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.
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.