Once you have decided to put some money aside for your children – or grandchildren, godchildren, nephews, nieces and so on – you then have to get to grips with the tricky question of how you should actually invest it. Your first instinct may well be to take the lowest-risk option available, say a deposit account or some other form of cash-based saving. While this will undoubtedly limit the risk to your invested capital, it is not going to produce particularly attractive returns.

Making the right choice
Andy Parsons of stockbroker The Share Centre notes, ‘I would say that there are three key investment strategies parents can adopt. If the child was born since September 2002, then they will be entitled to the Child Trust Fund (CTF). This has restricted investment levels but is still a wonderful way to get started. The problem is that the CTF becomes available to the child at the age of 18, which might be earlier than the parents want them to get their hands on it.’

He adds, ‘Another option is a pension, which can be set up on a stakeholder basis. This deals with the problem of children getting their hands on the money too early, as they can’t access it until they are 55. The third option is simply to invest a sum of money generally, outside of these products, but earmark it for the child’s future use.’

For most parents with children born since the introduction of CTFs in September 2002, these funds are the obvious starting point. Zach Hocking, head of investments at Co-operative Insurance, explains, ‘Up to £1,200 per year can be contributed to a CTF.
The fund will build up free of tax on investment income and capital gains, just like an individual savings account (ISA), until the child reaches 18, when funds can be withdrawn. Every child living in the UK and born after 31 August 2002 should receive a voucher from HM Revenue and Customs (HMRC) to open a CTF.’

James Budden, managing director of Witan Investment Services, observes,
‘The government has made efforts to encourage parents to put money aside
for their children’s future, and the introduction of the CTF has helped position saving for children at the heart of a family’s financial planning. This has led to a significant increase in [the public’s] interest in child savings schemes, so that we currently manage around £60 million on behalf of some 20,000 children through our existing Jump Savings Plan.’

However, not every parent seems keen to take an active role in managing their child’s CTF investment. Jason Hollands of F&C Investments reports that, according to figures released by HMRC, around 24 per cent of CTF vouchers issued in the first six months of the scheme (in 2005) failed to be invested by expiry 12 months later, and the figure for the following year was 30 per cent. In fact, around 750,000 vouchers have expired in this way since the scheme’s inception, so have been invested in the default option – a randomly chosen stakeholder CTF.

Hollands points out that ‘This suggests that vouchers that are collectively worth millions of pounds have either been chucked in the bin or left languishing in drawers or stuffed behind the sofa. Ending up with an account randomly allotted by the taxman may not necessarily represent the best investment option for your child, and you will have lost out on a year of potential growth.’

Taking control
But it doesn’t have to be like that. Andy Parsons asserts, ‘I am a strong advocate
of the fact that, in the early years, a CTF investment should move the risk up a notch. I think it makes sense to put some money into a CTF or a junior investment account, but also put something into a pension to build up a nice little nest egg.’

The key point is that when you are talking about making investments for children, you actually have a relatively long period over which to make them. So, in theory at least, you should be able to take quite an aggressive approach to the portfolio, at least in the early years.

David Bulteel, head of private clients at stockbroker Rensburg Sheppards, asserts that ‘It is a combination of starting early and investing in the equity markets that provides superior returns over time. I must say that, in dealing with this area, I have to combine my experiences as a parent and an investment manager. One of the key things is that, on a compound basis, if you start early enough with very small sums, it can really add up over a long time.’

This is another key point to remember. Even relatively small amounts of money, attracting what appear to be modest short-term returns, can build up into significant sums over longer periods, if the interest or dividend income that they generate
is reinvested to boost the overall return.

Obviously, the greater the annual rate of return, the faster your money will grow, so that, for example, a rate of one per cent a year still only produces a little over £110 over ten years, while seven per cent per annum nearly doubles the amount invested over the same period. Eight per cent doubles the value in nine years, nine per cent in eight years and ten per cent in less than seven and a half years.

More than just cash
Indeed, you don’t even have to take that much risk to get, say, seven per cent on your children’s savings, with several children’s savings accounts and CTF providers currently paying around that figure. But a cash deposit, even one aimed specifically at saving by or for children, is unlikely to maintain that level of return for a decade, let alone two.

If you want to maximise your returns then you are going to have to consider investing in equities and, in this context, the sooner the better.

Budden argues that ‘The period over which investments for children are being made lends itself to investing in equities, so the choice for parents is then what medium and what approach to equity investments suits them best.’

Parsons points out that ‘With CTFs, you have 18 years, so why would you put cash into an CTF? Over the first ten to 12 years, you need to take more risk with this portfolio and then, as it matures, you start putting more into less risky investments – in the same way that you would with a pension as you get close to retirement.’

This approach is illustrated in chart 1 on page 12, which compares the returns from three model portfolios over the past five years. One invests 75 per cent in bonds and 25 per cent in equities, the second 50 per cent in bonds and 50 per cent in equities and the third 75 per cent in equities and 25 per cent in bonds. Over the five-year period, the higher the equity content, the higher the volatility and the better the performance, and vice versa.

