InvestmentsMar 22 2012

Spotlight on ISAs: building blocks to success

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Isa season is gathering pace and we expect income to be a hot topic for many clients. Interest rates have been at their record low for years now and, given the persistent economic malaise, I do not expect them to rise any time soon.

Clients need other investments to fill the gap and, at a time when so many people are struggling to make ends meet, fund providers and advisers can be a real force for good by helping clients achieve immediate income and long-term financial security.

When Isas replaced Peps (13 years ago, how time flies) the yearly allowance was £7000: a fortune for some, but a pittance to others. Back then I sometimes heard advisers say they did not bother with Isas for their high net-worth clients. It struck me as odd that anyone would ignore such a flexible and tax-efficient vehicle. I doubt that anybody ignores Isas today, especially now that the allowance is more generous and is linked to inflation.

So whether you are mopping up your clients’ Isa allowances or making plans for early in the new tax year, there are a wide range of income options to consider.

Equity income funds are some of the best known and most successful funds in the UK. Their enduring popularity is testament to the appeal of dividends combined with capital growth potential.

The ability to pay consistent dividends is a great indicator of a strong company. This can give investors confidence, but the recent fiscal crisis has demonstrated that even stalwarts of the market – such as banks – are not immune to the cycle of boom and bust. So we must remember the principles of diversification.

Asian equity income funds have recently emerged as an alternative to the UK. You will not need me to tell you that Asia is the engine that will drive global economic growth in future. What is more, the investable universe is large, with more companies in Asia yielding over 4 per cent than in the UK and continental Europe combined. The long held belief that you can combine good levels of income where the income rises over time and get above average capital growth is really being borne out in many Asian companies - and it is a great geographic diversifier.

For those whose risk profile does not allow for equities, or if you simply want to introduce some diversification, then bonds are of course the other obvious asset class to consider. The shakeout in the corporate debt market in the last few years has created a situation where astute active managers can use their research expertise to add value.

Bond interest payments take precedence over the distribution of dividends, which is why bonds tend to provide a more consistent source of income than is available from equities. This also explains why their returns, particularly within the higher quality ‘investment grade’ area, tend to be less volatile than equities. High yield bond funds offer more income, but with more equity-like volatility, so maybe there is a good half-way house.

Strategic bond funds are a particularly interesting way to invest in fixed income. These highly flexible mandates are able to choose from government bonds, corporate bonds, asset-backed bonds, investment grade and high yield bonds as well as derivatives, thus providing a wealth of asset allocation and security selection opportunities for skilled and well-resourced fund managers to exploit.

Many investors will have fallen out of love with property after the boom and bust of the last decade, but it would be a mistake to ignore the asset class completely. Do not forget that commercial property is first and foremost an income investment. The rental income is a key driver of long-term returns and provides a base level of return during challenging times.

Property is also a true ‘alpha’ asset class: there is no cost-effective way to invest through a tracker. Fund managers have the ability to enhance income (and capital) not only through property selection, but also through asset management. The ability to renegotiate leases, perform improvements to the property and manage tenants can be crucial sources of extra return in the hands of a skilled fund manager.

It is worth remembering that there are two main flavours of property fund. Direct property, or ‘bricks and mortar’, funds predominately invest in physical property. A Reit fund, by contrast, invests in listed securities and, although these certainly have a role to play, investors should be aware that their risk/return profile can be closer to an equity fund than to a direct property fund.

Both types can be found within the IMA Property sector, but investors should be wary when comparing the performance of property funds. The sector’s average sits somewhere in-between the two on the risk/return spectrum and reflects the true profile of neither group. It is more instructive to compare a direct property fund with its direct property peers, and likewise for Reit funds, when analysing performance.

At times fund selection can be a headache. Even if you have a strong idea of where investment markets are heading (pretty difficult right now) and arguably there are just too many funds to choose from when most clients only need to buy a handful.

In addition, adding and deriving value from running portfolios for smaller case sizes is uneconomic. The rise of multi-manager funds, particularly those that pay an income, has really helped financial advisers expand the services they offer clients by outsourcing portfolio management. These products look set to grow even more in future.

It is clear that in such difficult economic times there is still a wide selection of quality investments from which to build effective income portfolios for clients. Sure, they will have to take on some risk, but the shortfall created by low interest rates will force many to consider the alternatives. Combining higher yielding asset classes, and explaining how risk is being managed out should bear fruit, and obviously if this can be done within an Isa wrapper then you should have a real winner. After all, if you straddle the tax year a couple could tuck over £40,000 away within a matter of days in a solid portfolio paying out a tax-efficient income. Now that is a client solution worth having.

Simon Ellis is managing director of Legal & General Investments