Cash or bonds or shares – what's best for this year's ISAs?

With the end of the financial year fast approaching, it's time to ensure you make the most of tax-free savings

With less than a month until the end of the tax year, savers should be hurrying to top up their ISAs (individual savings accounts) and make the most of their tax-free allowance, but with cash rates so low is it time to switch to the stock market?

Figures from comparison site Moneyfacts highlight how poor cash ISA rates are; the average rate has fallen from 5.15 per cent five years ago to 2.56 per cent one year ago and a paltry 1.79 per cent today. Even worse, many of the best rates do not accept transfers in from a former account, while with a stocks and shares ISA not only can you invest the entire allowance of £11,280, but you are also free to move all of your old ISA money into the stock market without losing the tax-free benefits. But, as with all things stock market related, there are risks involved.

"Four years after interest rates hit a record low of 0.5 per cent, many reluctant investors are accepting they will have to take some level of risk in order to have any chance of achieving a higher income," says Tom Stevenson, the investment director at Fidelity Worldwide Investment.

If you do decide to take the plunge, the all-important decision is where to pile your money. Past-performance tables are worth keeping an eye on, but don't let them dictate your investment choices.

The top two performing ISA funds since April 2012 according to fundexpert.co.uk were Legg Mason Japan Equity and First State Asian Property Securities, while the dog funds included various gold funds such as SF Webb Capital Smaller Companies Gold. Sector-wise, Europe excluding UK and European smaller companies offered top results, while investors with exposure to UK gilts and absolute return saw the poorest returns.

Experts aren't hopeful for a turnaround in UK gilts and many experts believe there is still opportunity for British investors buying Japan-based funds that hedge the weak yen such as Neptune Japan Opportunities. However, chasing last year's story isn't generally a good strategy.

"Don't bank on Europe continuing to be a top performer. The big macro problems haven't gone away. This was recently highlighted by the Italian election result, which was almost revolutionary," says Tom Purdie, a research analyst for Fundexpert.co.uk.

Equally, dismissing poor past performers could mean you miss out on future opportunities.

"We see gold mining funds as undervalued at the moment. Gold mining shares were horrible performers in 2012 (down 19.38 per cent). In contrast the gold price itself edged up. There is now the opportunity for these relative performances to reverse," says Mr Purdie.

"This dichotomy is certainly a lesson to be learnt. Gold mining shares are fascinating, cheap, and an interesting punt for contrarian ISA investors at a loss on what to do this tax year. Those looking to invest should drip money into Smith and Williamson Global Gold".

Initially, the main choice will be whether to focus on bonds or equities. Bonds have proven the popular choice in recent years amid falling interest rates and volatility in the stock market, but equity is the leading asset class for the fifth consecutive month according to the latest statistics from the Investment Management Association (IMA), and for Jason Hollands of fund supermarket Bestinvest bonds now look expensive and offer low income yields.

"In contrast, with the exception of US shares, equities generally look good value compared to where they have traded over the longer term, especially those in latterly unloved markets such as Europe (we like Threadneedle European Select), Japan (we like GLG Japan Core Alpha) and Emerging Markets (we like First State Global Emerging Market Leaders)," he says.

Equities do offer potential for growth but bring more volatility, so it may be prudent to have bonds in your portfolio too. In general, mixing general categories such as equities, bonds and property is a good way to spread risk, but beyond this you need to think about variation in both the geography and the size of the companies you invest in. Diversification should smooth the ups and downs, so consider both UK companies and emerging or developed markets away from home.

Britain has lost its AAA credit rating so investors will be understandably cautious but many of the big UK companies earn profits overseas and offer income yields. Equally, developing countries such as China and India offer impressive potential returns and adding exposure to markets such as Japan and the US will enable you to access areas such as technology and consumer goods companies which are difficult to gain exposure to in the UK.

How you invest will also affect the success of your ISA, so again you may want to combine both passive and actively-managed stock-picking funds withinit. Passive investments such as index trackers and exchange traded funds are cheaper and have a role to play, but you can never outperform the index.

"Passive funds are likely to be best suited to well-researched developed markets where gaining a competitive edge can be more difficult for fund managers while in less well-researched emerging markets, or when investing in smaller companies for example, an active approach is likely to be better," says Mr Stevenson.

The experts also recommend a disciplined approach to an ISA's structure, with no more than 20 funds, which should force you to reassess existing funds every time you are tempted to invest in a new one. Costs are another factor, of course, so keep an eye on fees. If a fund comes with high fees, you need to be confident the manager is able to deliver the right performance. Picking the right adviser or broker will help too, so make sure you understand clearly the potential costs and benefits involved.

Keeping an eye on your existing investments is vital too as a cautious portfolio could become higher risk or vice versa. "Appraising your existing portfolio will show areas where it is weak or too heavily weighted and where any new ISA investments should be focused", advises Mr Hollands.

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