UK - For growth, think small-caps and emerging markets

Investors who want to get the maximum tax benefit from individual savings accounts (Isas) should use them to hold smaller companies and emerging markets funds, advisers say, as these investments have the potential to deliver the highest long-term returns.

But they stress that choosing a fund involves balancing any future growth – and capital gains tax savings – against the volatility in these markets.

“Growth funds are potentially an attractive option for long-term saving within an Isa wrapper as any gains are being built up in a very tax-efficient manner,” explains Stephen Walker, head of equities research at Ashcourt Rowan.

Graham Spooner, investment research analyst at broker The Share Centre, agrees and recommends that all long-term investors allocate the maximum £10,680 to equity investments in their Isas.

“Investors can grow their portfolio without having to worry about capital gains tax,” he says.

However, Walker argues that the funds achieving the strongest growth will be those backing companies generating the most consistent income. “That can mean funds that facilitate the reinvestment of income,” he says, “or those that conventionally generate very little income because the companies themselves are reinvesting their profits.”

He cites Warren Buffett’s Berkshire Hathaway – which has grown into a $200bn US company – as the best example of “the constant profitable reinvestment of profits”.

For UK private investors, the nearest equivalents will be funds focused on profitable companies that limit their dividends, he says. “Funds that stand to deliver the best long-term returns are those that invest in companies with a sustainably high return on invested capital – ie, they can earn high returns on their reinvested profits – and a relatively modest, or zero, dividend pay-out ratio.”

Anna Sofat, director of Addidi Wealth, suggests that these growth funds are most likely to be found in smaller companies, emerging markets, energy and consumer brands sectors.

Smaller companies funds have been among the best performers over longer periods, notes Tim Cockerill, head of collectives research at Rowan Dartington, “because of their ability to grow quickly, especially in niche markets”.

He says the new Standard Life Global Smaller Companies fund looks well-placed while, in more specialist sectors, the Polar Capital Global Healthcare investment trust has the potential to capture “huge growth in the middle classes in the emerging markets”.

Technology is another niche sector where smaller companies offer opportunities, according to Walker. While the cash being retained by larger technology groups suggests “they can’t find suitably attractive investment opportunities”. He believes “funds with a focus on companies at the smaller end of the spectrum might be one way to go”. His suggestion is the Herald investment trust.

Isa investors with more risk appetite can think smaller, argues Dennis Hall, chartered financial planner at Yellowtail Financial Planning. He recommends HgCapital Trust, which gives investors exposure to a diversified portfolio of private equity investments, primarily in the UK and continental Europe.

Emerging markets offer more of these early-stage growth companies, but also more risk.

Gavin Haynes, managing director of Whitechurch Securities, acknowledges that emerging markets funds had “a tough year in 2011”, as share prices in developing economies amplified the global market volatility. Even so, he suggests those price falls now provide “an attractive entry point for the long-term investor”. His growth fund recommendation is therefore Templeton Emerging Markets, whose manager Mark Mobius has a 30-year record of above-average performance.

Walker also backs the Templeton fund, as well as the Pacific Assets investment trust and Fidelity South East Asia fund. “The other area that ought to be near the top of the pile is that of emerging markets,” he argues. “There are many industries in the early stages of development and where there must be substantial long-term growth prospects.”

Some even suggest combining the smaller company and emerging market growth themes, through a single Isa fund.

Cockerill recommends Aberdeen Asian Smaller Companies as a way to do this. “The region offers investors exposure to high- growth dynamic economies, a huge population that is growing steadily wealthier, resulting in an expanding domestic economy,” he notes. “And smaller companies have the ability to grow more quickly than larger companies. The fund is focused on the domestic markets in the region and smaller companies which are high quality, profitable and well managed. All in all a very attractive package.”

But with many investors seeking tax-free growth with less volatility, some advisers are starting to look to larger companies in wider markets.

Research carried out for The Share Centre found that Isa investors are still looking to equity markets for opportunities – but that 27 per cent are concerned about the uncertainty in share prices, and 30 per cent are prepared to take less risk than 12 months ago.

For investors like these, broker Selftrade suggests shares and funds backed by established global brands. It is advising clients to “invest in what you know – a dominant player in a growing market, or the producer/provider of an indispensable product no matter what the economic climate”.

Independent advice firm AWD Chase de Vere suggests a simple way to do this is to choose the M&G Global Basics fund as this year’s Isa holding. It focuses on shares in western companies that stand to benefit from economic growth in the emerging markets – “a prevalent theme” over the next ten years or more. Although its exposure to commodities will expose it to further volatility, advisers argue that longer-term investors have to ride this out.

Neil McCarthy, investment analyst at Heron House Financial Management, advocates a similarly global approach, by holding the SVM Global investment trust. “It is broadly structured into six different themes and offers the opportunity to gain exposure to areas that more mainstream trusts avoid,” he says.

Performance in the past has been volatile – and McCarthy says this may continue – but he believes that the fund itself and many of its shareholdings, remain undervalued.

Matthew Vincent

Financial Times

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