Parsons also suggests a possible way of funding these investments: ‘One relatively easy way to do this is to use the child benefit allowance. If you are not accounting for that already in your monthly budget, then why not put that into an investment for your children? Again, you could put some into a CTF or children’s account and some into a pension.’

Hocking explains that ‘Child benefit is not means tested or taxable. Anyone failing to claim could be missing out on £941 a year for their eldest child, and £629 a year for other children. It would also prevent any parent that stays at home to look after their children from getting Home Responsibilities Protection, which stops a parent’s time away from work reducing their state retirement pension entitlement.’

Venturing into equities
The problem for many parents in venturing away from the security of cash for their children’s savings is the risk involved. Certainly, shares are more volatile than many other asset classes, but it is precisely this volatility that generates superior performance
over longer periods.

In a comparison of the performance of shares (the FTSE All Share Index), gilts (FTSE A British Government All Stocks Index), cash (Halifax Liquid Gold over £5,000) and residential property (Halifax Property Index), over one year, shares are down nearly 11 per cent, while the other three asset classes are showing a positive return
over the 12 months, with considerably less volatility. But over five years, shares have delivered the strongest performance, again with the greatest volatility – up over 68 per cent, compared to 55 per cent for property and 3.6 per cent for cash, while gilts were actually negative.

David Bulteel points out that ‘There is an old stock market adage that it is time, and not timing, that is important. For a small child and the small amounts of money that are being put away each month, they are not going to worry about the ups and downs of the market.’

He adds, ‘Nobody can time the market consistently, but if you have got enough time on your side, as young children will have, then you are not going to be worried about short-term volatility.’

Bad timing
Budden argues, ‘You hear financial advisers saying that you should be in commodities or in emerging markets at the moment, and that may be fine in the current circumstances, but you then have to decide when to move into something else. Funds like ours do that for you and you will still get exposure to these exciting areas from time to time.’

He adds, ‘Also, you have to remember that with this type of saving we are talking about relatively small amounts on the whole, so trying to second-guess the markets is a dangerous thing.’

Indeed, private investors should be very wary of trying to make their own investment decisions, according to Chris Taylor, chief executive of Blue Sky Asset Management, which has recently published some detailed research into the ups and downs of stock market returns.

He says, ‘The results of the Blue Sky study of the UK’s All Share index highlight the need for retail investors to make smarter investment decisions, especially during periods of uncertainty, and particularly those that will result in a stronger long-term portfolio performance. The results demonstrate dramatically that missing out on the
early stages of market recoveries can hit investors’ returns hard, causing a potentially significant erosion of long-term portfolio performance.’

He adds, ‘The temptation for many investors can be to try to “wait out” periods of market volatility before “stepping in” when they feel markets are going up. The trouble with this is that, all too often, retail investors display an alarming propensity not just to get their timing wrong, but to get it almost diametrically wrong, vis-à-vis the best long-term investment decisions.’

Taylor concludes, ‘Investors need to appreciate that, while markets always
look bearish on the way down and during periods of volatility, over the longer term portfolios can be expected to weather the downdrafts and benefit from bull trends.’

Professional management
The solution to this dilemma is to invest in some form of managed fund, invariably via a savings scheme (see page 14 for more details). Traditionally, the generalist investment trusts have been seen as the ideal vehicle for this type of long-term saving, providing a broadly spread, global portfolio at relatively low cost.

Witan’s Budden affirms that ‘Global diversification is what we do, as it is a much better option to have your investment spread across a range of global markets than trying to pick when to move from one to another. It is a brave person who is both willing and able to asset allocate and switch their investments as they go along. Not only are there difficult choices to make but there will always be costs involved in managing your own portfolio.’

He points out that ‘You have very low costs with investment trusts, around 0.5 per cent total expense ratio with Witan. That might not seem a lot different from, say, a standard charge of one per cent, but those one per cents do compound up and can be quite significant over time.’

Budden also sees another distinct advantage to using investment trusts as the basis for children’s savings. ‘Also, with an investment trust, you are treated as a proper, bona fide shareholder. It is useful from an educational point of view as being involved in an investment trust savings scheme will hopefully encourage children to take an interest in investing later on.’

However, not everyone shares this enthusiasm for investment trusts, especially for investors who have no previous experience of the stock market. Rensburg Sheppards’ Bulteel feels that ‘Collective investments for the novice investor should probably mean unit trusts and OEICs. More experienced investors will gravitate towards investment trusts, where you have to deal with the question of timing. Professional investors will be looking to arbitrage the discount between investment trust holdings, but investors who are just looking for market exposure should stick to unit trusts, as the unit price reflects that actual asset value of the fund.’

He adds, ‘You need to ask whether you are trying to buy investment trusts at a discount or, if you just want exposure to a particular area, whether you should be buying unit trusts instead of investment trusts. A little professional advice in these areas will be a very good idea.’