This article is part of the special series, Investing with ISAs Week.
Morningstar's 'Perspectives' series features guest contributions from third parties such as asset managers, academics and investment professionals. The below article was written by Tom Stevenson from Fidelity Worldwide Investment.
With less than a month to go until the end of the tax year, it is decision time for all of us last-minute ISA and SIPP investors. Making the sensible choice to use these use-them-or-lose-them tax breaks is unfortunately just the start. As both ISAs and SIPPs are nothing more than tax wrappers, you still have to decide what to put in them.
It goes without saying that nobody’s circumstances are the same so the following thoughts should be taken as ideas and not recommendations but here are six questions you might want to ask yourself as you decide how to invest your ISA allowance during the next few weeks.
1. Cash or stocks and shares?
This is the first key question to answer. For me the answer is, this year more than most, a relatively easy one because the rates on cash are so pitiful. The government’s funding for lending scheme is designed to encourage banks to lend more by giving them access to cheap funds. It has been more successful than many imagined and cheaper mortgages have been one welcome consequence for borrowers. For savers, the result has been less happy. Banks are no longer competing with each other for savers cash and so cash ISA rates this year are even worse than they have been in recent years. This is one reason why we and other fund managers are seeing increased rates of saving into stocks and shares ISAs, which in many cases offer investors a higher income, albeit with the risk that their capital may be at risk. Many reluctant investors are accepting that, four years after interest rates hit a 300 year low of 0.5%, this is a risk they are prepared to take.
2. Bonds or equities?
Once you have decided to take the plunge with a stocks and shares ISA, the next question is whether you want to invest in shares or bonds. In recent years, investors have favoured bonds because they have historically been less volatile than shares and, in an environment of falling interest rates, have also enjoyed equity-like returns. It’s been a very attractive combination for many people, especially those reluctant refugees from cash accounts. Today, however, the relative attractions of shares and bonds are much more finely balanced. Some have talked about a “great rotation” out of bonds and into equities although the evidence on this is mixed. Equities offer income and the potential for growth but more volatility. Bonds also offer income and lower volatility but probably less prospect of a capital gain than in recent years. There’s no right answer to this question and many investors will still decide they want a bit of both in their portfolios.
3. Home or away?
The UK economy is bumping along the bottom and just the other week Britain lost its prized AAA credit rating. There is even talk of an unprecedented triple dip recession. It is not hard to see why investors should be wary of investing at home. However, the UK stock market is one of the most international. Many of our leading companies earn a high proportion of their profits overseas and this has led to a mismatch between the performance of the UK economy and that of the London stock market. Shares are trading close to a five-year high and have regained almost all of the losses since the financial crisis erupted in 2008. People are rightly more comfortable investing in companies they are familiar with and which they can track in their daily newspaper. And UK companies offer very attractive income yields today.
However, a glance at the best selling funds on Fidelity’s personal investing supermarket shows that some of the most popular investments are currently in Asia and other emerging markets. Investors seem to be taking a barbell approach – half at home and half away. In an uncertain environment, that seems pretty sensible to me.
4. Developed or emerging markets?
Investors “get” the emerging market story. The world is clearly rebalancing towards big developing economies like China and India. But some of the best-selling funds right now are US tracker funds. There are a couple of good reasons for this. First, the American economy is recovering more strongly than most thanks to the decision (correct in my opinion) to delay restoring fiscal discipline until growth is more firmly entrenched. Second, some experts believe that investing in emerging markets can just as easily be done via those big multi-national companies in America and Europe which derive an increasing proportion of their sales in the developing world. Again there is considerable merit in splitting your portfolio between both emerging and developed markets.
5. Passive or active?
Both actively managed, stock-picking funds and passive funds are currently on our lists of best-sellers right now. This makes sense because passive funds have some advantages over active funds (they can be cheaper and they are simple to understand) but some disadvantages too (simply buying every share in an index means an investor is guaranteed to not outperform that index and they will automatically have a higher exposure to the index’s biggest companies, which may well not be the most attractive investments).
My view is that passive funds are best suited to well-researched, developed markets where gaining a competitive edge can be more difficult for fund managers. Meanwhile, in less well-researched emerging markets, or when investing in smaller companies for example, an active approach is likely to be better.
6. Income or growth?
There are as many different investment styles as investors but these are often grouped into two broad approaches – income or growth. As the names suggest, the first type of investor focuses on the dividend income that companies pay to shareholders and tries to assess how reliable that income is and by how much it is likely to grow over time. Growth investors are more interested in how fast profits are likely to grow.
Both approaches have their merits although growth investors have a tendency to be more optimistic by nature and are generally prepared to pay a higher price for their investments. This can make them more volatile than income funds where expectations for growth are lower so there is less room for disappointment. My temperamental preference is for income funds because over time dividends contribute the lion’s share of total returns. If you don’t need to take the income from a high-yielding share, reinvesting it can be a fantastic way to create capital appreciation. Again it can provide the best of both worlds.
The original version of this article was issued by Fidelity on February 28, 2013.
Morningstar Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com.
Fidelity Disclaimer
Note the value of an investment and the income from it can go down as well as up, so you may get less than you invested and tax rules and allowances can change. The ideas and conclusions in this column are the author's own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security. Past performance is not a guide to what may happen in the future and the figures and returns in this article are purely to illustrate the author's points.
