What is an ISA?

ISAs are strictly speaking not investments themselves but wrappers which allow investments to be made tax free. By putting money into an ISA it is possible to shelter various kinds of investment from the need to make capital gains tax (CGT) or income tax payments.

A failure to distinguish between the wrapper and the investment itself causes a lot of unnecessary confusion about ISAs among new investors. If the two things are seen as separate – although related – it is much easier to understand how they work.

When someone is “putting money into an ISA” they are actually doing two things at once. They are investing in some kind of financial asset and putting a wrapper around it to protect it from the taxman.

So any investments made within the ISA are, subject to various annual allowances, tax free. For example, an investor who wanted to put money into assets that paid out income could quite legally avoid tax on that income. Any investments made within the ISA wrapper would not need to be declared to the taxman.

Similarly an investor who expects his investments to rise significantly in the near future or further ahead could use an ISA to protect himself from paying CGT. Although the CGT rules are complicated the basic principle is that above an annual allowance it is necessary to pay a certain proportion of capital gains to the taxman. But if an investor builds up a portfolio of investments within an ISA wrapper – which over the years can quickly mount up to a significant level – he can further extend his protection against CGT.

But understanding how the ISA wrapper works is only part of the story. The key question remains of what to put inside the ISA.

Inside an ISA

The regulations allow various types of assets to be included in ISAs. These include cash (such as savings accounts), gilts (government debt) and shares. But this guide will concentrate on investment funds.

Funds are essentially pools of assets which, as a general rule, are run by a professional fund manager. Funds can invest in cash, bonds, shares or a combination of asset types.

It is also possible to use funds to invest in a particular geographic region or type of share. For example, there are funds that specialise in North American shares while other invest globally in technology shares. The Morningstar categories are a guide to the kinds of assets in which a particular fund invests.

The main advantage of investing in a fund – as opposed to investing directly into shares – is that it enables investors to diversify risk more easily. So, for example, if one company in a portfolio has a share price collapse it is likely to have a limited effect on the fund as a whole.

Also it is possible to diversify between sectors (such as retailers, technology companies or pharmaceutical firms) and countries. In such circumstances problems in one area, such as a fall in technology shares or the Japanese stockmarket, tend to be counterbalanced by rises elsewhere.

Naturally it is not possible to guard against a catastrophe such as a total market meltdown of some sort. But most forms of risk can be managed by a sensible strategy of diversification.

Diversifying the portfolio

Admittedly it is possible for investors to build up their own portfolio of shares rather than rely on a fund manager. However, all but the very rich are likely to have sufficient assets to diversify widely. Take, for instance, a relatively concentrated fund with holdings in about 40 companies. A private investor might need £1,000 in each company – or £40,000 in total – to begin to replicate such a fund.

In contrast an investor with only a few hundred pounds could easily invest in a much more diversified fund. The fund could also invest in bonds or overseas shares which are often closed or at least expensive for private investors.

In addition, most people do not want to spend a large amount of time monitoring their portfolios. For hard core investors, for whom investment is a hobby as well as a way of making money, it is probably preferable to invest directly into shares. But for most people, even those proficient in finance, it is preferable to hand over the day-to-day investment responsibility to a professional fund manager.

Essentially those who invest in funds are making a simple trade-off. In return for paying various charges, such as an initial charge and an annual charge, they are handing over the responsibility for managing their money to a fund manager. The fund manager will make the day-to-day decisions and make sure that risk is properly diversified. ________________________________________

ISA terminology

Active fund. A fund managed by a professional fund manager rather than one that tracks a market index such as the British FTSE 100 or the American S&P 500.

Bond. A form of debt issued by a company (corporate bond) or government. Bonds issued by the British government are known as gilts.

CAT (charges, access, terms) standard. A voluntary standard set by the government to indicate that they are simple, clear and fair. Those ISAs that invest in the stockmarket can charge investors a maximum of 1% of their assets per year. This standard should not be taken as a guarantee of investment performance.

Equities – Another term for shares

Financial Services Authority (FSA) – The body which regulates the financial services industry in the UK. Its website can be found at www.fsa.gov.uk.

Index tracker or “passive” fund. A fund that trackers a particular stockmarket index such as the FTSE 100 or S&P 500.

Open Ended Investment Company (OEIC) – A form of fund that can be invested within an ISA.

Maxi ISA – An ISA which can invest in a variety of assets such as cash, funds or shares up to a maximum level of £7,000 a year.

Mini ISA – It is also possible to invest in ISAs which invest separately in cash, insurance polices and stockmarket investments. It is important to note that those who take out one form of a mini-ISA, such as a cash ISA, will have the amount they can invest in other forms of ISAs restricted.

Personal Equity Plan (PEP) – A form of tax incentive for investment that existed before ISAs. Although it is not possible to take out new PEPs it is possible to transfer old ones from one portfolio to another.

Stocks – Often used as an alternative term for shares.

Unit trust – A form of fund that can be invested within an ISA.