An IFA can broaden your investment horizons.
Introduction
Although the idea of investing to provide for your future
financial security is gaining wider acceptance, for the would-be
investor, finding the most appropriate investment can be a
daunting prospect.
Consulting an Independent Financial Adviser (IFA) will be an
obvious first step for many, particularly those who are looking
at the various types of collective investment vehicles available
rather than planning to invest directly in shares.
Most of us now recognise the need for some kind of retirement
funding, but there is an increasing emphasis on the need for the
individual to take out some kind of private provision across a
broad range of areas, from healthcare to education.
But while retirement funding is obviously a basic need, a
pension plan need not be the only route to providing for your
future.
As well as savings vehicles designed for specific purposes –
such as school fees provision – there is also a whole range of
opportunities open to the investor wishing to generate extra
income or build up a capital sum for the future. Additionally,
the investor can address the need to provide for dependants in
the event of an unexpected loss of earnings.
Direct investment
All the forms of investment open to UK investors can, broadly
speaking, be split into two main categories – direct
investments, such as stocks & shares, or collective investment
schemes.
Firstly, direct investment. For the majority of UK investors,
this generally means shares or bonds or gilts. Although the
spread of share ownership has widened considerably in Britain
since the early 1980s, and with it public awareness of what
share ownership means, it is worth reiterating the basic
principles.
The price of a company’s shares is determined by the value of
its assets and its potential to generate further revenue. If
shareholders begin to see the estimates of future revenue as
unduly optimistic, or if the value of the company’s assets
declines, they are likely to sell their shares and this may
cause the share price to fall. If the reverse happens, demand
from buyers will increase – thus pushing the share price up.
The trade in stocks and shares, facilitated by market makers
whose role is to quote both a buying and selling price for
listed stocks and shares, is known collectively as the
stockmarket.
Public Limited Companies (PLCs) in the UK are listed on the FTSE
All-Share index, with the 100 largest listed on the FTSE 100.
Companies wishing to issue shares but lacking the financial
muscle for a full market flotation, or new start-up companies,
may opt for the Alternative Investment Market (AIM), which means
that, in most cases, companies listed on
AIM carry higher risk than those listed on the main stockmarket.
For the investor, the drawback to investing in AIM stocks is
their lack of liquidity. Market makers will constantly quote buy
and sell prices for FTSE stocks, but as trading volumes on AIM
are much lower, transactions are conducted using a process known
as “matched bargain”. This means the buyer or seller approaches
the designated broker who finds a counter party for the deal.
However, this in turn means the price agreed by the broker may
be some way off the last quoted trading price.
Bond and gilt investment
The second principle form of direct investment is bonds and
gilts. Bonds are basically chunks of debt. In buying a bond, the
investor is effectively lending money to the bond’s issuer. The
investor knows in advance what sort of return they will get on
their investment and bonds are generally regarded as a much
lower risk category of investment than shares.
Gilts are bonds issued by the UK government – the name derives
from the term “gilt-edged stock” – so by buying gilts the
investor is lending money to the UK government. As the UK is
regarded as a safe bet to honour its commitment to buyers of its
government stock, gilts are in turn regarded as one of the
safest forms of nvestment. The issuer – in this case the
government – is guaranteeing to repay your capital at the end of
the bond’s term, (if there is a redemption date) and you also
get a guaranteed coupon return throughout its life.
A bond with a face value of £100 will also pay a pre-set figure
in interest every year to the holder – the coupon rate. When the
rate is set it must be competitive with current interest rate
levels but these may change, thereby rendering the return on
your bond relatively less attractive than cash deposits. So
bonds are traded in the market to reflect this. For example, a
bond may be issued at a time when 6 per cent is an attractive
interest rate return and as a result your £100 bond may pay a
coupon rate of 6 per cent. So you have paid £100 to get £6 per
year plus your original investment back at the end of the bond’s
term.
But if interest rates jump to 9 per cent your coupon rate starts
to look a bit weak. You therefore sell your bond in the market,
but no-one will pay £100 to get only £6 a year so you have to
sell at a lower figure that builds in the difference in rates.
Of course you can take comfort from the knowledge that you will
get your capital
back at the redemption date, in this case from the UK Treasury.
But it is not just governments who issue bonds. Corporate bonds
work in a way that is broadly similar to government bonds – they
are issued by companies as a way of raising money from
investors. Again, they pay a coupon rate coupled to a pledge to
repay the capital at the maturity date. Like gilts, they can be
traded on the market if investors want their capital back before
the maturity date.
However, companies can default on corporate bonds, so return of
capital is not guaranteed. Corporate bonds are therefore
risk-graded, with higher risk bonds paying a higher coupon to
attract buyers.
