The ISA road less travelled

Last week I promised to come up with some ideas of where investors might think about putting their last-minute Individual Savings Account (ISA) money. The aim is to follow a different approach from that which you will find by pursuing current conventional wisdom, which I define as being the funds which are most heavily promoted on the basis of their strong recent performance. Most of the independent financial advisors' (IFA) literature I have seen this year follows this approach.

Last week I promised to come up with some ideas of where investors might think about putting their last-minute Individual Savings Account (ISA) money. The aim is to follow a different approach from that which you will find by pursuing current conventional wisdom, which I define as being the funds which are most heavily promoted on the basis of their strong recent performance. Most of the independent financial advisors' (IFA) literature I have seen this year follows this approach.

What follows is not mainstream advice from conventional channels. If you act on any of this, you, of course, do so at your own peril. What I am seeking to do is to follow logically the reality of the circumstances in which ordinary investorsmake their decisions about ISAs. If you have still not made your ISA decision, you are almost certainly not someone who spends a lot of time following the markets and studying investment opportunities.

The chances are that you are thinking about putting your money into an ISA now because you are aware of the tax breaks and want to take advantage of them. You have some money to spare. My guess is that you are going to leave the money in the ISA pretty much where it is for a number of years; and in practice you are unlikely to go in for a lot of switching between funds.

The other assumption must be that you have taken a conscious decision to put the bulk of your ISA money into equities, despite having noted the risk inherent in today's historically high stock market valuations. You are wise enough to know that investing in the latest stock market fad is a high risk approach that, over time, only produces good results if you are smart enough and disciplined enough to know when to get in and out. (There is nothing wrong with putting money into technology funds or go-go shares at current prices provided you are aware of the risks you are running and have the time and information resources to be able to spot trouble coming. Even then, a much better way has to be to invest in the firms - brokers, investment banks and the like - which are selling the shares in firms such as lastminute.com than to buy the companies themselves).

My approach then is to look for ways of using your ISA money that offer both long-term value and measurable risk. You want a fund that offers you a good chance of delivering a result over 10 years, rather than six months. That inevitably means looking at routes which are not in fashion and where there is some reason to believe that they will deliver a superior, risk-adjusted return.

Route one then has to be the dull but predictable tracker fund. The latest study of fund performance produced by the WM Company (published last week) once again confirms their reliability. Its study of returns over a period 1989-1999 shows that more than 75 per cent of actively managed funds failed to outperform the All-Share index. It also demonstrated that the odds of doing better using active, rather than passive fund management, are of the order of one in four - and that is before you take account of the drag which bid/offer spreads put on active fund performance.

What WM also showed was that even the best performing actively managed funds are difficult to make money from - because by the time investors found out that these funds are in the top 25 per cent, most of their expected outperformance is already behind them. The average time period during which these top- performing funds sustain their advantage is around three years.

So a tracker fund, which guarantees to underperform the index, but by only a small and predictable margin, remains an obvious ISA choice. The fact that trackers have had their worst period for relative performance in the crazed market conditions of the past six months, only strengthens the case on a 10-year view. In my view, funds that track the All-Share index are a better bet than those tracking Footsie.

Provided you buy from a reputable management house, the best choice of tracker fund is the cheapest. Equitable Life, Fidelity and M&G, which all offer funds with below-average costs, all fit the bill on this criterion.

Taking a 10-year view, I still find no better value than a Japanese fund. The Tokyo market has already recovered to the 19,000-20,000 level, with second line stocks doing best of all. Although the Japanese market has always been more volatile than others, the risk in buying a well-managed Japanese fund looks more than reasonable.

Another promising looking strategy is to take out a self-select ISA and build your own portfolio of distressed blue chip companies with relatively high yields. A self-select ISA is obviously a more expensive route than buying a fund directly, but the added cost seems justified in this case by the exceptional value that is now appearing in the UK market.

Some of the more blatant cases of good stocks being oversold are already beginning to be redressed, but there is no shortage of candidates for building a value portfolio of your own. Taking a 10-year view, and assuming you already have some overall market exposure through your existing investments, then a self-select fund, split between three or four companies which have secure finances and good prospects of surviving whatever new technology may throw at us, stands to do very well. Companies in sectors that appeal to me that appear to pass this test are Land Securities (property), BAT (tobacco), Whitbread (brewing) and Lloyds/TSB or Abbey National (banking). With the yield curve inverted, and the Bank of England tightening policy, this looks a particularly good time to add some more banking exposure.

This last approach is a contrarian one - as it has to be if you follow my "buy cheap, sell high" philosophy. The great thing about taking a long view is that you don't need to worry too much about when or how quickly your choices have to come back into favour. The important thing is, what odds the market is offering and when those odds turn back in your favour.

There is also a case for looking at investment trusts rather than unit trusts/Oeics as the best way to invest in the current market. The caveat here is that you have to make a mental note to follow the performance of your funds more closely - and remember to sell when the shares achieve a 5 per cent discount or less. That way you can lock in the extra gain of a narrowing discount, on top of the underlying performance of the fund manager. Scottish Value, which buys shares in other investment trusts, and Foreign & Colonial are two to consider.

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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