Last year was yet another fruitful one for small-cap investors, as the performance of the UK stock market minnows trounced that of their larger rivals for the third year in succession.
The Hoare Govett Smaller Companies Index (HGSC), which was launched in 1987 and has since become the authoritative benchmark for measuring small-cap performance, recorded a total return (including dividends) of 28.6 per cent in 2005, beating the return on the FTSE All-Share by nearly six percentage points. In fact, since equity markets bottomed out in March 2003, the HGSC index - which is made up of the lowest 10 per cent of the UK market by market capitalisation - has ramped ahead by an impressive 168 per cent overall, comfortably beating the FTSE All-Share index, which has returned 97 per cent over the same period.
This small-cap outperformance is no fluke. Looking back over the 51-year period from 1955 - as far back as the HGSC can calculate - the index has produced an annualised return of 16.5 per cent. To put that into perspective, if you had invested £1,000 in these small caps back in 1955, and reinvested all your dividends, you would be a multimillionaire by now, sitting on a portfolio worth £2.34m (before dealing costs and taxes) at the start of this year. And the same investment in the Hoare Govett 1000 index, which represents just the bottom 2 per cent of the UK market excluding investment companies, would have grown to a staggering £5.68m in the same 51-year period, representing an annualised 18.5 per cent return.
By contrast, the FTSE All-Share index has produced a 12.9 per cent total return (of which capital gains accounts for 8 per cent per year) over the past 51 years, which would have turned your £1,000 into less than £500,000. In other words, over the past five decades small caps have not only consistently outperformed their larger rivals, but they have well and truly trounced them.
Interestingly, it is worth noting that if you had not reinvested your dividends at all, the £1,000 invested in the two Hoare Govett portfolios in 1955 would have only grown to £181,000 (HGSC) and £350,336 (HG1000), respectively, which not only highlights how compounding can have a dramatic effect on boosting long-term returns, but also how important it is to recycle dividends back into shares. So, given that retail prices have risen 17-fold over the same period, this represents a real capital gain (over and above inflation) of 4.6 per cent a year from the HGSC index - which more than doubles to 10 per cent a year if the dividends were reinvested - further underlining the attractions of small-cap shares as an asset class over the long run.
To put that into context, the same £1,000 investment in the FTSE All-Share index in 1955 would have only grown to £51,000 (capital gains only) at the start of 2006, a far cry from the £350,000 made on the HG1000 index. Small can indeed be beautiful.
Tax incentives for Aim shares
Capital gains and inheritance taxThere are also various incentives for investing in small-cap shares, but undoubtedly it is the classification of Alternative Investment Market (Aim) shares as 'business assets' by HM Inland Revenue that makes investing in this area of the stock market compelling for some.
Unlike shares with a full market listing, which are classified as non-business assets, investors in Aim shares can gain accelerated taper relief on capital gains made when they sell down some/all of their shareholdings. After a one year holding period, only 50 per cent of any realised gain made on Aim shares becomes chargeable for capital gains tax (CGT), and this falls to just 25 per cent after two years. So, in effect, this means that a higher-rate taxpayer, currently paying income tax at 40 per cent, would pay only an effective rate of tax of 10 per cent on any gains made on disposal of Aim shares after the two-year holding period.
By contrast, if the same investor made an identical gain on a fully listed share held for the same two-year period, the capital gains tax liability on disposal would be 40 per cent - four times higher than the tax liability on the Aim shareholding. Furthermore, after the two-year holding period, qualifying Aim shareholdings are exempt from inheritance tax, too.
Income tax loss relief and capital gains tax deferralIf an Aim company is approved by the tax authorities under the Enterprise Investment Scheme (EIS) there are other lucrative, but little-known tax breaks that private investors can use. First, if you have realised a taxable capital gain previously, you can shelter this by investing an amount equal in an EIS to the gain made between one year before and three years following the realisation of the gain.
Admittedly, all this means is that the gain is deferred rather than cancelled, as the disposal of the EIS shareholding would trigger the tax liability. However, with capital gains tax at 40 per cent, this can still be an attractive option as the taxman is, in effect, funding a chunk of your investment interest free. And let's not forget that after holding an EIS approved investment for three years, all gains made are free of capital gains tax.
Another major benefit of EIS-approved Aim share issues is that investors qualify for an upfront 20 per cent income tax relief on the issue of new shares in the company, subject to maximum relief of £400,000 in the 2006-07 tax year and a three-year holding period. And if the shares are then sold at a loss, you can offset this loss against either an income tax liability in the same or preceding tax year or a CGT liability in the same or following tax year, thereby minimising any potential capital loss if things do not go according to plan. To illustrate how this lucrative tax break works, consider the following examples.
- Example oneLet's assume that a higher-rate taxpayer invests £10,000 in an approved EIS share issue, and later on sells the investment for £6,000. The net book cost is deemed to be £8,000 (assuming the upfront £2,000 income tax credit is claimed), meaning that a net loss of £2,000 has been incurred. The taxpayer can then claim income tax loss relief of £800 (40 per cent of this net loss), meaning that the effective loss is not £4,000 on the £10,000 original investment, but only £1,200.
- Example twoTaking this one step further, let's imagine the worst-case scenario and assume that the company actually goes bust and all of the investment has to be written off. In this case, the taxpayer would claim a net loss of £8,000 (on the £10,000 investment) and apply for income tax loss relief of 40 per cent of this sum, namely £3,200. Together with the £2,000 original upfront income tax relief credit, this means that £5,200 of your original investment is recouped. In other words, given the tax breaks on offer, higher-rate taxpayers are actually only risking 48 per cent of any investment made under EIS approved share schemes.
- Example threeFinally, let's take the case where a higher-rate taxpayer has incurred a capital gains tax (CGT) liability of £50,000, on which the CGT liability is £20,000 (at the 40 per cent tax rate) and the taxpayer wants to defer this liability by investing in an EIS-approved portfolio of Aim shares. This is when the scheme really comes into its own as a tax shelter. Instead of being left with only £30,000 of capital after paying the tax man the £20,000 tax liability, by investing in an EIS scheme our investor can claim £10,000 income tax relief on the £50,000 investment as well as deferring the £20,000 CGT liability.
What's more, if our investor is successful and the share portfolio increases in value, then any profits made after the three-year holding period will be tax-free. In other words, it is, in effect, possible to use these generous tax breaks to create further capital gains that on realisation will actually pay down the original CGT liability. And the good news is that there are several fund managers offering Enterprise Investment Scheme Portfolio Services, including the likes of Rathbones Investment Management (promoted by Downing Corporate Finance - www.downingcf.co.uk) which has raised more than £30m across 400 individual portfolios since October 2000 when it established this tailor-made service for private investors.
The minimum subscription of £50,000 may seem high, but remember that you can claim 20 per cent income tax relief on this amount and the portfolio is normally spread across at least 10 qualifying investments, bringing the average holding value down to more reasonable levels. Also, by structuring share portfolios in this way, private individuals can gain rare access to the fund manager's 'institutional deal flow' to the Aim new issue market.
Other asset managers offering a similar bespoke EIS portfolio service for Aim shares include:
- Noble www.noblegp.com
- Octopus Asset Management www.octopusam.co.uk
- Brewin Dolphin www.brewindolphin.co.uk
- Singer & Friedlander www.singerfriedlander.com
- Smith & Williamson www.smith.williamson.co.uk).
Full details, including management and annual fees, can be found on www.taxshelterreport.co.uk.
