Identify the right investments

Introduction

Although the idea of investing for your future financial security is gaining wider acceptance, finding the most appropriate investment can be a daunting prospect.

Consulting Gow's Independent Financial Adviser will be an obvious first step for many, particularly those who are looking at the various types of collective investment vehicles available rather than planning to invest directly in shares.

Most of us now recognise the need for some kind of retirement funding, but there is an increasing emphasis on the need for the individual to take out some kind of private provision across a broad range of areas, from healthcare to education.

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Investment: the profits and perils

Why should the saver, who has been content to build up a nest egg in a deposit account, move into the riskier area of investment in equity or bond markets? Well, the main reason is the chance of a higher return than can be obtained from deposit accounts. If the investor is prepared to be patient, over time he or she should be able to expect a higher return.

The investor must also consider the question of risk. In a low interest rate environment the return on your deposit account may decrease, but there is no threat to your capital. Investing in shares is different. Potential returns can be much greater than those offered by cash deposits. But if the shares in which you have invested were to fall in price, there is a real threat to your capital itself. If you are forced to sell your shares at a time when they are performing poorly, you could actually end up with less money than you started with.

Gow's can help establish what level of risk you should take with your investments.

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Tax efficiency

ISA

If you are looking to invest directly in shares or bonds or collective investment schemes, a tax-efficient method of doing so is through an Individual Savings Account (ISA).

An ISA is not an investment in itself – it is a tax-efficient “wrapper” which you may use to hold a range of investments.

As the UK’s principal tax-efficient investment plan, an ISA can incorporate a stocks and shares element within which you can invest up to £7,200 in the 2009/2010 tax year. Up to £3,600 of this allowance can be saved in cash with one provider.  The remainder of the £7,200 can be invested in stocks and shares with the same or another provider.

Within the stocks and shares element of an ISA you may invest directly in shares or bonds or collective investment funds.

It makes sense to take advantage of all the existing tax allowances and your Gow's will be able to help you do this.

Friendly Societies

You are entitled to save £25 per month tax free, but only if you save with a Friendly Society. Save monthly or annually and, after a minimum of 10 years, you can look forward to receiving a tax-free lump sum.

It’s an ideal way to build up a nest-egg for the future or to save for something special. You can also pay into a plan on behalf of a child or new-born baby – maybe to help them pay for their first car, university fees or a deposit on their first home

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National Savings and Investments

There are many types of national savings available suitable for different people e.g. Children's Bonus Bonds and Pensioner Bonds. As the rates of return change regularly, and the tax-treatment varies from product to product, you can get more information is at www.nsandi.com.

Direct investment

All the forms of investment open to UK investors can, broadly speaking, be split into two main categories – direct investments, such as stocks & shares, or collective investment schemes.

For the majority of UK investors, this generally means shares or bonds or gilts. Although the spread of share ownership has widened considerably in Britain since the early 1980s, and with it public awareness of what share ownership means, it is worth reiterating the basic principles.

The price of a company’s shares is determined by the value of its assets and its potential to generate further revenue. If shareholders begin to see the estimates of future revenue as unduly optimistic, or if the value of the company’s assets declines, they are likely to sell their shares and this may cause the share price to fall. If the reverse happens, demand from buyers will increase – thus pushing the share price up.

The trade in stocks and shares, facilitated by market makers whose role is to quote both a buying and selling price for listed stocks and shares, is known collectively as the stockmarket.

Public Limited Companies (PLCs) in the UK are listed on the FTSE All-Share index, with the 100 largest listed on the FTSE 100. Companies wishing to issue shares but lacking the financial muscle for a full market flotation, or new start-up companies, may opt for the Alternative Investment Market (AIM), which means that, in most cases, companies listed on AIM carry higher risk than those listed on the main stockmarket.

For the investor, the drawback to investing in AIM stocks is their lack of liquidity. Market makers will constantly quote buy and sell prices for FTSE stocks, but as trading volumes on AIM are much lower, transactions are conducted using a process known as “matched bargain”. This means the buyer or seller approaches the designated broker who finds a counter party for the deal. However, this in turn means the price agreed by the broker may be some way off the last quoted trading price.

