It is all very well understanding the annual investment limits for ISAs and which investments you can and cannot put into them, but at some point the ISA investor is going to have to grit their teeth and decide exactly which investments their ISA is going to hold.

As we have pointed out many times in these pages, an ISA is not an investment, but a tax-efficient wrapper into which investments can be put. The key to maximising the tax breaks is, of course, choosing investments that will make effective use of the exemptions from personal taxation.

ISAs in context
So, how should you go about choosing the investments for your ISA allowance? Mark Dampier, head of research at Hargreaves Lansdown, suggests that ‘It all depends on whether you have got any other investments and, if so, what they are. Are you making a first investment or is your ISA simply a top-up to an existing portfolio?’

Anna Bowes, investment manager at AWD Chase de Vere, feels that ‘You almost have to divorce yourself from the fact that you are dealing with an ISA and look at it purely as a series of investments.’

She adds, ‘The investments you choose will depend upon your investment objectives – are they long term or short term? If you are genuinely a short-term investor, then you should be in cash.’

Bowes adds, ‘If you have longer-term objectives, do you want income or capital growth, or a combination of both? How much risk do you want to take and how does it fit in with the rest of your portfolio? It is important that you pick a fund that will suit your investment strategy and your financial goals.’

Tim Cockerill, head of research at Rowan & Co, agrees, ‘You have to start with what you are trying to achieve. You should pick a fund that fits in with your overall objectives. You might not think that you are gaining much advantage now, but in a few years’ time you could have an investment that has grown substantially in size. You also need a little bit of forward planning when making your ISA selections. Try to think what is going to show the most growth in ten years.’

Indeed, it is important to realise that it can take a while for the advantages of ISA investing to show through. The table above shows the performance figures of the five largest open-ended investment funds to the end of January. These funds are shown because their size and performance records mean they are likely to be popular with ISA investors. The figures show the difference in performance for a lump-sum investment in each fund over one, five and ten years, between investing net outside an ISA and gross within it.

As you can see, it takes a while for the tax efficiency of the ISA to take effect, and in the case of Fidelity European, the uplift remains marginal even after ten years. But the three income funds, in which dividend payments have been re-invested over ten years to give the total return figures, show an uplift of around ten per cent over the decade. Not spectacular, but undoubtedly worth having.

Be honest with yourself
The most important thing to do is be realistic with regard to the returns you are looking for and the level of risk you are prepared to take to achieve them. Dampier insists that ‘Above all, you must be honest with yourself regarding your goals and constraints. You need to establish what you are trying to achieve and you need to take your age into account. If you are relatively young and will be able to top-up your investments out of earned income in the future, you can adopt a very different investment strategy than if you are in retirement.’

He says, ‘If you are retired, you are probably looking for something that generates income, or maybe a total return fund, so you would probably be looking towards something like an equity income fund.’

But he adds, ‘If you are a first-time investor, with a long period ahead of you, then you can take more risk. You are probably better off drip feeding your money into the market through some form of regular savings though. If you are looking for a long-term investment, I think an emerging market fund makes a lot of sense, and adopting this approach should bring long-term rewards.’

Indeed, Dampier is a strong advocate of using regular savings within the context of long-term ISA investments. He points out that ‘Once you set up a direct debit, you can forget about it, which is very useful. People worry too much about what is going to happen in the next two weeks, but these are long-term investments. People talk about five-year minimum horizons but you should really be looking at equity-based investments over ten years or more.’

The question of risk
Jason Britton, co-fund manager at T Bailey, points out that ‘The Financial Services Authority (FSA), the government’s financial watchdog, says cash ISAs are a good option for people saving over the short term, or for keeping money that may be needed in an emergency. Financial advisers recommend that anybody putting cash on deposit, who is not planning to invest in shares, should always invest in a cash ISA up to their annual allowance.’He adds, ‘The non-cash element of an ISA can be invested in a variety of different forms of asset, including unit trusts and open-ended invested companies (OEICs), or in directly held shares, corporate bond funds
and investment trusts.’

Britton adds that ‘The FSA recommends that people investing for
the longer term– periods of more than five years – should consider a stocks and shares ISA because, over longer periods you are likely to beat the returns offered by a deposit-based bank account. According to the Barclays Equity Gilt Study, the UK’s longest-running analysis of the relative performance of different asset classes, over the past 107 years equities have returned, on average, four per cent
a year more than cash on deposit.’

However, equities are more volatile over the short term, and when putting money into stocks and shares it is important to remember that the value of your investment can go down as well as up and you may not get back the original amount you invested. Some equity ISAs are more risky than others and it is important to make sure the one you choose matches the level of risk you are happy with. An independent financial adviser (IFA) will be able to recommend a fund that reflects your risk profile.’

