Recent market volatility reminds us that there is no point having an investment with tax-free proceeds if there are no proceeds. If your ISA investments reduce in value or produce little or no income then they become useless.

But what options are available to ISA investors wanting to limit potential losses? The ISA rules permit access to a wide range of investments, some of which can significantly reduce the risk profile of your tax-free portfolio.

Tim Cockerill, head of research at Rowan & Co, says that, ‘It is at times such as those we are now experiencing that you find out if the investment that you thought was low risk is genuinely low risk. Property is a great example of something that was seen as low risk – because it wasn’t correlated with equities and investors were picking up a yield – but is now not what it seemed.’

But, he adds, ‘It is also the case that the level of risk that people are happy with changes with market conditions. If you are invested in something today that is holding up well, then it is a genuinely low-risk option, but the disadvantage is that when the market recovers the upside will be low. Although that is what you signed up for when you adopted a low-risk strategy, there is still likely to be some disappointment that you haven’t matched the market on the way back up.’

Clinging on to cash
Clearly the safest option of all is cash, and there is a wide range of cash ISAs to choose from. Anna Bowes, savings and investments manager at AWD Chase de Vere, believes that ‘Cash ISAs are the best option for people who want to take no risk at all. They make a lot of sense as returns are tax free, so you have a better chance of beating inflation. If you are an investor who is interested in investing in the stock market but doesn’t want to be exposed to the full risk of equities, you could go for some form of structured product, but you have to be very careful choosing which ones to hold as they can be very different.’

She adds, ‘The ones that I don’t like are those that give you a minimum return, as all that will do is affect your total return by limiting your potential upside. If you are that worried about losing your money, then you might as well have a cash ISA anyway.’
However, structured products do represent a sound option for risk-averse investors if they get it right. The Share Centre’s Guy Knight argues that ‘One aspect of the ISA rules that is very relevant to our investors is that capital-protected funds can be put into ISAs. One of our recommended funds is the Close Protected 100 Fund, which locks in gains on a quarterly basis.’

He adds, ‘There are many of these funds about – there are now over 90 structured products on the market, from the very simple up to the quite complex. They all work in a slightly different way, but we believe that this is one to have on our recommended list as it helps to limit the downside.’

Degrees of protection
The key difference between the capital-protected funds is the amount of protection they offer. A 100 per cent fund will effectively provide a guarantee that the price will never fall below a certain level, while a 95 per cent fund will allow a five per cent fall, and so on. However, the advantage that capital-protected investment funds have over other structured products is their flexibility.

Knight emphasises the advantages of using capital-protected funds over structured products, such as guaranteed equity bonds (GEBs), within ISAs to reduce risk while still retaining some stock-market exposure. ‘With volatility being so much in evidence recently, investors will be very keen to limit their risks. The advantage that these downside-protection funds have over GEBs is that, typically, with a bond you are locking your money away for five to seven years and it is very difficult to get your money out before maturity if you want it early. These things can be very difficult to unravel and there may also be penalties for withdrawing your money early.’

He adds, ‘So the advantage of choosing one of these capital-protected funds is that, if you want to move into a different investment, or simply cash out, it is much easier to do that with these funds. Charges are relatively low, the minimum investment can be as little as £10 and, for example, since it is on our recommended list we wouldn’t charge investors anything on top of that. Few investors will want to put everything into these funds, but they can provide a very stable core to an ISA portfolio.’

Neither equities, nor cash
Possibly the most sensible strategy in the current volatile circumstances is to choose a middle way and opt for bonds.

Malcolm Cuthbert, head of financial planning at stockbroker Killik & Co, suggests, ‘We think that putting gilts into ISAs is a good idea at the moment. You will also have, under the new rules, the option of moving money invested in cash ISAs across to equity ISAs.
We have a lot of customers who are understandably wary of banks at the moment, so we say to them why not move from a cash ISA to an equity ISA and put the money into gilts?’

This strategy will appeal particularly to those investors using their ISAs to fund their retirements, Cuthbert adds: ‘Our chairman, Paul Killik, has long been of the opinion that, when you get to retirement, you should switch your ISA portfolio into gilts and take an income from it. Indeed, it is sometimes better to take your ISA and put it into your SIPP and take the benefits.’

This touches on the long-standing debate over whether it is better to save for your retirement in an ISA portfolio or a self-invested personal pension (SIPP), which we look at in more detail in the article beginning on page 17. Cuthbert argues that the most efficient way to save for retirement is to use both strategies at different stages of the process, adopting the same general investment principles throughout.

He explains, ‘Investors wishing to maximise their retirement pot should make sure they are effectively utilising all the tax benefits available to them. There has long been disagreement about what is more tax efficient, PEPs/ISAs or SIPPs/pensions, but in reality there is no reason why you shouldn’t have both and move from one to the other when it benefits you most.’

Cuthbert adds, ‘We encourage our clients to use their yearly ISA allowance but, for some investors, it may be beneficial to transfer existing PEP and ISA savings into a SIPP, particularly those nearing retirement. This makes sense, particularly where higher-rate tax relief can be claimed.’

He suggests that ‘If you are over 50 this can be beneficial, as you are getting tax relief on the money you use to set up your pension. For example, if you have a total of, say, £78,000 invested in ISAs, that will become £100,000 when invested in a SIPP and will only cost a higher-rate taxpayer £60,000. Then you can take a £25,000 tax-free lump sum when you retire and still have £75,000 invested to provide the retirement income.’ The downside is, of course, that this income will be taxed.

Security and returns
Tim Cockerill agrees that fixed-interest is the most sensible asset class for low-risk investors to be looking at in current circumstances: ‘I would say that if you were looking for something lower risk at the moment, you should be looking at fixed-interest. With interest rates falling both in the US and the UK, that is going to be supportive of the fixed-interest markets. So I would say that that is a relatively low-risk area at the moment.’

He adds, ‘This is a sound strategy, particularly if you are going into a broadly diversified fund like the F&C Strategic Bond fund, which holds both investment-grade and sub-investment-grade corporate bonds and is actively managed.’

Anna Bowes also argues in favour  of ISA investors reducing their risk by increasing the diversification of their portfolios: ‘The next step would be something like a multi-asset fund, where you will be investing in things like corporate bonds alongside equities, which will take away a lot of the risk.’

And Tim Cockerill concludes, ‘I would say that fixed-interest is probably the safest place to be, with a reasonable degree of upside at the moment. You have to be careful with any equity fund that you hold currently. If it has been performing well then you will know where it has been invested – natural resources, maybe a bit of technology and so on – and they are likely to be volatile areas.’

He adds, ‘But whether you are looking at a fixed-interest or an equity fund, diversification is clearly important because it does lower your risk profile as the risk of each individual holding is reduced.’