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Bond and gilt investment

The second principle form of direct investment is bonds and gilts. Bonds are basically chunks of debt. In buying a bond, the investor is effectively lending money to the bond’s issuer. The investor knows in advance what sort of return they will get on their investment and bonds are generally regarded as a much lower risk category of investment than shares.

Gilts are bonds issued by the UK government – the name derives from the term “gilt-edged stock” – so by buying gilts the investor is lending money to the UK government. As the UK is regarded as a safe bet to honour its commitment to buyers of its government stock, gilts are in turn regarded as one of the safest forms of nvestment. The issuer – in this case the government – is guaranteeing to repay your capital at the end of the bond’s term, (if there is a redemption date) and you also get a guaranteed coupon return throughout its life.

A bond with a face value of £100 will also pay a pre-set figure in interest every year to the holder – the coupon rate. When the rate is set it must be competitive with current interest rate levels but these may change, thereby rendering the return on your bond relatively less attractive than cash deposits. So bonds are traded in the market to reflect this. For example, a bond may be issued at a time when 6 per cent is an attractive interest rate return and as a result your £100 bond may pay a coupon rate of 6 per cent. So you have paid £100 to get £6 per year plus your original investment back at the end of the bond’s term.

But if interest rates jump to 9 per cent your coupon rate starts to look a bit weak. You therefore sell your bond in the market, but no-one will pay £100 to get only £6 a year so you have to sell at a lower figure that builds in the difference in rates.

Of course you can take comfort from the knowledge that you will get your capital back at the redemption date, in this case from the UK Treasury.

But it is not just governments who issue bonds. Corporate bonds work in a way that is broadly similar to government bonds – they are issued by companies as a way of raising money from investors. Again, they pay a coupon rate coupled to a pledge to repay the capital at the maturity date. Like gilts, they can be traded on the market if investors want their capital back before the maturity date.

However, companies can default on corporate bonds, so return of capital is not guaranteed. Corporate bonds are therefore risk-graded, with higher risk bonds paying a higher coupon to attract buyers.

Guaranteed return of capital is clearly an attraction, although it has to be weighed against the potential for higher returns offered by the stockmarket. However as recent months have shown the stockmarket cannot be relied upon to consistently rise, the investor cannot rely on every individual company to produce an increase in the value of its shares.

This is the major potential pitfall of direct share investment – any company is at the mercy of conditions in its own particular business sector, and even companies in generally profitable sectors can fall victim to bad times. Correctly identifying which companies to invest in is therefore vital for direct share investment. Warning against putting all your eggs in one basket may seem a little obvious, but relevant in this context.

You should keep a close eye on how your investments are doing. Potential investors often find the prospect of constantly keeping tabs on their share portfolio too daunting and for this reason – as well as those outlined previously – many opt to take their first step into these markets via collective investment schemes rather than direct stocks and shares investment.

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Pooled investment schemes.

In the UK there are three principal types of mainstream collective or pooled investment schemes – unit trust, investment trust and Open Ended Investment Company (OEIC).

All three will take the pooled monies of a large number of investors and put them in the hands of a professional fund manager. He or she will choose a broad spread of instruments in which to invest, depending on their investment remit. The main asset classes available to invest in are shares, bonds, gilts, property and other specialist areas such as hedge funds or ‘guaranteed funds’.

There are key differences between the three types of scheme structure.

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Unit trusts

An investor in a unit trust ‘buys’ a number of units, while an investor in an investment trust or OEIC ‘buys’ shares. Unit trusts are open-ended, which means that units can be issued as demand requires. The price of these units is dependent on the value of the underlying assets, and they can be sold back to the fund managers by the investor. Most UK collective investment schemes are authorised by the Financial Services Authority (FSA).

Investment trusts

Investment trusts are structured as companies so their shares are traded in the same way as any other limited company’s shares.

Investment trusts offer a wide range of investments.

