IT’s in your ISA

Kathleen Hennessy explains how investment trusts can provide a low-risk affordable way of investing in the stock market

Equity investment is not for the faint-hearted: stock markets can go down as well as up and there are costs involved that you wouldn’t face with a savings account. Shares in well-performing companies are not cheap, either – a single share in Microsoft costs $26.53, for example, and that’s before you add in the stamp duty and stockbrokers’ fees payable every time you buy even one share. There is a more affordable and less risky way to own shares, however – by buying through an investment trust.

The big attraction

Investment trusts are companies set up purely to invest in the shares of other firms. They are collective investments, similar to unit trusts (though with several important differences – see below), in which your invested money is pooled with other investors’ and spread across shares in a range of companies. This reduces the level of your investment risk because not all your cash is riding on a single share. It also means you can afford to buy into several shares at once without committing thousands of pounds – something that could be prohibitively expensive if you bought on your own.
But if you can get the same spread of investment risk with a unit trust, why choose an investment trust? ‘First, every investment trust on the market is eligible for inclusion in an Isa – this isn’t true of all unit trusts,’ explains Annabel Brodie-Smith of the Association of Investment Trust Companies (AITC).

As investment trusts are listed companies with independent boards of directors, investors also get more say in how their investment is run. ‘There’s an advantage to being a shareholder in a company rather than just an investor in a pooled fund of units,’ explains Brodie-Smith. ‘Company boards are democratically elected and the directors are accountable to the shareholders, who can challenge the board’s actions and vote against proposed business decisions.’

Similar, but not the same

Despite both being collective investments that can be held in an Isa, there are major differences between investment trusts and unit trusts:

When you’re buying an investment trust Isa, this discount is to your advantage because it means you will get, for example, £1-worth of shares for every 90p you invest. Conversely, if the share price rises above the NAV, the trust is trading at a premium – this tends to happen when an investment trust becomes very popular and its shares are in demand. This is not such good news if you’re hoping to invest, but might represent a good time to sell.

‘Obviously gearing is a bit of a double-edged sword, but you shouldn’t be getting into the stock market unless you think it’s going up - and if it is going up, the ability to gear is a very useful one,’ explains Mike Woodward, head of investment trusts at Martin Currie.

Star performer

One of the biggest deciding factors when choosing an investment is how well it has performed historically. Over the past 12 months, the average investment trust returned 10.5 per cent, according to the AITC. Over the same period, the average UK all companies unit trust returned 6.45 per cent. The comparative figures move further apart in a three-year performance analysis, with investment trusts returning an average 13.4 per cent while unit trusts slumped to a loss of 0.83 per cent. Over the longer term, average investment trust performance demolishes that of unit trusts: 74.2 per cent compared with just 7.27 per cent.

‘In many cases, if the fund fails to meet set performance criteria, the fund manager doesn’t earn his/her fee,’ says Woodward. ‘That can be a powerful incentive to meet performance targets.’

Choosing your Isa

There is a vast range of markets and geographical areas in which to invest. You could confine yourself to companies in the UK, for example, or to firms across Europe or the US. Alternatively, you could pitch your investment at emerging market companies, where the risk level is higher but there is also an opportunity for capital growth because you will be able to pick up shares more cheaply than if you invest in long-standing blue-chip companies.

You can also choose between different market sectors – you might be drawn to technology companies, for example, or to stocks in traditionally dependable businesses such as banking. ‘Basically, investment trusts offer bespoke investment briefs, which means they can suit even very specialised investors,’ notes Simon Moore, investment trust analyst at IFAs Bestinvest. ‘If you have other investments – property, shares, bonds – and you’re just trying to fill a niche, investment trusts can provide access to private equity funds, for example.’

To find the right investment trust for your needs, you first have to identify what those needs are. Are you looking for an income from your investment, or are you more interested in seeing your capital increase in value? You might even want a mixture of income and growth. Your starting point should be one of these three options.

Next, decide what level of investment risk you’ll be comfortable with. Investment is not a science and any money you invest could be lost, though the likelihood of this – the risk level - varies enormously depending on where you invest. Generally the smaller and less established the market or company you invest in, the greater the risk. There are also currency fluctuations to consider when investing in foreign companies, because this can further increase the volatility of share prices.