Guaranteed return of capital is clearly an attraction, although
it has to be weighed against the potential for higher returns
offered by the stockmarket. But while recent years have seen the
long-term appreciation of prices in the stockmarket as a whole,
the investor cannot rely on every individual company seeing an
increase in the value of its shares.
This is the major potential pitfall of direct share investment –
any company is at the mercy of conditions in its own particular
business sector, and even companies in generally profitable
sectors can fall victim to bad times. Correctly identifying
which companies to invest in is therefore vital for direct share
investment. Warning against putting all your eggs in one basket
may seem a little obvious, but relevant in this context.
You should keep a close eye on how your investments are doing.
Potential investors often find the prospect of constantly keeping
tabs on their share portfolio too daunting and for this reason –
as well as those outlined previously – many opt to take their
first step into these markets via collective investment schemes
rather than direct stocks and shares investment.
Pooled investment schemes.
In the UK there are three principal types of mainstream
collective or pooled investment schemes – unit trust, investment
trust and Open Ended Investment Company (OEIC).
All three will take the pooled monies of a large number of
investors and put them in the hands of a professional fund
manager. He or she will choose a broad spread of instruments in
which to invest, depending on their investment remit. The main
asset classes available to invest in are shares, bonds, gilts,
property and other specialist areas such as hedge funds or
‘guaranteed funds’.
There are key differences between the three types of scheme
structure.
Unit trusts
An investor in a unit trust ‘buys’ a number of units, while an
investor in an investment trust or OEIC ‘buys’ shares. Unit
trusts are open-ended, which means that units can be issued as
demand requires. The price of these units is dependent on the
value of the underlying assets, and they can be sold back to the
fund managers by the investor. Most UK collective investment
schemes are authorised by the Financial Services Authority
(FSA).
Investment trusts
Investment trusts are structured as companies so their shares
are traded in the same way as any other limited company’s
shares.
Investment trusts offer a wide range of investments.
Open Ended Investment Companies (OEICs)
The OEIC is structured along similar lines to the unit trust,
but it differs as it has no bid/offer spread. This means buyers
and sellers get the same single price. Additionally, the OEIC
has an “umbrella” structure allowing numerous sub-funds
investing in different types of assets, so the investor can
switch easily between different investment funds.
Given the range of options of unit trusts, investment trusts or
OEICs, the choice can be confusing – consulting an Independent
Financial Adviser could help simplify your investment choice.
Index trackers and active management
Among the various types of fund management, two definite methods
have emerged – active management and index tracking.
Proponents of these two approaches debate over their respective
merits, but many observers have concluded that a “horses for
courses” attitude is appropriate for investors.
Through research and analysis an active manager will seek to
identify companies which he or she believes will perform better
than their rivals, or whose current share price makes them a
bargain buy. Potential returns depend on whether the manager
gets it right or wrong.
An index tracker fund tracks a stockmarket index. Having decided
which recognised market index is most appropriate for the
tracker fund, the manager (often a computer rather than a
person) will invest in such a way as to replicate the make-up of
that index. In times of good stockmarket performance tracker
funds are attractive.
But the critics of tracker funds point to two potential
drawbacks. Firstly, if the index falls, the fund must go with
it. Secondly, the cost of running the fund – administration
fees, management fees, etc, can mean that tracker funds’
performance is just below that of the index itself.
Active managers argue that their skills allow them to produce
better returns than the market average, and hence the index, as
well as to avoid the worst of any market falls by switching away
from the worst-affected shares. “Ah yes...”, say the trackers,
“...but how often do the active managers actually beat the
index?”
The debate rages on, but the argument serves to reinforce the
importance of getting good independent financial advice.
There are hundreds of collective investment schemes to choose
from. The services of an Independent Financial Adviser can
greatly simplify the investment process.
Investment. The profits and perils
So why should the saver, who has been content to build up a nest
egg in a deposit account, move into the riskier area of
investment in equity or bond markets? Well, the main reason is
the chance of a higher return than can be obtained from deposit
accounts. If the investor is prepared to be patient, mainly
types of investment are not for the short term, over time he or
she should be able to expect a higher return.
The investor must also consider the question of risk. In a low
interest rate environment the return on your deposit account may
decrease, but there is no threat to your capital. Investing in
shares is different. Potential returns can be much greater than
those offered by cash deposits. But if the shares in which you
have invested were to fall in price, there is a real threat to
your capital itself. If you are forced to sell your shares at a
time when they are performing poorly, you could actually end up
with less money than you started with.
An Independent Financial Adviser can help establish what level
of risk you should take with your investments.
