InvestmentsMar 6 2014

Isa season:Using ETPs to manage a portfolio

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What follows is an evaluation of the savings that can be made through Isas (both the ‘cash’ and the ‘stocks and shares’ variety) and the benefits of using exchange-traded products (ETPs) as an investment vehicle.

Isas

The maximum Isa allowance is £11,520 for the tax year running from 6 April 2013 to 5 April 2014. Investors can save up to £5,760 in a cash Isa with the remainder in a stocks and shares Isa, or, they can invest their full allowance in a stocks and shares Isa. Stocks and shares Isas can include a number of investment vehicles, including shares in funds authorised by the FCA and shares in authorised non-Ucits retail schemes (for example swap-based ETPs tracking commodity indices).

Investors who have allocated capital to Isas do not pay any tax on income received from their Isa investments, which includes dividends and interest. Additionally investors pay no tax on capital gains arising from their Isa investments. Losses in Isas, however, cannot be used to offset gains made elsewhere.

In the current low interest rate environment it is understandable that investors might be reluctant to put their full Isa allowance into a cash Isa. However, stocks and shares Isas provide an opportunity for investors and advisers looking to generate higher levels of return. This all, of course, comes with the risk that stocks and shares Isa investments can go up or down in value.

In Chart 1, we have compared the gross returns of two hypothetical investments of £11,520 (the maximum Isa allowance), assuming a 5 per cent annual return over 30 years. One portfolio is invested in an Isa (not including Isa fees) and the other is invested outside of an Isa and subject to capital gains tax of 18 per cent. After 15 years the Isa would hold £23,949 and the non-Isa £21,712. Over the full 30-year period the returns generated in the non-Isa are 18 per cent lower, reiterating the savings that can be made by investing through Isas. The returns for non-Isa portfolio would be even lower for higher rate-tax payers who are subject to higher levels of capital gains tax.

The example above does not, however, take into consideration the impact of product fees on net returns. It is on the issue of costs that the case for considering exchange-trade products in asset allocation becomes compelling for private investors and advisers.

Exchange-traded products are financial instruments, traded on stock exchanges, which typically aim to replicate the returns generated by an underlying benchmark index or asset. This form of passive investment is inherently less cost intensive than more expensive actively managed strategies. Additionally ETPs have their own tax-saving characteristics as investments are free of 0.5 per cent stamp duty in the secondary market (and soon the primary market in April 2014).

In Chart 2, we have compared the returns of the Isa investment, referred to in the example above, when fees of 0.37 per cent (average TER for equity ETPs ), 0.85 per cent (average TER for equity index funds ) and 1.6 per cent (average TER for equity actively managed funds) respectively are applied over time.

After 15 years the Isa-using equity ETPs holds £23,009; the Isa using equity index funds holds £21,786; and the Isa-using actively managed funds holds £19,874. Over the full 30 years the returns generated through the Isa-using actively managed funds are 26 per cent lower than the Isa-using ETPs. This example demonstrates very clearly how Isas holding ETPs can potentially generate higher levels of return, compared to Isas-using index tracking and actively managed mutual funds, particularly when higher product fees are compounded over an extended period of time.

Inflation is an additional factor that advisers should consider when evaluating portfolio performance. Although Isas provide tax savings, they are still subject to inflation, which can erode future returns considerably over time, especially if levels of inflation increase. This reiterates the potential of using relatively low-cost investment vehicles like ETPs to generate higher levels of return.

The benefits of using ETPs in Isas, however, extend beyond low-expense ratios. The superior accessibility provided by ETPs, in comparison to both tracker mutual funds and actively managed mutual funds, can be an important factor for advisers to consider when constructing client portfolios. For example, mutual funds are typically priced only once a day, and sometimes less frequently, which means that orders are placed without knowing the actual price of the fund until some time after execution of the order.

In contrast ETPs are traded intra-day and priced on a continual basis, which means that live prices can be monitored and orders placed at any point while stock markets are open. Therefore, like stocks, advisers can choose the optimal time to execute, for example when the price of a security falls to a certain target level during a given trading day. Additionally, given that ETP prices are determined by trading activity on an open market as opposed to the fund company itself, as is the case with mutual funds, a greater level of pricing transparency is ensured.

Importantly also, advisers can use ETPs as the building blocks of multi-asset portfolios. Since the advent of ETPs, advisers have had the opportunity to construct portfolios exposed to a diverse range of assets that perhaps would otherwise be very difficult to access, for example agricultural ETPs offering exposure to coffee and corn futures returns. Physically backed precious metal ETPs have also provided access to historically popular investments like gold, providing cost-efficient and flexible alternatives to physical delivery.

Exposure to more mainstream asset classes like equities and fixed income can also be provided by ETPs. Instead of buying shares in individual companies which carries a certain level of risk, advisers can use ETPs that track indices providing exposure to movements in the share price of a number of companies across a particular market sector, for example, FTSE 100, small-cap US equities or global gold miners. The use of ETPs tracking multi-constituent indices can potentially help reduce the overall volatility of portfolio returns,while giving advisers the flexibility to blend tactical and strategic positions.

The broad asset class coverage that ETPs provide access to, ranging from traditional assets such as equities and fixed income to alternative assets such as commodities and currencies, allow advisers to easily construct tailored portfolios incorporating diversified strategies, which can be tailored specifically for a client’s given level of risk tolerance. As wrap platforms continue to increase their ETP coverage, advisers will be presented with a growing number of investment options.

As the 6 April Isa deadline looms for the 2013/14 tax year, advisers may well be considering how best to maximise portfolio returns within the tax wrapper. Although there is a rich tapestry of factors that will determine overall portfolio performance, the use of ETPs as an investment vehicle in Isas is something that advisers should evaluate closely.

Frank Spiteri is head of retail distribution at ETF Securities

Key points

* Investors looking for good returns on their Isas should consider investing in ETPs

* After 15 years the Isa using equity ETPs holds more than the Isa using equity index and actively managed funds

* Advisers can use ETPs that track indices providing exposure to movements in the share price of a number of companies across a particular market sector.