A new approach can boost your Isa performance

Investors only using their cash allowance should diversify

DON’T expect the simple approach to your individual savings account (Isa) to bring home the bacon. Cash Isas can offer investors flexibility. But with inflation at 2.7 per cent, you’ll struggle to find one that delivers a real return – even if you tie your money down for longer periods of time.

But the tax advantages offered by Isas shouldn’t be ignored. Fidelity recently found that basic rate taxpayers could lose £75,000 over 25 years (£115,000 for higher rate taxpayers) by failing to use Isa allowances. This is akin to “surrendering your hard-earned money to the government,” says Fidelity’s Tom Stevenson.

So now is a good time to seriously consider other types of investments, especially if you already have money tied up in a medium or long-term cash Isa. Many types of investments can be held within an Isa wrapper, from stocks and shares to fixed-income. These investments carry more risk than cash Isas, but they offer the potential for higher returns.

If you’re wondering why equity markets are performing well, even though underlying economic fundamentals are weak, it’s partly because of monetary easing by central banks. This reduces real interest rates, and drives money into “risk assets” like equities. The abundance of cash flowing into global stock markets has boosted performance. And with central banks set to continue their relentless easing programmes, having exposure to equities makes sense.

Tom Elliott of JP Morgan Asset Management says “there is an old saying: don’t fight the Fed”. Or indeed, the might of other central banks. So Elliott firmly believes that equity markets are attractive.

And financial equities might be a good buy. Banks have had a tough time since 2008, and the JP Morgan Global Financials fund has lost 55 per cent since then. But it has recently rebounded, growing by 70 per cent over the last four years – and by 24 per cent in 2012 alone – comfortably outperforming the FTSE 100 index.

The fund has an initial charge of 3 per cent of assets under management (AUM), and a 1.5 per cent annual charge. But be warned that the sector is vulnerable to “risk off” sentiments. If you are considering investing, it may be sensible to select an actively-managed fund, as opposed to a passive one.

For investors who are tentative about dipping their toes into potentially volatile equity markets, sectors like fixed-income are a good option. They offer more certainty about the level of returns that you can expect.

There is ongoing debate over whether bonds are in a bubble, because yields have fallen to record lows. But all experts agree that a diversified portfolio should have exposure to fixed-income assets.

Again, the effects of monetary easing can support some areas of the bond market. Oliver Boulind of Aberdeen Asset Management says that “investors should seek funds with a strategic view of the market,” where fund managers have the flexibility to invest in various types of bonds, like high-yield, corporate or government bonds across emerging and developed markets.

In the Investment Management Association’s (IMA) sterling strategic bond sector, the best performers over the last two years were the Royal London sterling yield fund, and the Baillie Gifford corporate bond fund – both primarily investing in company rather than government debt. The funds have respectively grown by 18 and 15 per cent over the last three years – more than double the sector average.

For those who already have allocations in equities, fixed-income and cash, alternative investments could be a consideration. And of these, absolute return funds might be suitable. They aim to deliver a positive return, regardless of market conditions.

But investors should proceed with caution. The different funds within the sector are exposed to different asset classes, and use different strategies. This makes it harder to compare relative performance. And many funds don’t achieve their aim of delivering absolute return. Recently announced changes to the classification by the IMA should help to bring more transparency, but investors will still need to closely scrutinise a fund’s track record.

Since its inception, Odey’s absolute return fund has been one of the few consistent performers, growing in value by 27 per cent. It invests in a variety of different asset classes, and takes both long and short positions. Portfolio manager James Hanbury says that the fund looks for assets that are either above or below their intrinsic value. But you’ll need to stump up at least £5,000 to invest, as well as 4 per cent of AUM.

Investors must weigh up their own risk appetite and how much they are prepared to pay for performance. But with the global investment landscape clearly not favouring cash, stepping outside your comfort zone may be worthwhile.