Maintaining a balance
Another element of ISA investing that is often overlooked is the need to maintain a balance of holdings across a range of funds and asset classes. This balance is likely to change over time as your circumstances change.

Adrian Locock of financial adviser Bestinvest insists, ‘You start by identifying what you want from your investments, your timescale and your attitude to risk. The first two are relatively straightforward, but determining your risk profile can be a lot more difficult. People have very different ideas of what the word “cautious” actually means. So, for example, we start by asking investors how much they are actually willing to lose.’

He adds, ‘We will then create a model based on your risk profile that leads you into where to invest. These models are created on the basis of risk. So, if you wanted to take a very cautious approach, you would have a portfolio with a very high proportion of bonds, and so on.’

One way of dealing with this is to invest in a broadly based, probably multi-asset, fund as a core holding. This will limit the upside potential of the fund when equity markets are booming, but should provide much more stable returns over the longer term, and
at levels that are still a significant improvement on cash.

Dampier says, ‘In those circumstances, I would suggest going for something like the BlackRock Merrill Lynch Absolute Alpha Fund. Because this is essentially a retail hedge fund it is going to grind out a long-term return rather than producing spectacular short-term performance, and that is what you want from a core holding. Of course, you will be giving up something. This type of fund is not going to go up by 25 per cent in a year, but it is not going to lose you 50 per cent either.’

A flexible attitude
The question of risk is an important one in determining your ISA investment strategy. Conventional wisdom suggests that the younger you are and the more time you have to invest, the more risk you are likely to be prepared to take. This means creating portfolios heavily slanted towards equity investment, and to higher-risk areas, such as emerging markets or single-sector funds in particular. Then, as the investor gets older, they become less inclined to cope with the ups and downs of the stock market and seek to reduce the volatility of their portfolios by moving into other assets, such as bonds and cash.

However, there is evidence that ISA investors of all ages have become less inclined to take risks as markets generally have become more volatile. Andrea Horner, associate director at Barclays Stockbrokers, reports, ‘It appears there are two types of investors seeking tax-efficient investments – those looking to protect their assets during volatility, and those in it for the long haul, looking for long-term growth in emerging sectors such as Asia.’

She adds, ‘These self-directed investors remain confident and active, taking advantage of recent market turmoil. It is also extremely encouraging to see just how active our ISA investors are in terms of the number of times they trade each year.’

Advice for beginners
Bowes suggests, ‘If you are a first-time ISA investor, you could choose a core holding, for example a UK equity income fund. This is the type of long-term investment that is generally regarded as a less risky way to get into equities as it focuses on yield.’
She adds, ‘However, for the more risk averse, these days you have things like the cautious managed funds, which hold portfolios of equities and bonds,
or the multi-asset funds. Here you have portfolios that invest across a range of assets and they are a very attractive proposition for people who don’t know where to invest and who want someone else to do it for them.’

One of the reasons investors might choose to rely on such a broad-based approach is fear of losing their capital if it is too exposed to the stock market. Investor psychology plays an important role in determining our long-term investment choices and, as Dampier points out, it is important that you construct a portfolio that you are
happy with on a long-term basis.

‘You have to ask yourself whether
you can sleep at night with falling prices. Drip feeding money into the market will get around much of this problem, although it means you will lose some upside if the market rises very rapidly in the early stages of your investment.’

He argues that ‘It is extremely important that investors maintain
their confidence. What you don’t want is for first-time investors to have a bad experience, as happened to a lot of people with technology funds in the boom of the late 1990s, or they will never invest again.’

Doing your homework
It is also important to keep the performance of your ISA holdings under regular review. It is not enough simply to make an ISA investment and then forget about it, even if it is a regular savings scheme. Investors should monitor the performance of their chosen funds and be prepared to take advantage of the flexibility of the ISA system to change them if they are not coming up to scratch.

Dampier feels that ‘There is no substitute for doing a lot of research yourself. If you don’t know what to do, you should take your time. Hold your ISA investment initially in cash and then decide what to do with it later. These days, with financial advisers increasingly using fund platforms, you can invest cash into your ISA to secure your allowance for the coming year and hold it on the platform until you have decided which funds you want
to invest it in.’

Bowes agrees, ‘Don’t just rush into making an ISA investment. You must think about what you want to achieve and choose a fund to fit it.

You should adopt the same approach as when deciding what car to buy or which pair of shoes to wear. You wouldn’t wear a pair of high heels to go hiking. In the same
way, you should make sure that your ISA investments fit your needs and objectives.’