Can I invest better for my grandchildren?

Portfolio of trust

LAST THREE TRADES

Sold Beazley January 2013, Sold Sainsbury, purchased HSBC December 2012, Purchased Aviva

SHARES ON WATCHLIST

Experian, Serco, Dechra (to sell)

Colin Low, chartered financial planner, at Kingsfleet Wealth, who is affiliated to the Society of Trust and Estate Practitioners, says:

I would need to check the terms of the trust instrument before expressing a definitive view, but it sounds from the description as though the trust that has been established could be an Accumulation and Maintenance Trust. This is specifically a trust for the benefit of grandchildren with particular restrictions about how the income and capital may be used.

Until 2006, such trusts enjoyed favourable tax treatment but, since then, they have been taxed in the same way as discretionary trusts. Discretionary trusts are defined as trusts in which no beneficiary has a vested interest, and the trustees have discretion as to whom to benefit.

The income arising from the investments held within discretionary trusts is subject to penal rates of taxation, and the duty to which trustees are subject, to ensure the suitability of investments, should therefore consider ensuring that taxable income is kept to a minimum. Conveniently, this fits with the objectives of the trust which you have established.

Direct investment in equities generally creates taxable income and also makes diversification difficult, which is another aspect of suitability, and is an essential factor in minimising risk. For all but the largest portfolios, diversification may be better achieved by investing through collective investments, of which there are two main types; namely, funds and investment bonds.

Funds (such as unit and investment trusts, open-ended investment companies (OEICs) and exchange traded funds) produce income in the same way as direct investments, whereas investment bonds are essentially insurance-based tax 'wrappers' and, therefore, produce no income as such. The investment returns are rolled up within the bond and tax is only charged on realisation.

Additionally, segments of the bond may be assigned to beneficiaries prior to encashment and this may allow a more tax-efficient distribution of funds when they are required.

Consequently, many advisers regard investment bonds as the preferred medium for the investment of discretionary trust funds. These can be written in the UK or in offshore centres, the main differences relating to the way in which the funds are taxed within the bond and on realisation. The roll up with offshore bonds is tax-free, but, generally, the charges tend to be higher, as does the tax payable on realisation. However, each case must be looked at on its merits.

The range of funds that can be held within an investment bond, whether on-shore or offshore, is comparable to that which would be available if the investment were being made directly into these funds, and your timescale of 10 to 15 years would make it sensible to include equity funds as well as fixed-interest funds. There would also be an argument for including global funds.

The decision would be straightforward if the trust funds had not already been invested, but any change of approach now, in rotating from direct to indirect investments, would necessitate selling the trust's existing equity investments and possibly realising taxable gains (remember that the annual allowance for trusts is 50 per cent of that of an individual). In this respect, the recent market rise makes the timing inconvenient. The best answer would in my view be to move gradually out of the direct investments and into a more suitable and efficient bond wrapper.

Chris Dillow, Investors Chronicle's economist, says:

This makes an interesting change. Whereas many investors seek out income stocks you want to avoid them.

There is, however, a problem here. Although high-income stocks are unattractive for you because of their tax treatment, lower-income stocks bring other problems - namely that they underperform higher-yielding stocks over the long run around the world. This is because investors overestimate their ability to spot growth stocks, and so tend to pay too much for them. What you gain by avoiding tax, therefore, you might lose through lower returns. The best hope of avoiding this dilemma is that investors' sentiment right now might be sufficiently depressed - as measured by, say, the ratio of Aim stocks to the FTSE 100 - that growth stocks are not as overpriced as they are on average.

Luckily, though, there's one respect in which tax considerations and good ordinary investment behaviour are entirely compatible - in your desire to avoid regular trading. The problem with this is not just that it can generate a tax liability, but that doing so is expensive, regardless of tax. Research shows that investors who trade frequently tend to do badly. Churning portfolios certainly makes money for brokers, but it rarely makes money for investors.

For me, though, this portfolio raises a more interesting question: how should someone with genuinely long-term time horizons invest?

It's tempting to go for 'growth' stocks. Your portfolio has quite a weighting in emerging markets. But - tax advantages aside - this is dangerous. In theory, growth should be capitalised in prices so that high expected growth is associated with high prices now and thus only ordinary returns. And history shows this to be the case: for a long time, there has been no correlation across countries between GDP growth and stock market returns. It is, then, just a mistake to invest in emerging markets because such countries look like they will be fast-growing economies. The case for investing in emerging markets is that they are a leveraged play upon risk appetite and global share prices - which is another matter entirely.

What's true of national stock markets is truer still of individual stocks. Cast your mind back 15 years to 1998. Back then, investors thought that Baltimore Technologies, Dimension Data and Thus would be major companies by 2013 - they were growth stocks on premium ratings - while BAT and Rio Tinto were 'old economy' dinosaurs.

This shows it is difficult to predict what the economy or market will look like in 15 years' time. The problem here isn't just one of risk - quantifiable probabilities - but of uncertainty. The path and speed of technical change is inherently uncertain. Because of this, we cannot identify future winners and losers from creative destruction. It is easy to underestimate company death rates.

There are two possible solutions to this. If you want to hold individual shares directly, hold defensive blue-chip stocks - those that are at least likely to survive the next 15 years.

Alternatively, if you follow Mr Low's advice, and hold funds through a bond wrapper, hold a FTSE All-Share tracker fund. This means you are backing the field rather than particular horses, which is a reasonable thing to do when faced with huge uncertainty.