The longer you can leave your money untouched, the less risk you will suffer, because the trust will have time to recover any losses it makes during periods when share prices inevitably fall.

‘Generally speaking, investment trusts suit investors with a longer-term view than those who invest in unit trusts,’ says Woodward.

Investment options

There are two ways to invest in an investment trust Isa: lump sum or regular savings. Regular savings schemes start from as little as £25, which is ideal if you don’t have huge sums of capital to start with. What’s more, making regular contributions rather than committing all your cash at once means you are constantly investing during changing market conditions, increasing your odds of getting shares at a bargain price.

For example, if you invest £1,000 in January when share prices are up, you will get less for your money than if you invest monthly and share prices have dropped to lower levels by March.

‘Regular savings schemes are good for cautious investors, because they smooth out share price highs and lows,’ explains Brodie-Smith, ‘making investment a less risky venture.’

Of course, if you happen to commit your lump sum at a time when the market is stable or has suffered a fall, you might snap up many shares at favourable prices. And you don’t have to have thousands to invest, either: lump sum investment is available from just £250.

Charges

Investment trusts are cheaper to invest in than unit trusts: one third of all investment trusts have annual charges of less than 1 per cent. This compares well with unit trusts, which charge around 3 per cent-5 per cent a year. If you choose a tracker investment trust, annual charges could be as low as 0.25 per cent.

‘For us, the biggest reason for choosing an investment trust for your portfolio is cost – the costs involved in investing in even some of the biggest trusts available are very low,’ says Carolyn Corless, certified financial planner at IFAs Bloomsbury Financial Planning and Money Management’s investment trust planner of the year 2004. ‘Cost has become a real factor now, because with market performance so much lower, any charges have a significant impact on investment growth.’

There may be other costs involved, however. Depending on where and how you buy your investment trusts, you might have to pay advice or administration fees, which could cost up to 4 per cent. You’ll definitely have to pay stockbrokers’ charges whenever you buy shares – these can be on a flat fee or commission basis. Finally, stamp duty of 0.5 per cent is payable on all share purchases.

So if you invested £1,000 into an investment trust with a £50 admin fee and your broker charged 0.35 per cent commission, the total upfront cost would be £58.50.

During the last quarter of each tax year, however, most Isa providers offer deals on their products, often waiving administration fees, so it’s a good idea to shop around.

The future

From April 2005, the life insurance element of Isas will be abolished, subsequently pushing the investment limit for mini equity Isas from £3,000 to £4,000 a year. Tax credits of dividend income were scrapped for Isas at the beginning of the 2004 tax year, and the £7,000 maxi equity Isa limit was scheduled for a cut to £5,000 from the 2006 tax year. Investors were sent a reprieve in the 2004 pre-Budget report, however, when Mr Brown reversed his decision to cut investment limits and indicated that Isas might even run beyond their 2009 end date.

‘The government is more keenly aware than ever of the need to encourage long-term tax-efficient saving in the general populace, mainly because of the pensions shortfall,’ says Woodward. ‘So even if Isas cease to exist there will definitely be some sort of replacement vehicle – and whatever form it takes will almost certainly be suitable for wrapping around an investment trust.’

Recommendations

Income seekers

Corless: Temple Bar – good solid dependable trust offering professional management at an affordable price.
Moore: Perpetual Income & Growth

Balanced

Corless: Tribune Trust – index tracker offering exposure to broader UK market
Moore: Scottish Mortgage Worldwide or Alliance Trust - a bit dull but if you have nothing else in your portfolio but a good starting point.

Growth

Corless: Alliance Trust – wide spread of risk, very low-cost management.
Moore: Fidelity Special Situations – well diversified and safe. Or Aurora, for investors willing to follow a fund manager with the freedom to follow his own ideas.

Higher-risk

Corless: Merrill Lynch World Mining - definitely not a widows' and orphans' fund! Provides exposure to the commodities market in general, and gold in particular.

Moore: private equity fund Finsbury Pharmaceuticals – a real niche filler if you already have other investments

Regular savers

Corless: Foreign & Colonial, the granddaddy of the investment trust world - provides a wide spread across major world markets. A solid core holding in a long-term portfolio.

Moore: HG Capital, another private equity fund