Open Ended Investment Companies (OEICs)

The OEIC is structured along similar lines to the unit trust, but it differs as it has no bid/offer spread. This means buyers and sellers get the same single price. Additionally, the OEIC has an “umbrella” structure allowing numerous sub-funds investing in different types of assets, so the investor can switch easily between different investment funds.

Given the range of options of unit trusts, investment trusts or OEICs, the choice can be confusing – consulting an Independent Financial Adviser could help simplify your investment choice.

Index trackers and active management

Whichever approach is taken, the result should be smoother returns. However, neither should they be seen as a panacea. Diversity is a good thing but a manager still has to make choices – and can make the wrong ones. Shorting stock is a particular skill and could even increases losses. So, despite the label 'Absolute return', always remember that this is an objective only; there are no guarantees.

Among the various types of fund management, two definite methods have emerged – active management and index tracking.

Proponents of these two approaches debate over their respective merits, but many observers have concluded that a “horses for courses” attitude is appropriate for investors.

Through research and analysis an active manager will seek to identify companies which he or she believes will perform better than their rivals, or whose current share price makes them a bargain buy. Potential returns depend on whether the manager gets it right or wrong.

An index tracker fund tracks a stockmarket index. Having decided which recognised market index is most appropriate for the tracker fund, the manager (often a computer rather than a person) will invest in such a way as to replicate the make-up of that index. In times of good stockmarket performance tracker funds are attractive.

But the critics of tracker funds point to two potential drawbacks. Firstly, if the index falls, the fund must go with it. Secondly, the cost of running the fund – administration fees, management fees, etc, can mean that tracker funds’ performance is just below that of the index itself.

Active managers argue that their skills allow them to produce better returns than the market average, and hence the index, as well as to avoid the worst of any market falls by switching away from the worst-affected shares. “Ah yes...”, say the trackers, “...but how often do the active managers actually beat the index?”

The debate rages on, but the argument serves to reinforce the importance of getting good independent financial advice.

There are hundreds of collective investment schemes to choose from. The services of Gow's Independent Financial Adviser can greatly simplify the investment process.

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Absolute Return Funds

The thought of a fund that might deliver positive returns despite falling markets is very appealing, but is it actually possible? This is the potential being offered by 'absolute return' funds which reckon they can beat cash and smooth out market returns.

They use a variety of different techniques. One, the multi-asset strategy, blends asset classes like equities and bonds with alternatives such as hedge funds or gold. Therefore, when the mainstream asset classes are losing money, these managers have the opportunity to invest in alternatives delivering positive returns. The other main strategy uses 'hedging', ie: invest purely in equities, but 'short' some of those stocks. This involves borrowing them from someone else, selling them and then buying them back at a later date. There is a small price for borrowing but if the market moves down, the manager buys back the stock at a lower price than it was sold, making a profit in the turnover. This acts like an insurance policy, repaying some of the loss made on the fund holdings which will have fallen with the market over the same period.

Whichever approach is taken, the result should be smoother returns. However, neither should they be seen as a panacea. Diversity is a good thing but a manager still has to make choices – and can make the wrong ones. Shorting stock is a particular skill and could even increases losses. So, despite the label 'Absolute return', always remember that this is an objective only; there are no guarantees

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Commercial Property

Property has proved a very popular investment choice, as the benefits have become increasingly understood. Despite recent falls in valuations, the diversification benefits and characteristics it offers remain attractive for an investor looking to widen their portfolio. Commercial property in particular has garnered a lot of interest. It offers both an income stream and the potential for capital growth - in principle, the rental payments from tenants act like the interest payments from bonds and any rent rise not only helps that income increase but can also support the property's value.

Both residential and commercial property carry the same sort of risks - that tenants may not be found and so income may be zero and also the value may fall or the property may take a very long time to sell. However, when tenants are found, commercial leases tend to be longer, which offers greater stability of income. Commercial tenants are also subject to close financial screening, so are considered less likely to default.

However, for individual investors, commercial property is a very difficult asset class to get into. Lot sizes are large, the buying and selling process are costly and complicated and the management is onerous. Even so, since becoming an allowable ISA investment in 2006, the number of collective property schemes available to the smaller investor has mushroomed. The advantage is they offer a small piece of lots of properties for a smaller investment, diversifying away some of the risks of having everything tied up in just one.

