Isa decisions rest on taste for adventure

THE ISA reaches a significant milestone at the beginning of April when every investor becomes eligible for a maximum allowance of £10,200 a year, something that seems exceedingly generous from a cash-strapped government given that, until last October, the limit was just £7,200.

In October, the government raised the allowance for the over-50s to 10,200 for the current tax year, while younger savers must wait until the next tax year begins on 5 April.

Speculation is rife as to where interest rates will be six or 12 months from now. But it is worthwhile for investors to weigh up carefully the pros and cons of a cash Isa versus a stocks and shares Isa given historically low interest rates and an impressive rally in the stock market.

For cautious individuals, the cash option will always be first choice, while the more adventurous will conclude that a stocks and shares Isa is for them. However,

it is also worth remembering that many cash Isas are effectively losing money after allowing for inflation, which jumped to 3.5 per cent in January (its highest for 14 months). Many cash Isa investors will be hoping that this may prompt interest rates to rise, which in turn would be reflected in the rates offered to savers.

Still, I would caution going down the cash route purely – or largely – in the hope of increased returns on the back of rising interest rates. Despite January's inflation figures, which were boosted by the return of VAT to 17.5 per cent, there are as many worries about deflation as about inflation. True, it is not possible for interest rates to move significantly lower – but I doubt if we'll see them move in the opposite direction in the short term either.

The obvious attraction of a cash Isa, apart from capital security, is the fact that the returns are exempt from income tax. However, savers should not blindly accept a low interest rate in return for a tax saving. Some cash Isa accounts are offering interest rates that are so low there is no real advantage over a deposit account offering a higher rate on which tax has to be paid.

So, after the strong rally seen in the stock market, does a stocks and shares Isa still offer the potential for a decent return or will savers be nursing capital losses as leading market indices roll over once again?

It goes without saying that equity investment is "for the longer term", which is typically taken to mean five years or more. However, there are other options available to investors who do not wish to take on board the risk associated with equity investment.

As investors became increasingly confident during 2009 that the low point had been reached in the financial crisis, they became more comfortable with the idea of assuming some sort of capital risk with their savings. The first port of call was often corporate bonds, and firms such as Invesco Perpetual and M&G saw significant inflows to their funds investing in these markets. Unlike gilts, which are backed by the government, corporate bonds are certainly not risk-free.

However, the debt crisis in Greece also highlights the risks that can arise with sovereign bonds when a nation's finances are not managed correctly.

Last year's impressive performance by corporate bonds is unlikely to be matched this year; nevertheless, investors buying now should still see an attractive rate of return relative to cash deposits.

Investors should also consider the type of corporate bond funds they invest in and whether the fund manager has the tools available to protect, or even enhance, capital values if debt markets again deteriorate. Corporate bond funds we have supported in the past would include the M&G Optimal Income Fund and the Old Mutual Global Strategic Bond Fund.

Despite the rally seen in the UK equity market, there are still plenty of shares which offer a combination of relatively high, secure and in some cases growing dividends. Examples of these "defensives" would be GlaxoSmithKline, Diageo, Tesco, British American Tobacco and National Grid.

For the more adventurous, a rewarding choice could be a managed fund specialising in emerging markets. With economic growth in the West sluggish at best, investors have increasingly been drawn to the more rapidly growing economies of China and other emerging/developing markets. The point to remember about emerging markets is that significant gains in one year can be followed by a significant fall. For example, following a strong start to the year the Chinese market had at one stage fallen by more than 15 per cent as proposals were announced to curb growth and lending.

Investing funds via a regular monthly savings scheme could provide a measure of insurance against market volatility because "pound-cost averaging" should, over the longer term, smooth out the investment return.

An issue for those with the full amount to invest in a lump sum is that the annual deposit in a cash Isa is capped at 5,100 whereas, for stocks and shares, the full 10,200 is permitted, less any investment made into a cash Isa. Consequently, with the exception of those for whom safety is paramount, it seems sensible to take full advantage of the Isa allowance, given that, as a result of the parlous state of the nation's finances, it is likely that in future tax years the personal tax regime will become more onerous.

Charles Robertson is senior investment manager with Murray Asset Management