A version of this article was first published on Morningstar.co.uk in January 2010.
Giving a child an investment fund as a birthday present might not sound like the most exciting gift for an eight-year-old. After all, you're competing with gifts like Super Soakers, Star Wars stormtrooper helmets and the latest Barbie. But if you are truly out to do more than impress your child or grandchild, an investment for their future is a great alternative. And financial planners say you may be surprised at the side benefits of such a gift.
"We have a number of clients--grandparents--who insisted on taking out life insurance policies or savings plans," AMP financial Planner Mark O'Leary says. "When the money became available, the children were reminded where the funds came from, from their grandparents' hard work, and the children deal with the money with a lot more respect."
Here are some questions to address when considering a gift that keeps on giving.
Is a Managed Fund the Best Investment Vehicle?
If you're looking at an ultra long-term investment horizon, then managed funds can be very suitable. Further, a managed fund can generate capital growth and in some cases, income, while the simplicity of a managed fund means children can also learn some invaluable lessons about money.
Axa financial adviser Robert Joseph has seen first-hand the impression early investing can leave on a child. "When a child starts their own life and they have had a background of building their financial knowledge, you can see the children have their own knowledge," O'Leary says.
For the person providing the investment gift, a managed fund enables them to set up an investment with smaller amounts of money than other investments such as direct shares. They are also neat and portable and regular contributions can be made. Another benefit is the effect of compounding returns.
However, ultimately, when deciding on an investment vehicle, an investor must consider the main purpose of the investment.
Joseph adds that if the gift is intended to one day pay for a specific goal such as university, the flexibility of a managed fund is a major advantage over vehicles such as scholarship funds. That way, if the child opts for a different route in life, the funds can remain invested and can be accessed when the child's chosen path requires it.
Tax Matters
Generally funds with higher levels of growth assets attract higher fees. Many investors are attracted to index funds. "Index funds provide a systematic approach to investing," Joseph says. "They are less reliant on the skill of a particular investment manager which in turn is a risk that active funds can suffer should a manager leave that particular fund."
The key issue when it comes to tax matters are whose name the investment is held in and the purpose of the investment. Generally whoever's name the managed fund is held in will be liable for the tax but, though "tax [supposedly] doesn't have to be taxing," it can be certainly be complex and it's always worth checking with a financial adviser or speaking directly to HM Customs & Excise before plunging your pennies into a child's fund.
You can cut out the tax issue by investing in a Junior ISA, a tax-free savings and investment account for children. Read 5 Things You Need to Know About Junior ISAs for more details.
Suitable Asset Classes
The long-term nature of this type of investment means growth assets are going to give the child the best possible chance at maximising returns. Cash and fixed interest would not maximise the long-term benefits of this investment's time frame.
"Generally working on the rational that a child has a lifetime of 40-45 years of income earning, they could withstand the volatility in growth assets, as they have the ability to replenish any capital losses in such a portfolio," Joseph says.
Other issues to consider include the child's age, how long until they might want to access their funds, what level of volatility is acceptable, and what to do should the investment's value drop below the level of capital invested.
Choosing Funds
Morningstar's fund analysis manager Chris Douglas says if a giver wants a hands-off investment that doesn't need to be monitored on a monthly basis it is hard to go past index funds. A Vanguard multi-sector fund, which comes at a very low cost and investors do not have to worry about active investing, would fit the bill, for example. Another option might be a fund that offers a 60/40 split between equities and fixed interest, whereby the aim is to deliver equity-like returns without the risk of investing solely in equities.
Joseph suggests a giver might want to consider investing in a blue-chip fund or a value manager who invests in large-cap companies that provide consistent growth and income, which over the long term would be a safer option than investing in a small-cap equities fund or a blended medium-cap/large-cap fund.
"I think that time in the markets for a young investor is more important with less emphasis placed on timing and active management. Let's face it, there are only a handful of active managers that are consistent and can justify their fees," he says.
You Still Need To Be Diversified
Despite the long-term nature of an investment for a child, diversification remains a critical issue.
"Certainly when you are looking out 20 plus years, a lot can change," Douglas says. "Even over five-year blocks, equities do not always outperform global markets and equities over the short-term do not always provide negative returns."
The key message here is nothing is certain. But diversification does not only refer to diversifying between asset classes, but also within asset classes and manager styles.
O'Leary says that, given this, if an investor was comfortable in investing only in one asset class such as international equities, given the broad range of sectors it covers, there would be nothing wrong with this approach.
However, a more concentrated portfolio that does not include style or sector diversification does reduce the potential for a portfolio to improve returns and minimise losses. "Take, for example, investing in only mining stocks compared to a portfolio that invests in three to five sectors like mining, banks, Telcos, healthcare and infrastructure," Joseph says. "The latter portfolio is more insulated from a downturn in the consumption of commodities."
The act of diversification, though not a magic bullet, aims to minimise risk and is an important factor for investors of all ages to consider. Read this article for more on why diversification is important and how to go about ensuring your--or your child's--portfolio ticks the right boxes.
Top Tips
To sum up, here are our seven top tips to take into consideration when investing for a child:
1. Identify the purpose for the investment;
2. Consider index funds that provide a low-cost, long term option, while multi-sector funds ensure adequate diversification;
3. The long term nature of the investment means you can do better than cash and fixed interest investments;
4. Understand fees as they erode the real benefit of the investment;
5. Keep the investment flexible in case the purpose changes;
6. Use the investment as an opportunity to teach a child some basic principles of investing;
7. Be open to evolving the initial investment as needs and wants change.
To find out how Morningstar director of fund research Jackie Beard has been investing on her own niece's behalf for the past 18 years, read her An investment is a present that keeps on giving article.