INVESTMENT BONDS

Investment bonds are investment products offered by life companies, usually available for lump sum investments. Within the bond, investors have a choice about how that money is invested from a range of funds.

Traditionally, the most popular have been with-profits, managed and distribution funds, each combining different asset classes under one roof. Today, however, fund choices are much greater, as life companies offer links to fund management houses alongside their internal range.

When you take out an onshore investment bond, your income and gains within the fund are subject to tax, which is then deemed equivalent to you paying basic rate income tax. Therefore, if you are a basic rate taxpayer, you will pay no more tax on that investment. If you are a higher rate taxpayer, you will have another 20% on the total growth. However, there are ways to mitigate this. For example, during the lifetime of the bond, you can withdraw up to 5% of the initial value of the investment every year for up to 20 years - that is, to a maximum 100% of the initial investment - without immediately becoming liable for additional tax.

When the investment bond is finally cashed in, you will be liable for higher rate tax on any gain. So, if you postpone this encashment until you are a basic rate taxpayer - perhaps after retirement or when you are earning less - you could en

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Offshore investment

In specific cases, offshore investment may be worth considering. From the UK perspective, offshore funds have traditionally been used mainly by expatriates. Because UK expatriates do not generally pay UK income tax, it makes sense for them to invest in funds based in a low-tax centre such as Luxembourg or the Channel Islands. However, some funds, accumulation funds in particular, can offer a tax efficient use of offshore funds to the UK resident.

If you are a UK expatriate intending to return only on retirement when your tax status will be more favourable, there are benefits in keeping your investments offshore.

Funds based in an offshore centre are generally not covered by the regulations which govern their UK-based equivalents. This means the investor does not always enjoy the same level of protection offered in the UK. Funds based in several of the larger offshore centres are deemed to meet UK regulatory standards where that centre has been granted “designated territory” status by the UK. Such funds can be marketed in the UK, as can funds based in the European Union and approved under the EU’s UCITS (Undertakings for Collective Investments in Transferable Securities) regime. If this all begins to look like a minefield, that serves to highlight the importance of getting independent financial advice.

As well as offering tax advantages, lighter regulation in offshore centres means funds can invest in a much wider range of markets than most onshore vehicles – a big attraction for the more adventurous investor.

But do remember that capital and income values may go down as well as up and you may not get back the amount invested, also exchange rate variations may cause the value of overseas investments to increase or decrease. Past performance is no guarantee of future performance.

The offshore sector presents all manner of pitfalls for the unwary, so for investors considering a move in this direction, getting specialist advice from an IFA is of paramount importance.

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Venture Capital Trusts (VCTs)

A Venture Capital Trust (VCT) is an investment company broadly similar to an investment trust.
It will be quoted on the stock market and will have to invest at least 70% of its assets in
companies that would qualify under the EIS, and must distribute most of its income by way of
dividend. It must be able to demonstrate a spread of investments: none can account for more
than 15% of the value of its portfolio.

Individuals who subscribe for new ordinary shares in VCTs up to £200,000 per tax year, qualify for 30%
income tax relief, provided the shares are held for at least five years (three years if the shares were
issued before 6 April 2006). In addition, any dividend received by individuals aged at least eighteen
in respect of ordinary shares in a VCT is exempt from income tax.

Gains accruing to individuals aged at least eighteen on the disposal of ordinary shares in VCTs are not
chargeable gains, but equally, no capital gains tax relief is available for losses.

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The EIS is a government scheme that allows certain tax reliefs for investors who subscribe
for qualifying shares in qualifying industries.

What benefits does the Enterprise Investment Scheme provide the investor and companies wishing to
raise new finance?

