An individual savings account (Isa) is a great opportunity to take better advantage of investments returns, as investments held within the wrapper are free of income and capital gains tax. But if you fill your Isa with costly funds, high charges will eat away much of your returns.
To maximise the tax advantages of an Isa passive funds such as exchange-traded funds (ETFs) could be a good option. The total expense ratios (TER) of ETFs are usually well below 1 per cent, compared with an average of around 1.6 per cent for a unit trust or open-ended investment company (Oeic).
Countless pieces of research have shown that passive funds consistently beat the average actively-managed fund in a number of sectors as many active funds fail to outperform their benchmarks.
But before you pop an ETF into your Isa, it is important to ensure that the fund is indeed Isa eligible. Most ETFs listed in London are domiciled in Dublin or Luxembourg, which means they are classed as offshore funds, and some might not benefit from the tax advantages of an Isa. You should check on the ETF provider's fact sheet and other literature to see if this is the case - if you cannot find the information, contact the provider before you invest.
Offshore funds also do not automatically have UK reporting status which means that once you sell your shares or units in them you may incur income tax rather than capital gains tax, as you would when you sell a UK-domiciled fund. Many ETFs listed in London have share classes with UK reporting status, but again check the provider's literature before you invest.
ETFs are listed shares which you have to buy from a stock broker, so every time you buy one you will incur trading charges. This can become costly if you make regular payments into your Isa rather than a lump sum once a year, so if you are going to do the latter, you may be better looking at other types of funds. This does not necessarily have to be an active fund - you could use a tracker such as those offered by Vanguard and HSBC.
Portfolio construction
Investors are increasingly opting for a mixture of ETFs and active funds in their Isa. Some choose to hold ETFs to cover core mature markets such as the UK, US and Japan. ETFs can be particularly useful in efficient markets such as the US and Japan where many fund managers fail to outperform, while in less efficient markets such as emerging and frontier markets, good active managers can add value. There are also some excellent active investment trusts focused on continental Europe including Jupiter European Opportunities charging a 1.39 per cent total expense ratio (TER), BlackRock Greater Europe (1.35 per cent) and Henderson Eurotrust (1.28 per cent). With problems in Europe an active manager is particularly useful not just to pick good companies but to avoid trouble spots.
An alternative approach is to use active funds for your core holdings and ETFs for smaller 'satellite' exposure to more unusual asset classes and markets. You may not be able to access some assets with active funds, for example, commodities, while the more esoteric markets tend to be covered by a wider range of ETFs than active funds. Also, active funds which cover unusual markets sometimes have very high TERs.
For your core holdings you could invest in db X-trackers FTSE 100 which has a 0.3 per cent TER. Deutsche Bank ETFs use synthetic replication so do not buy the physical assets they invest in but rather a swap, relying on the swap counter party to deliver the returns the assets make, which of course introduces new risks. If you prefer physical replication where the fund buys the shares it tracks, options include iShares FTSE 100 ETF with a 0.4 per cent TER.
Other ETFs for core UK exposure include db X-trackers FTSE All Share ETF with a 0.4 per cent TER, iShares FTSE 250 with a 0.4 per cent TER and db X-trackers FTSE 250 which uses synthetic replication and has a 0.35 per cent TER.
The cheapest US fund is HSBC S&P 500 ETF with a 0.09 per cent TER which uses physical replication, while db X-trackers S&P 500 has a 0.2 per cent TER.
Japan funds include db X-trackers MSCI Japan charging 0.5 per cent, iShares MSCI Japan with a 0.59 per cent TER and HSBC MSCI Japan with a 0.4 per cent TER.
For global exposure iShares MSCI World comes with a 0.5 per cent TER while HSBC MSCI World charges 0.35 per cent.
Income hungry investors may choose the iShares FTSE UK Dividend Plus which tracks the FTSE UK Dividend+ Index via physical replication, an index composed of the 50 highest yielding UK stocks in the FTSE 350 excluding investment trusts. The ETF has a TER of 0.4 per cent.
Mick Gilligan, head of research at Killik & Co, suggests the SPDR S&P Dividend Aristocrats ETF. This tracks the performance of the S&P High Yield Dividend Aristocrats Index, comprising the 60 highest dividend yielding constituents of the S&P Composite 1500 Index that have increased dividends every year for at least 25 consecutive years. It has a 0.35 per cent TER and makes uses of physical replication. The fund is currently seeking UK distributor status.
Core ETF holdings for your Isa
| Fund | Replication method | 1-yr tracking error (%) | Total expense ratio (%) |
| db X-trackers FTSE 100 | Synthetic | -0.31 | 0.3 |
| iShares FTSE 100 | Physical | -0.42 | 0.4 |
| db X-trackers FTSE All Share | Synthetic | -0.4 | 0.4 |
| iShares FTSE 250 | Physical | -0.27 | 0.4 |
| db X-trackers FTSE 250 | Synthetic | -0.34 | 0.35 |
| HSBC S&P 500 ETF | Physical | 0.23 | 0.09 |
| db X-trackers S&P 500 | Synthetic | -0.16 | 0.2 |
| db X-trackers MSCI Japan | Synthetic | -0.44 | 0.5 |
| HSBC MSCI Japan | Physical | -0.35 | 0.4 |
| iShares MSCI World | Physical | -0.5 | 0.5 |
| HSBC MSCI World | Physical | 0.1 | 0.35 |
| iShares FTSE UK Dividend Plus | Physical | -0.55 | 0.4 |
| SPDR S&P Dividend Aristocrats | Physical | na | 0.35 |
Source: db X-trackers, iShares, HSBC, State Street.
Satellite options
ETF Securities has a wide range of exchange-traded commodities (ETCs) including a few funds which physically own the metals they invest in, such as ETFS Physical Gold (0.39 per cent management fee) and ETFS Physical Silver (0.49 per cent ). The ETFS Physical PM Basket tracks gold, silver, platinum and palladium and has a 0.43 per cent management fee.
iShares also offers physical metal funds, for example the iShares Physical Gold and Physical Palladium ETCs with respective TERs of 0.25 and 0.4 per cent.
All other ETF Securities funds use synthetic replication and in the case of the ETCs track the price of futures rather than the actual commodity price, which can result in the ETF underperforming the price. Ensure you understand these funds and their structures before you buy them.
HSBC offers a wide range of emerging market single country funds which use physical replication with a 0.6 per cent TER though these are high risk and should not account for more than around 1 or 2 per cent of your portfolio. A more diversified option such as the HSBC MSCI Emerging Markets ETF with a 0.6 per cent TER may be better, or if you're happy with synthetic replication db X-trackers MSCI Emerging Markets TRN ETF with a 0.65 per cent TER.
For thematic exposure, Mr Gilligan suggests PowerShares Global Agriculture Portfolio which tracks the NASDAQ OMX Global Agriculture Index. This measures the performance of the largest and most liquid companies involved in this sector using physical replication and has a TER of 0.75 per cent.
