ISAs may be all the rage, but there's still life in the PEP in the transfer market.
Is there life in PEPs? Hundreds of thousands of people who raced to beat the investment deadline ahead of their abolition on 5 April may be forgiven for thinking the issue is no longer up for discussion. In fact, while PEPs are no longer sold - they have been replaced by the Government's new tax-free wrapper, the ISA (as the individual savings account is known) - this does not mean the end of the PEP market itself.

Not being able to buy does not mean you cannot transfer your PEP allowance from one provider to another. In fact, you can switch without losing your allowance, as long as you abide by the original investment rules governing where PEP money can be placed.

The scope for transfers is massive. More than pounds 55bn is invested in PEPs by some 4 million people in the UK, according to Autif, the unit trust managers' trade body. On average, each investor has accumulated in the region of pounds 16,000 in such funds.

And the evidence suggests that some of them are not shy in transferring them. Autif calculates that in May alone, pounds 217m was transferred. According to financial consultants Chambers & Stoll this is likely to get much bigger as only 5 per cent of PEP holders have so far transferred between providers.

In fact some financial advisers and fund managers see the inability to add to PEPs as stimulating the PEP transfer market. If you can't add a new fund to your PEPs then at least you can switch into it by selling an existing one.

In its report entitled "PEP Transfers - Threat or Opportunity?", Chambers & Stoll estimates that only half of PEP holders even know that switching between funds and fund providers is an option. That means that another 2 million people would be potential switchers if they knew it were allowed.

But the big question is: should they?

Claire Arber, an Autif spokeswoman, says there are several reasons why people may want to transfer their PEPs:

l Their investment needs have changed; for instance they seek income rather than capital growth.

l They are disappointed with the performance of their fund and have identified a better managed PEP.

l They have relatively small amounts invested across funds and managers and seek to consolidate.

l They feel their investments are too concentrated and want to diversify.

However, a number of people in the industry feel that, too often, PEP holders are transferring their PEPs without due consideration and against their own interests.

Janice Thomson, a director of Chelsea Financial, compares this to "swapping queues at the supermarket". She says: "A lot of people transferring their PEPs are simply chasing recent performance rather than looking for the best way to fulfil their investment objectives." Many people have much too short a time-horizon and concentrate on the recent stars rather than look for long-term performance.

The accompanying table, supplied by Standard & Poor's Micropal, shows the performance of the top and bottom 10 performers in UK bonds, European equities and UK equities. We can see from the figures that performance over the past six months often bear little relation to the longer term performance.

For instance, the Hill Samuel Bond Index fund has generated a disappointing minus 7.42 per cent in the six months ending 1 July, thus making it 62nd out of a universe of 66 funds. And yet when we look at the performance over one year and three years, the fund comes out ranked either first or second.

Similarly the Murray European fund has been an underperformer in the past six months, ranking 60th out of 66 funds, and yet it has outperformed over the one- and three-year periods.

Ian Hunter is an investment manager at the discount broker, Hargreaves Lansdown. He says: "People should resist the temptation to move too readily just because of a brief period of underperformance. The Perpetual High Income Fund is a perfect example. Last year this underperformed and a number of our clients expressed concern; however, if you look at the performance recently, it has done really well, already up 8.5 per cent year to date."

In addition, Mr Hunter points out that, by switching providers, the investor will usually find him or herself out of the market for a period of several weeks as the necessary paperwork gets done. In rising markets this can be an expensive thing.

The investor should also be aware that partial transfer of a PEP accumulated during a particular tax year is not allowed and, to make it even more difficult, some fund managers such as Legal & General, Invesco and Schroders bundle all the clients' PEPs into one, thus forcing them to transfer either all or none of the PEPs they have accumulated over the years.

Apart from making the mistake of switching out of a fund simply because the manager is going through a rough patch, some people are also losing out by ignoring the costs of effecting such a transfer. Ms Thomson says: "A transfer is usually as expensive as an outright purchase, and unless they are going through a discount broker, they can lose up to 5 per cent in initial charges before they even start."

Some management houses also charge an additional exit fee. For instance, both Legal & General and M&G impose sliding penalties on selected funds. At M&G, redeeming in the first year means that you pay a 4.5 per cent penalty, reducing to nil after five years. For some internal transfers between M&G funds, the exit penalty is waived.

With all those costs in mind sometimes an investor who is really determined to get out of a fund should consider switching between the funds of the same provider rather than going to look elsewhere.

Of course that doesn't mean that all transfers between providers are bad. Often there are very good reasons why they are desirable. For instance, one such reason cited by many practitioners has been the desire to gain exposure to higher yielding funds.

John Beale of TQ Direct, a Wolverhampton-based execution-only broking service, has seen a lot of transfers coming into the Aberdeen Corporate Bond fund, the MG High Yield Corporate Bond fund, the CGU Monthly Income Plus fund, the Perpetual Monthly Income Plus fund and the Fidelity Extra Income fund.

Another discount broker, Chartwell Investment Management, also identifies a similar trend to high-yielding funds. Martin Laverick, its marketing director, names Fidelity's and CGU's corporate bond funds which are yielding 6 per cent net - a very attractive yield in this low-interest rate environment. Mr Laverick adds that recent tax changes in the way funds can reclaim Advance Corporate Tax (ACT) favours corporate bond funds over equity funds.

Another type of fund which has seen sizeable positive transfers has been among those investing in Continental European equities. Among the winners are Newton, Gartmore and Invesco. Europe is seen as providing diversification away from the UK at a lower risk than US or Far Eastern markets and, of course, European funds are defined as qualifying funds under the PEP rules, meaning that investors are not limited in the percentage exposure they have in them. The word among financial advisers is that the big losers are Schroders, Perpetual, M&G and Johnson Fry.

M&G does not publish figures for the transfer market, but its spokeswoman, Destina Constantinides, says: "The transfer market is quite active at the moment as people assess their portfolios in these fairly choppy markets, and although investors cannot add to their PEPs, they realise that they can switch between them." The M&G corporate bond fund has proved attractive to investors, Ms Constantinides adds.

As a whole the fund management industry is increasingly likely to focus on PEP transfers as a source of funds - especially as, from next year, investment into ISAs will be restricted to pounds 5,000 per year, almost half the pounds 9,000 that was formerly allowed into PEPs.

The market for tax-efficient funds is shrinking, and fund managers are bound to look at ways of attracting transfer funds. As Bryan Chambers, of Chambers & Stoll, says: "Fund managers cannot afford to ignore the transfer market if they are to remain competitive in the future."

Hargreaves Lansdown has published a `PEP Transfer Directory', available free by calling 0800 138 0456

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