The investor

The investor can expect:

• Income tax relief at the 20% rate of tax on the amount invested in qualifying investments of up
  to £500,000 per annum. The EIS relief may be withdrawn if certain events occur within three years
  , e.g. shares sold
• Any gain arising on a disposal of the shares after three years to be free from capital gains tax
• Deferral of capital gains (no limit) on any other assets, by reinvesting all or part of the gain into
  an EIS company within one year before, or three years after, the gain accrued. The deferred gain
  becomes chargeable to capital gains tax if certain events occur later
• Relief for any losses made on the disposal of EIS shares against capital gains tax or, in some
  circumstances, income tax
• The opportunity to participate in the running of the business and to receive reasonable remuneration
  for doing so

As a result of the above, an individual could have a total tax saving and deferral of 60% of his investment.

The qualifying company

• The company can enjoy the opportunity to raise finance, either for initial start-up or for expansion

For shares issued after 6 April 2006 and where shares were subscribed to after 22 March 2006, the main
condition is that the scheme be limited to companies with gross assets of less than £7 million before, and
no more than £8 million after, the investment. For shares issued after 18 July 2007, the company must
have fewer than 50 full time equivalent staff. Please contact us for shares that fall outside of these criteria.

Outline of the scheme rules

Throughout its relevant three-year qualifying period, the company must:

• Be an unquoted company
• Have only fully-paid issued shares
• Be a trading company, carrying on a qualifying trade, wholly or mainly in the UK
• Exist for genuine commercial purposes, and not be part of a scheme for the avoidance of tax
• Not be a 51% subsidiary of another company, or otherwise be under the control of another company

In addition:

• An investor cannot be 'connected' with the EIS company, i.e. he or she cannot own more than 30%
  of the shares, directly or indirectly
• Individuals who are paid directors or employees of the EIS company at the time of the issue of
  shares are normally disqualified from claiming EIS relief. Otherwise, qualifying investors can in c
  ertain circumstances be paid for their work, provided the total remuneration package is 'normal and
  reasonable'
• The money raised by the EIS share issue must be wholly used for the qualifying business activity
• Schemes that involve guarantees or exit arrangements will not attract tax relief

Qualifying trades

The definition of qualifying trades is quite extensive, but certain activities (such as most dealing operations,
banking, leasing, legal, and accounting services) are specifically excluded, as are those considered to be
'asset backed' (farming, forestry, property development, hotels, and nursing homes). From 2008 excluded
activities also include shipbuilding and steel or coal production.

Spreading your risk

Investors who do not want to put all their eggs into one basket could consider an EIS approved investment
fund or a Venture Capital Trust (VCT).

Approved investment funds are collective investment vehicles employing a fund manager to invest
subscribers' money in qualifying companies. The fund manager brings together the total investment of
a number of investors over a number of companies.

Conclusion

The scheme is becoming more and more popular, and currently there appear to be more potential investors
than there are opportunities. As may be expected, the tax breaks have been introduced by the Government
to encourage would-be investors in what, given the nature of the investment companies concerned, must be inherently risky ventures. However, readers with an entrepreneurial spirit, surplus cash, and the appetite for a healthy payback, may be interested to learn more.

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VCT & EIS Compared

The reliefs for Venture Capital Trusts and the Enterprise Investment
Scheme are similar in many respects, but there are some significant
differences. The table below highlights the main reliefs.

* No limit on CGT deferral

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Questions and answers

Whatever the nature of the investments you are considering, the starting points should be the same. Gow's Independent Financial Adviser will be able to help you identify the type of vehicle best suited to your needs, based on your own preferred balance between risk and return.

One of the most obvious questions you should ask is “How much will it cost?” All collective investment schemes have built-in charges, but these vary, Gow's will answer all your questions in this regard. For the newcomer, the charges can be difficult to understand so it is important that this is explained properly.

Another key factor is how long you intend to invest. Gow's will clearly establish your requirements when it comes to short, medium and long-term investments and will endeavour tomake sure you understand all the risks of your chosen investment.

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• Profits and Perils
• ISA
• Friendly society
• National Savings
• Direct Investment
• Bond and gilt investment
• Pooled investment schemes
• Unit trust/ Investment Trust
• (OEICs)
• Absolute Return Funds
• Investment Bonds
• Offshore Investments
• Venture Capital Trust (VCT)
• Enterprise investment Scheme (EIS)
• VCT & EIS Compared