The benefits of investing using Isas may not be fully appreciated until the end of life, when you can reap your tax-free dividends and investment gains without a penny of tax owing.
However, a growing number of investors want their tax relief in advance – and are willing to take increasing risks to get it.
As the end of the fiscal year approaches, the rush to invest in venture capital trusts (VCTs) is on. A record £1billion is set to be invested in funding fast-growing UK start-ups in the year to April 5, according to investment platform Wealth Club, which says current inflows are £20m a week.
Selling tax breaks to investors is clearly big business, but look beyond those benefits, and is the underlying investment case really that great?
So far this year, £886m has been raised, around 75% more than at this stage the previous year, and the highest annual amount since VCTs launched in 1995.
After sifting through nearly 900 comments from readers who responded to the FT’s recent bonus survey, it’s clear that the ‘cap’ on retirement savings is what is really driving the growth of riskier investments and fiscally advantageous.
VCTs and the Business Investment Scheme (EIS) are fast becoming mainstream investment choices, with just over 7% of FT readers in our survey intending to invest bonus money in them. – many of them for the first time.
In exchange for a multi-year investment in qualifying UK early-stage companies, investors can benefit from tax relief up to 30% upfront, and up to 50% for riskier Seed EIS (SEIS).
The precise rules, annual limits and benefits vary, but may include tax-free dividends, tax-free growth and potential estate tax benefits, as well as “loss relief” in the event of investment failure. All of this helps investors tolerate the other thing these investments have in common: high fees.
Readers are wise about this. While VCT fees are high, one commented, at least the trust structure forces managers to be transparent about fees. What he struggled with was assessing the ability of specific managers to provide investment returns that might justify those costs – a major concern when making long-term illiquid investments. Can I offer other thoughts?
Before even considering a fund manager’s ability to pick winners, what worries me most about VCTs is their recent popularity.
Years ago when I started on the Investor Chronicle, these investments were a nice niche choice. Now a billion pound industry, fierce competition to invest in the companies of tomorrow is driving up prices and stretching the valuations of start-up fund managers’ target, which doesn’t bode well. for future returns.
“There are only a limited number of good growth companies that managers can invest in, so they will look to drive prices up,” says Ben Yearsley, a seasoned VCT investor and director of Shore Financial Planning. .
However, the strong past performance of VCTs has attracted more investors to their tax-free benefits. According to data from the Association of Investment Companies, VCTs generated average total returns of 24% in 2021, albeit after a difficult year in 2020.
For those wishing to compare the past performance of different managers, a free comparison tool on the AIC website helpfully lists VCT total returns over one, five and 10 years, as well as statistics on dividend growth and ongoing charges.
Yearsley has invested in several VCT and EIS augmentations since the late 1990s. Representing 15% of his overall portfolio, he claims his overall returns (net of fees) average around 7% per year. “Take into account the tax breaks, and it’s closer to 10%,” he says, adding that it’s nice to get the regular dividend checks and not have to pay tax on them.
Given the superior long-term performance of Isa’s top picks such as the Fundsmith or Baillie Gifford trusts, you might be surprised that the VCT investor target “growth spurt” doesn’t produce higher returns.
Those salivating at the thought of jumping into “unicorns” such as Cazoo or Zoopla early should remember the reason for the tax breaks – the risks. For every unicorn, there are hundreds of lame ducks.
The largely benign economic conditions of the past 10 years have generally been good for start-ups, and the tech sector bias of many VCTs has helped protect them during the pandemic. However, the outlook – and soaring inflation in particular – is more challenging, especially given today’s bountiful valuations.
This brings me back to the impact of fees. If the size of VCT’s assets under management grows at such a pace, can investors expect a drop in the ongoing fees of fund managers? I doubt.
The minimum ticket size of £5,000 typically required to access these types of investments means that building a diversified portfolio across multiple funds is costly – not to mention illiquid, as the money must remain invested for years, otherwise you lose the tax relief.
One FT reader who took our survey said he invested £20,000 of his bonus in his Isa, and a further £20,000 in SEIS, where the risk of backing ultra-startup companies means investors benefit from even higher tax breaks of 50%.
“I was attracted to the initial relief which means I will get £10,000 back when the money is invested and my certificates arrive, but I was unaware of the loss relief benefits which can be offset by future tax bills if these investments don’t work out,” he says. “Also, you never know – there’s a slim chance I could stumble upon the next Uber.”
Yearsley warns that because of the risks, the “natural route” should be VCT first, EIS second and SEIS last. “I invested in a SEIS program with 36 start-ups, and 28 went bankrupt,” he says. “I’ll probably get my money back over eight years, but that’s mostly due to the tax breaks.”
More experienced investors may prefer to take on the role of fund manager themselves, targeting EIS investments in a single company of their choice, rather than a fund.
If you can handle this concentration of risk, you’ll typically need £15,000 to £25,000, and the introductory fee could be 5% or more. But as Yearsley says, “A big part of the call is to get involved. You can choose which projects you invest in and you will usually have access to management. »
He has chosen to invest in his local brewery – he obviously loves beer, but also feels satisfied with the jobs that are being created as the business grows – and he hopes to double his money over eight to ten years.
Above all, he is ready to swallow the losses if things do not go as planned. But I wonder how many investors cramming into VCTs this spring have made such a sober assessment of the risks they’re taking in exchange for tax relief.