Getting the mix right

On April 6, the Inland Revenue will finally scrap the dividend tax credit on Isas. This was a decision made long ago – back when Isas were first conceived in the late 1990s. Since then, the industry has spent more than five years lobbying the Government to change its mind, but alas, to no avail.
Once it became clear that the battle was lost, the industry quickly set about working out how it could make the most of the change. While many had grown rather attached to the tax credit, its removal is in fact no great loss to investors and accepting defeat has not proved too hard.
For the average equity Isa, the credit is worth just £10 a year. However, once the credit is removed in six weeks’ time, an old tax loophole will rise to prominence – a loophole that some of the industry is keen to exploit, in a bid to attract Isa investors back to the market.
Any fund that has a minimum of 60% in fixed interest has its income treated as “interest”, rather than “dividends” when it comes to tax, and will qualify for a 20% tax rebate on the fund’s income for its Pep or Isa investors. So while the benefits of the dividend tax credit outweighed the advantages of this loophole in the past, any fund that holds 60% or more in bonds will provide a more tax-efficient Isa investment than a plain equity fund once the credit has been removed.
Enter the likes of Jupiter, New Star and Invesco – all of which have launched new so-called “distribution” funds over the past two years, which provide a mix of 40% equity and 60% bonds – so qualifying for the favourable tax treatment. These managers hope to tempt those investors who will now lose out because of the removal of the dividend tax credit.
Even the life insurers have joined the bandwagon in the hope that they may pick up a piece of the action. Distribution funds are no new thing to the insurers – most of which have offered them within investment bond wrappers for years. But at the end of last year, Legal & General became the first to make a move to exploit the new tax loophole, opening its distribution fund to Pep transfer and Isa investments.
Many fund strategists have been very complimentary about distribution funds. Indeed, last year, when Jupiter’s fund reached its first anniversary, it managed to line up a raft of the leading media commentators to sing the praises of its latest creation.
Hargreaves Lansdown’s Mark Dampier, Torquil Clark’s Philippa Gee and Bates Investment’s James Dalby were among the pundits who waxed lyrical about Jupiter’s fund – and to be fair, its relative performance has so far been impressive. Since launch in March 2002, the fund is up 7% and is ranked fourth in the Cautious Managed sector. Over the same period, the FTSE 100 is down by around 15%.
While there may be nothing wrong with distribution funds per se, a tax regime that guides investors towards them goes against many of the Government’s objectives and aims for Isas. Peps, created under the Conservatives in the 1980s, and Isas, launched by the current Government 10 years later, were both invented to promote, among other things, an equity savings culture in the UK.
Yet with its removal of the dividend tax credit, the Government has now created a more tax-advantageous regime for cash and bonds. Peter Shipp, director of policy and member service for the Pep and Isa Managers Association, says: “The removal of the tax credit on dividends effectively pushes investors towards corporate bonds, or funds that hold at least 60% of their portfolio in corporate bonds. But that’s only part of the equation and we hope, with the right advice, that investors will consider the bigger picture. But we have already had reports from several of our members that there has been a movement towards bonds within Isas, to take advantage of the new tax regime.”
If magnified, this could become a worrying trend. For those investors who opt for pure bond funds over equity funds simply for the tax advantages, the losses could be even greater.
Justin Modray, business development manager for BestInvest, says: “There’s definitely a worry at the moment that investors are reading about corporate bond funds becoming more tax-efficient, and deciding to invest when it may not be the best time to be getting into the bond market. It’s certainly very dangerous to invest for the sake of tax efficiency at the expense of the right investment decision.”
While distribution funds will be right for some more cautious investors, they will not fit the needs of everyone. Younger investors, for example, could miss out on thousands of pounds worth of growth, which they would have achieved had they invested in a more suitable equity-based fund. Although the tax savings that will be made on 60:40 funds are not totally insignificant, they are unlikely to compensate for the wrong investment decision.
Ben Yearsley, an investment manager at Hargreaves Lansdown, says investors should never select their investments based on potential tax breaks. “Investors’ first priority should be selecting the right asset allocation for what they are trying to achieve – not investing in a fund because they might benefit from a minor tax break. Equity income funds, for example, will be hardest hit by the loss of the dividend tax credit – but if they are right for you, then yes, it’s a shame, but you should still put your Isa allowance into one.”
The fund managers, of course, claim that their new funds are not simply a marketing gimmick to attract confused investors in the wake of the changes to the tax regime.
Paul Dickson, head of product development and product management for Invesco Perpetual, says its new distribution fund was launched for a number of reasons – not least that it filled a gap in the group’s otherwise fairly comprehensive fund range.
“Our primary thinking was in terms of the investment proposition,” he says. “At the moment, we think it is quite difficult to make the call between equities and bonds, so we thought that a fund that makes that decision for you would be popular with both advisers and investors.”
Dickson concedes that the tax status was one of the motivations for launching the fund. However, he insists that the fund managers have the ability to exceed the 40% and sacrifice the fund’s tax efficiency if they believe there is sufficient reason to do so.
