Secrets Of Success: It's time for your yearly ISA review

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The Independent Online

With only a few weeks to the traditional end-of-financial-year rush, this is a good time to reiterate some themes about the art of picking a fund for your individual savings account. The Government's recent decision to make the ISA regime permanent is helpful, although it still shows no sign of wanting to raise the upper limit from the £7,000 it has been stuck at for some time.

The first point to make is admittedly unhelpful; this is not the best time of year to make your ISA selection. Given the strong seasonality common in stock markets, you will normally obtain better results if you make your decision in October, when markets are entering their traditionally strongest six months.

But, human nature being what it is, large numbers of people don't seem able to get round to this decision without the help of a deadline, in this case the end of the tax year. The mighty sales machine of the funds industry is certainly primed to make its biggest effort around this time of the year, and advisers naturally tend to take their cue from that.

The second point is that, for those who value income, using an ISA wrapper to hold fixed income securities can make a real difference to your annual return. In today's markets, simply holding a gilt (government bond) in an ISA wrapper is not a dumb thing to do.

Mark Glowrey of Stockcube Research, which has launched an excellent free website devoted solely to UK bonds (, points out that an investment that yields 5 per cent is worth 8.2 per cent to a higher-rate taxpayer if it is held within a tax-free wrapper.

In the current market environment, with a mildly inverted yield curve (long-term bonds yielding less than short-term ones), and most other assets looking quite richly priced, the short end of the gilt curve looks attractive. As ISA rules require a minimum five-year holding period for bonds, the Government's latest issue, Treasury 5.25 per cent maturing in June 2012, looks a good bet for those wanting income. (Only if you are worried that big inflationary pressures are building does that look risky.)

In this context, I can't help reiterating my con-cerns about the value of bond funds. It is bad enough that most equity funds fail to beat their benchmarks over periods of a few years, but the record of bond funds is worse. In the United States, hardly any bond funds beat their benchmarks; and in one recent survey of UK gilt funds, I noticed that not one of the 22 funds in the UK gilt sector managed to beat their comparable benchmark.

When you think about it, this is not really surprising. When gilts yield between 4 and 5 per cent, and the yield curve, while mildly inverted, is fairly flat, there is precious little that any manager of a gilt fund can do to add value. Yet, as most funds continue to charge an annual management fee of close to 1 per cent, taking 20 to 25 per cent of the potential return in fees is a huge potential drag on performance. At least with equity funds, you can cling to the notion that there could be large capital gains to offset the management fees, but with gilt funds there is no such compensation.

Nor, at current levels, is there much to be said for corporate or mixed bond funds, where not only do the same considerations apply, but, as the broking firm Collins Stewart pointed out this week, fund managers have recently been forced to take increasing risks with capital to sustain attractive-looking headline yields.

So the third point to make about ISAs is my by now traditional warning: beware of commission-driven advice, however well-intentioned. The FSA has finally started to talk tough about the distortions that sales commission can introduce into fund choice. Its Treating Customers Fairly initiative lays out six principles advisers should meet.

Yet many of these aims, as the fee-based advisory firm John Scott & Partners pointed out this week, sit uncomfortably with the way many IFAs operate. "The qualification hurdles to become a financial adviser are astonishingly low," it said. "The relevant examinations can be passed after relatively little study and no practical experience.

"Financial advisers rely heavily on inducements from product providers. Many larger 'independent' financial advisory companies are now partly or wholly owned by product providers. Product providers also provide financial support to advisers for marketing activities, annual conferences and even Christmas parties."

A fair point. There really is no mystery as to why so few advisers recommend gilts, investment trusts or exchange-traded funds (which pay no commission) in preference to open-ended funds (which do), or continue to press the case for investment bonds (which pay higher commissions still) over sensible lower-cost alternatives. Listen carefully to advice by all means - but don't act on it unless you are clear about the basis on which it is given.

The fourth point concerns rebalancing your portfolio. Most people who have money in ISAs typically contribute a lump sum or regular payments each year. This can build up into a sizeable sum. It then becomes just as important to keep the overall balance of this portfolio under review as it does to find the "best" fund for the current year.

Do you still have an appropriate balance between income and capital growth? Is the mix of equities and bonds sensible? Is there enough diversification? Are there any clear cases of extreme overvaluation? Just adding a new fund every year is highly unlikely to produce an optimal result, particularly if that new fund is simply the year's flavour of the moment. According to a recent study of the behaviour of investors in Vanguard's retirement plan, 80 per cent remarkably make no changes at all to their holdings as the years go by.

That is good in one sense, as constant tinkering is the surest way to disappointing results, but it may be taking sensible passivity to extremes. For those investing to build a pension, it makes no sense not to adjust your mix of assets as retirement nears. A once-a-year review of the shape of what you have should be added to your annual ISA checklist.

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