Finding the right formula for equity ISA success

Neasa MacErlean offers advice before the window closes.

If you are unsure where to invest your equity ISA this year, you could do worse than follow the crowd and put your allowance into an income-producing fund. More than four in ten investors took this route last year, and the signs are that this pattern will be repeated in 2013 before the end-of-year guillotine comes down on 5 April.

Last year, income ISAs accounted for 42 per cent of the total, according to Chelsea Financial Services. Danny Cox, head of advice at ISA platform provider Hargreaves Lansdown, expects that pattern to be repeated: "Income is going to be the predominant theme for this season."

The big advantage of income ISAs over the capital growth alternatives is that the short-term income prospects should be easier to predict and, therefore, more reliable than capital growth. The capital growth of a share, for instance, depends on how the market views its long-term prospects – and that evaluation is vastly more complicated than predicting whether its dividends will go up or down in the next year.

Speaking of equity income funds, Danny Cox says: "Over time, you would expect the value of the investment and the income to go up. This means that the income keeps pace with inflation." Since consumer price inflation is now 2.7 per cent and expected to rise, savers could well lose out or stand still in real terms if they put their money into cash ISAs, where the top rates on notice accounts are about 2.8 per cent. Equity income funds are attractive for those who can afford to take the risk that stock and bond markets entail. "Equity income is a good place – so long as you can take a five-year view," Mr Cox says.

Equity income funds tend to allocate most of their investments into blue-chip companies such as Unilever and the pharmaceutical giants. Unilever has increased its dividend each year for the past two decades. Income funds are yielding 3.5 to 4 per cent at the moment, with some exceeding that. Looking at two of the most popular funds, Invesco Perpetual is yielding 3.48 per cent while Artemis Income is on 4.3 per cent.

But a big change between the 2012 and 2013 ISA seasons will be the role of bond funds. These have grown in popularity in the last few years, and have been one of the smart places to be. However, advisers are nervous about recommending them at the moment, as their capital value is expected to fall. Experts predict rising inflation and interest rates – the economic conditions which push bond prices down.

Last year, bond funds accounted for about half the flow into income funds at Chelsea Financial Services. This year, managing director Darius McDermott predicts "a higher proportion going into equity income rather than bonds". Mr Cox says: "You'd be pretty silly going into government bonds now. You would be taking a large risk." Since corporate bonds are priced off government bonds, he will be avoiding them too. Keith Evins, head of retail marketing at JPMorgan, agrees: "You'd be better compensated in equities now."

Ben Yearsley, head of research at Charles Stanley, thinks holders of bond funds need to start reviewing them soon: "The biggest dilemma of the next two to three years will be when to sell out." But he reckons bond funds are probably "good to hold" for the next six months.

A recent trend that is attracting more expert, risk-tolerant investors is the launch of income funds in the emerging markets – such as last October's Newton Emerging Income Fund, which has a yield of 3.74 per cent. There is a culture of saving in other parts of Asia that fund managers see as very promising for sustaining healthy income funds. There are also numerous international income funds that cover the world or particular regions or countries.

Many income funds, including the Troy Trojan Income Fund, offer two options to investors – whether to take income or accumulation units. The standard choice of income means investors get the return on the funds as and when they are paid out. For accumulation units, the income is reinvested (accumulated) instead. On the ISA and investment platform offered at JPMorgan, 60 per cent opt for income and 40 per cent for accumulation.

Mr Evins has a slight preference for the latter. "Accumulation units are just easier," he says. Someone with income units can ask for the income to be reinvested each time but that is a more cumbersome process and investors may simply be tempted to spend this income rather than save it. Reinvesting fund income makes a huge difference to the total investment return over the years. Someone who invested £10,000 in the Invesco Perpetual High Income Fund when it was launched 25 years ago, spent the income as it arose and cashed in the fund today would have received more than £106,000 through the original capital, income and the capital growth combined, according to Hargreaves Lansdown. Someone who reinvested all income would now have a fund worth £180,000 – 70 per cent more.

While many investors think of unit trusts as the vehicle for their ISA, the more sophisticated ones will often look for an investment trust first. Although the two types do the same job, they are structured in different ways. In the past, unit trusts were favoured by many financial advisers as they paid automatic commission to those advisers while investment trusts did not.

Changes at the start of the year, forcing advisers to make explicit fee charges to clients rather than let them be hidden in product charges, have changed the environment. But it will take a while before the playing field becomes level. An important point to remember is that charges on investment trusts tend to be lower.

Invesco Perpetual Income, run by Neil Woodford, has an initial charge of 5 per cent and an annual one of 1.5 per cent. Whilst the initial charge is cancelled out at many platform providers by a handsome discount, there is usually still all or most of the annual charge to pay. Mr Woodford, however, also runs the Edinburgh Investment Trust, with very similar objectives. This has no initial charge and an annual charge of 0.7 per cent. The yield on the investment trust is also higher: Edinburgh Investment Trust's is 4.13 per cent, 0.61 per cent higher than the yield on Invesco Perpetual Income.

Chelsea Financial Services says the funds that are likely to be big sellers this year include Invesco Perpetual Income, Invesco Perpetual High Income, Troy Trojan Income, M&G Global Dividend, Newton Global Higher Income and Newton Asian Income.

Mr Cox recommends Artemis Income and Troy Trojan. When choosing between income and higher income funds, investors need to remember that while higher income funds try to do what it says on the tin, they do so at the cost of taking greater risks with the capital value.

In a well-established area such as income funds, it is well worth thinking about the different possibilities before investing. It seems as if we struggle to do this, however.

"There is typically a last-minute rush," Mr Evins says. "And that rush is getting later and later – happening right at the end of March and in April."

Case study: Cathy depends on own judgement in managing her investments

"I don't consult an independent financial adviser," says Cathy (not her real name), a 48-year old freelance translator.

"It's probably a good job as they would faint at my approach. I've got about £80,000 in ISAs altogether and I would like to get to £150,000 before I retire. Up until a couple of years ago, I was drawn too much to the growth stories of India and China. About a third of what I have is invested over there and in other emerging markets. Even if it could work out swimmingly in the long-term, I think I have probably over-invested in that sector.

"But around about 2011 I started discussing my investments much more with a friend. He spends a lot of time analysing his funds and he has done pretty well.

"He recommended income funds and, in particular, investment trusts because they can be cheaper and more flexible. Going for a 'cheaper' way of investing does not mean you are tight – but it can mean that you end up with a significantly larger fund over 20 years, which is my kind of timescale. So I went into the Murray Income Trust which is run by a reliable name, Aberdeen Asset Management.

"The dividend has increased in each of the last 10 years – so that is rather reassuring.

"I also put a couple of thousand into Invesco Perpetual Higher Income a year back, on an accumulation basis, and the value of my holding is now up 13 per cent.

"I will carry on investing in income investment trusts for the next couple of years anyway so that I can balance out some of the risk I have taken on in Africa, the Pacific Rim and elsewhere. And I won't be going to an adviser.

"I enjoy managing these funds even though I know that I should spend more time managing them well."