“The mandate is wide enough to allow the managers to have any mix of equities and bonds that they want,” he continues. “However, there is a constraint in terms of the Cautious Managed sector definitions – the fund will be excluded if it exceeds 60% in equities – and we will lose the tax efficiency if we exceed 40% in equities.”
So what is the right asset mix for income, or the right asset mix for growth? Naturally, there is no straight answer – it is a function of age, objectives, risk tolerance and a host of other factors. However, the Government is now tacitly pushing investors towards a 60:40 mix.
At the same time, a new breed of 60:40 funds is set to emerge from the Government over the next couple of years – the stakeholder medium-term savings product. This is one of the babies of Ron Sandler’s review of the retail long-term savings industry, and is part of a Government initiative to produce a new suite of simple savings products that theoretically will need no advice to be sold.
Included in this new range will be a medium-term savings product, which will have its equity content capped at 60% – once again a 60:40 product, but this time with the larger proportion in equities than bonds.
So where did these plans come from? Were they based on any magic formula of asset allocation, or any hard number-crunching? It would seem not.
In a section entitled “risk control”, the Treasury document outlining the stakeholder product detailed how it had taken a look at the IMA’s Balanced Managed sector (which has its equity content capped at 85%), the IMA’s Cautious Managed sector (which has its equity content capped at 60%) and the ABI’s Defensive Managed sector (with its equity content capped at 35%).
After calculating that equities were more volatile than bonds, but conceding that they had better returns, the Treasury decided to opt for the middle of the three models. The paper said: “In the past five years, the absolute volatility of returns for the IMA Balanced Managed sector has a mean of almost 14.04% compared to the cautious managed mean of 9.34%. And almost 50% of balanced managed funds have lost money during this period, against only two Cautious Managed.”
The study failed to mention, however, that while the Balanced Managed sector has more than 70 funds with a five-year track record, its study of the Cautious Managed sector was based on a sample of just 18, most of which are managed under different mandates to that proposed for the new stakeholder product. Beyond this brief analysis, there was no further explanation as to why 60:40 would represent the ideal asset mix.
Paul Niven, head of strategy for Isis Asset Management, says the main problem with the stakeholder concept is that it tries to achieve the impossible. While having a balanced portfolio is essential, you cannot take an average of all the different suitable mixes and decide that it will fit the bill for every investor.
“The move towards balanced products in the retail area has to be positive,” he says. “One only has to look at the anecdotal evidence over the last few years, when providers have traditionally pushed hot areas such as technology funds, and the retail investor has tended to get in at the end of a boom rather than the beginning.
“But the problem is that although you’re getting a better mix with some of these funds, you’re not necessarily getting a fully diversified product. The equity component will probably invest only in one market, and have one style. You’re not going to get the same level of proper diversification as you may get in a multi-manager fund, for example.”
Niven points out that Isis remains relatively bearish on corporate bonds at the moment, particularly at the investment-grade end of the market. Hence its own distribution fund currently has just 25% in bonds, with 75% in equities. This would exempt the fund from the favourable Isa tax treatment for which other distribution funds are so keen to qualify. However, Isis believes its performance numbers will eventually vindicate its decision.
Jason Hollands, head of communications and strategy for Isis, says: “The fund management industry has neglected asset allocation as a skill set over the past 20 years. But in the kind of markets we see going ahead, we believe multi-asset class products are going to play a bigger part, because investors want absolute returns.
“Investors are boxing themselves in. If you look at the corporate bond fund component of most of these distribution funds, they tend to be largely invested in investment-grade bonds.
“We’ve got to the point where with equity funds, almost everyone believes the fund manager should have more flexibility – just look at the popularity of focus funds – but that stops when it comes to corporate bond funds.”
Hollands points out that the corporate bond component of Isis’s distribution fund holds a decent proportion in junk bonds – a sector from which most of its peers have tended to shy away because of its higher-risk label.
As the experts all know, there is no magic recipe for asset allocation, but there are some general, reasonably reliable guidelines that the Government could follow – such as making higher-risk, higher-return products available for younger investors, and offering funds with higher bond content for older investors. Instead, however, it has persisted with its “one size fits all” approach.
A look at the performance for various different mixes of asset classes is interesting. Even with the ravaging that UK equity markets took between March 2000 and March 2003, the average level of return for a five-year investment still has a linear relationship with the amount of equities in the portfolio over the longer run (see box above).
Admittedly, if you’d taken the higher-risk approach and gone for 80% equities, 20% bonds at the wrong time, you could have got caught out. For example, £1,000 invested for five years in an 80:20 fund in 1998 would have been worth just £1,007 by the end of 2003. However, an element of “lifestyling” would have improved this performance considerably – a feature that the Sandler suite of products is unlikely to have.
For the fund strategist, the Government’s continued persistence with designing a one-size-fits-all, no-advice savings culture is frustrating. Only with the proper advice and more flexible products will investors achieve the returns they want, and be encouraged to continue to save.