Direct investment
Direct investment in shares is conducted through stockbrokers
who will buy or sell shares on your behalf for a commission.
Terms will vary from one stockbroker to another but commission
will be charged as a flat fee or a set percentage.
If you intend to actively manage your share portfolio by
regularly buying and selling different shares then the
commissions will start to stack up. The shares which offer the
greatest potential for high returns may also present the
greatest risk to your capital. So unless you intend to invest
directly in a broad range of stocks and shares, you should
probably consider a collective investment scheme instead.
Collective investments
• Unit trusts and OEICs can be bought directly from
the provider of the fund or more commonly, through an
Independent Financial Adviser.
• Investment trusts are most commonly bought through a
stockbroker, but again an IFA can also advise on their purchase.
Details of funds and fund providers are published in a range of
specialist financial publications as well as sections of the
national press.
Investing online
Use of the internet has opened up another access route for
investors. Many providers now offer their funds via websites.
However, given the range of investments and the amount of
information available it is a good idea to seek professional,
independent financial advice before proceeding.
Tax efficiency
If you are looking to invest directly in shares or bonds or
collective investment schemes, a tax-efficient method of doing so
is through an Individual Savings Account (ISA).
An ISA is not an investment in itself – it is a tax-efficient
“wrapper” which you may use to hold a range of investments.
As the UK’s principal tax-efficient investment plan, an ISA can
incorporate a stocks and shares element within which you can
invest up to £7,000 for the current tax year. Alternatively, you
can set-up two mini ISAs, the components being cash, stocks &
shares. The investment limits for mini ISAs are lower.
Within the stocks and shares element of an ISA you may invest
directly in shares or bonds or collective investment funds.
ISAs are explained fully in another IFA Promotion booklet,
entitled ‘ISA guide’.
It makes sense to take advantage of all the existing tax
allowances and your IFA will be able to help you do this.
Offshore investment
In specific cases, offshore investment may be worth considering.
From the UK perspective, offshore funds have traditionally been
used mainly by expatriates. Because UK expatriates do not
generally pay UK income tax, it makes sense for them to invest
in funds based in a low-tax centre such as Luxembourg or the
Channel Islands. However, some funds, accumulation funds in
particular, can offer a tax efficient use of offshore funds to
the UK resident.
If you are a UK expatriate intending to return only on
retirement when your tax status will be more favourable, there
are benefits in keeping your investments offshore.
Funds based in an offshore centre are generally not covered by
the regulations which govern their UK-based equivalents. This
means the investor does not always enjoy the same level of
protection offered in the UK. Funds based in several of the
larger offshore centres are deemed to meet UK regulatory
standards where that centre has been granted “designated
territory” status by the UK. Such funds can be marketed in the
UK, as can funds based in the European Union and approved under
the EU’s UCITS (Undertakings for Collective Investments in
Transferable Securities) regime. If this all begins to look like
a minefield, that serves to highlight the importance of getting
independent financial advice.
As well as offering tax advantages, lighter regulation in
offshore centres means funds can invest in a much wider range of
markets than most onshore vehicles – a big attraction for the
more adventurous investor.
But do remember that capital and income values may go down as
well as up and you may not get back the amount invested, also
exchange rate variations may cause the value of overseas
investments to increase or decrease. Past performance is no
guarantee of future performance.
But the offshore sector presents all manner of pitfalls for the
unwary, so for investors considering a move in this direction,
getting specialist advice is of paramount importance.
Here the services of an IFA with specialist knowledge of the
offshore market can prove invaluable.
Questions and answers.
Whatever the nature of the investments you are considering, the
starting points should be the same. An Independent Financial
Adviser will be able to help you identify the type of vehicle
best suited to your needs, based on your own preferred balance
between risk and return.
Most obvious among the questions you should ask is “How much
will it cost?” All collective investment schemes have built-in
charges, but these vary, so ask your IFA to explain. For the
newcomer, the charges can be difficult to understand so it is
important that this is explained properly.
Another key factor is how long you intend to invest. Make sure
your IFA understands your wishes clearly when it comes to short,
medium and long-term investments. Lastly, make sure you
understand all the risks of your chosen investment.
For further
information on the subject contained in this guide, please
contact your IFA.
This guide is issued
on behalf of Britain’s Independent Financial Advisers and has
been approved by a person authorised and regulated by the
Financial Services Authority.
Your home may be
repossessed if you do not keep up repayments on your mortgage.
Tax benefits may
vary as a result of statutory change and their value will depend
on individual circumstances. The name IFA Promotion® and the
Independent Financial Adviser (IFA) logo® are registered
trademarks of IFA Promotion Limited.
June 2007
