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Buyer's Guide to High-Return Individual Savings Accounts (Isas)

Created:
16 March 2007

The most fundamental rule of investing is that returns come as a reward for taking on risk. So, if you aim to outperform standard investments, you must be prepared to take on a higher degree of risk.

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Before making an investment in your individual savings account (Isa), you therefore need to consider your personal investment objectives, your time horizon and your attitude to risk. The latter may well depend, at least partly, on the former two.

For example, if you are investing to provide for your retirement, but do not expect to retire for another 40 years or so, you should be seeking capital growth, and should be able to withstand periods of market volatility along the way. You could also afford to take a higher risk approach, in the hope of outperforming. However, if you are investing for retirement, but planning to retire within a five-year period, you would have little time to make up any significant losses. So a lower-risk strategy, focused on capital preservation, would, in this instance, be more appropriate.

Taking on riskInvestments that offer the possibility of a high return are most likely to be taking on risk though specialising. For example, rather than taking diversified exposure to the whole UK market, a fund may only invest in smaller companies or technology companies.

With luck - and your manager's skill, in an actively managed fund - you could beat the FTSE All-Share index. However, if market conditions were not favourable (even with a good fund manager), you could underperform - for example, technology companies might be out of favour, even though the overall market rises.

As well as being specialist, the sectors that offer the possibility of high returns tend to be particularly risky. For example, small companies have less fat than their larger peers to help them survive a recession, while a technology company, for example, may never become profitable if its product is not widely adopted.

Most higher risk areas are also relatively illiquid, which means they can be hard to trade. Apart from the risk that you might struggle to sell an investment at a decent price, this also explains, in part, why higher risk areas can offer outperformance.

Illiquid assets over-react to market moves, rising faster than the market (due to an oversupply of buyers) or falling harder (due to an oversupply of sellers). For example, smaller companies often trade at a discount to large caps, reflecting liquidity and recession risk - but this discount can narrow in a bull market, leading to outperformance.

Specialist and illiquid sectors also tend to be under-researched, which provides opportunities for fund managers to spot undiscovered growth potential or valuation anomalies.

So if you decide to invest in a higher risk area in the hope of achieving higher returns, you should quantify the sort of risks you are taking on. You could look at the historical volatility (a measure of risk) of an investment, compared with its peers or a benchmark.

And the beta will show how an investment moves relative to its benchmark. Betas below one show investments that have historically moved less than the index, whereas betas over one show investments that have enhanced market movements.

You also need to consider the style of a fund. Tracker funds replicate the performance of an index, whereas active fund managers take bets away from their benchmark index in an attempt to outperform, thereby running the risk of underperformance.

But it's only worth paying for an actively managed fund if the manager has a strong track record. Some actively managed funds, known as quasi trackers, take very little risk away from the benchmark index, and are a waste of money. Actively managed open-ended funds cost approximately 1.6 per cent a year, whereas tracker funds should cost no more than approximately 0.5 per cent a year.

Some fund managers use highly-concentrated portfolios to enhance the effect of their stock-picking conviction, taking on more risk, rather than diversifying. These focus funds tend to hold less than 50 companies, whereas standard funds hold 100 or more companies.

Nowadays, though, more managers are adopting absolute return mandates by aiming to deliver positive returns each year, rather than aiming to outperform a benchmark index (which might fall). These funds offer some downside protection, but are more likely to underperform in a rising market. So, if you are seeking high returns, you should avoid them.

Click here for tables of top-performing Isa-qualifying funds (as a PDF file)

Building a portfolioIf you are going to take on risk, you should diversify your portfolio to protect yourself against market volatility. This means holding assets that have low correlations - in other words, they tend not to move in line with one another. For example, a growth investor might also invest in low-risk gilts (UK government bonds), as these should act as safe havens if equities fell.

Given the possible downside risk, you should certainly not stake everything on one high-return fund or sector. For example, Justin Modray, of independent financial adviser (IFA) Bestinvest, notes, "Even the most aggressive growth investor should not hold more than a quarter of their portfolio in smaller companies."

Novice investors should therefore build up portfolios around core holdings - generalist global and UK equity funds - before considering higher-risk specialist funds as satellite holdings. Don't forget, too, that there is likely to be some overlap between generalist funds and specialist funds - for example, a regional fund will often hold some smaller companies and technology companies.

Most open-ended funds only require a minimum investment of £1,000 each, so you could build a well-diversified portfolio, with a single year's £7,000 Isa allowance.

Fund managers- own Isas only offer in-house fund ranges, which may be quite limited, and there is no advice is available. Fund supermarket Isas allow you to mix and match open-ended funds from different management houses, with or without advice from an IFA. Execution-only IFAs (known as discount brokers) can often offer additional discounts on top of those available if you bought a fund supermarket directly.

Self-select Isas allow the widest possible diversification, as you can invest in shares and investment trusts, as well as open-ended funds. Nevertheless, you should check what investments a self-select Isa provider or fund supermarket offers, as some are more restricted than others, and your choice of provider will depend on your own investment needs.

For example, Hargreaves Lansdown offers more than 1,500 open-ended funds in its self-select Isa, but charges 0.5 per cent a year on any shares held (capped at £200). By contrast, Alliance Trust does not have an annual management charge on shares held in its Isa, but offers a restricted choice of open-ended funds.

Open-ended funds tend to be lower-risk than investment trust equivalents. Investment trusts can trade at a discount or premium to their underlying values - discounts narrow in rising markets, but widen during downturns. In addition, investment trust managers can use gearing (borrowing to invest) to boost returns, although this magnifies losses in a falling market.

However, investment trusts have closed-ended portfolios, so  managers do not need to disrupt their portfolios to deal with inflows or redemptions. Open-ended managers can be hit by ouflows when markets are falling, and force selling at weak prices.

The effects of gearing and narrowing discounts mean that investment trusts tend to outperform when markets are rising. For example, Investors Chronicle's annual investment trust tips have produced an average return of 83.86 per cent during the past five years, compared with a 61.56 per cent average gain from our open-ended fund tips, and an average 50.23 per cent return from the FTSE All-Share index (see the online version of this article for the full data).

  • For comprehensive details on self-select Isa providers - not to mention this year's fund and trust tips - see our sibling publication Investor Guide. Click here for details.

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