isa millionaires have simply reinvested their income.

Not everyone will have the resources to save enough, year after year, to build portfolios of this size, but there are lessons for all savers here. II makes the perfectly valid point that becoming an Isa millionaire requires patience – and it’s true that investment companies are often thought of as “buy-and-hold” assets to store up for a rainy day. That perception isn’t wrong, but it does the investment companies sector a disservice. The lesson of II’s figures is that actually, if you’re impatient for portfolio growth (as we all should be), investment companies have been the way to go.