ISAs, or Individual Savings Accounts, are one of the big investment stories of the past 20 years.
They were introduced in 1999 to encourage saving and investment. They offer generous tax breaks, so that, through an ISA, you can invest up to £20,000 a year without paying tax on the investments.
That’s a pretty big incentive, so it’s not surprising that ISAs have proved to be so popular. According to a HM Revenue and Customs report of April 2019, at the end of 2017-2018 the market value of Adult ISA holdings stood at £608bn, a 4% increase compared to the value at the end of 2016-2017.
There are now seven types of ISA accounts: Basic ISAs; IFISAs; Junior ISAs; Inheritance ISAs; Help To Buy ISAs; Flexible ISAs; Lifetime ISAs. Five of these are for specific investment circumstances, so we’ll just look at the first two.
Basic ISAs can themselves be divided into: Cash ISAs, Fixed Rate ISAs and Stocks & Shares ISAs.
A Cash ISA does what it says on the tin. Your investment is in the form of cash and you receive interest on it, as you would in a bank deposit account, but that interest is tax free. It’s the same with a Fixed Rate ISA, except that here you commit to locking your money away for a fixed term, typically between one and five years, in return for a fixed rate of interest, which will usually be higher than you can get in a simple Cash ISA.
With a Stocks & Shares ISA, your money is invested in company shares and in government and corporate bonds. Your investment can earn a return from dividend and interest payments, as well as any capital gains resulting from a rise in the value of the investments. The rates of return will typically be higher than those available in either of the two types of Cash ISA.
Which ISA is best for investing?
IFISAs, or Innovative Finance ISAs, are the newest addition to the ISA range, having been introduced a little over three years ago. They were set up in response to the growing interest in the peer to peer lending market and more investors taking advantage of the opportunities offered by high growth businesses raising funds on online platforms. But they had to declare their income from these investments, typically through their self–assessment return, and any gains were taxable.
With the introduction of IFISAs, however, they could use some, or all, of their annual ISA investment allowance to lend funds through the peer to peer lending market and buy other debt based securities, getting the ISA tax advantages. These can include property bonds, issued by a company to fund property projects, including the purchase of land or properties, development finance and planning finance. They are typically held for fixed period, of say to two to five years and carry a fixed rate of interest, which can be paid to the holder regularly or rolled up to be paid over at maturity, along with the face value of the bond.
How portfolio strategy can impact ISAs
These are the main different types of ISA investment: so which is the best?
That’s one of those questions to which there isn’t a single, definitive right answer. It depends on what you are looking for in your investment portfolio and on your individual circumstances.
For example, if you think you might need access to your money at short notice then Fixed Term ISAs nor IFISAs are probably not for you.
Usually, a more important consideration is your attitude to risk. People have different attitudes to risk, which vary according to their personality, circumstances and age. A person who wants to grow the value of their capital as quickly as possible will take a different view of risk to another who may, for example, be on the edge of retirement and who wants to defend the value of the capital they already have. Their different risk profiles will lead to different investment strategies.
A rule of thumb in investment is that the lower the element of risk that an investment carries, then the lower the rate of return it is likely to give. Investors always want to maximise their returns, but they will also have an eye on the risk. If the risk of loss is too high, then they may judge the potential return as not being worth it.
How to choose which ISA is best
In terms of ISAs, the most secure is the Cash ISA. The investor doesn’t need to fear a company going bust or doing so badly it can’t pay a dividend or the state of the stock market. But, the investment will only earn around the market rate of interest which, at the moment are historically low. A Fixed Term ISA will pay a better rate of interest but there is a slightly greater risk, in that inflation might rise above the fixed rate, so the value of the capital is eroded or market rates might rise above the rate you are tied to, so you lose out.
Stocks & Shares ISAs can bring greater returns, particularly when stock markets are rising, but, as we’ve seen, that’s not always the case and the investor can suffer serious short term losses.
IFISAs sit between Cash ISAs on the one hand and Stocks and Shares ISAs on the other in their balance between risk and reward. They’ll usually pay a better rate of return than a Cash ISA, while having a greater element of risk, but they can be more secure than a Stocks & Shares ISA, even if they tend to pay a lower rate of return. Also property bonds held in an IFSA may be secured against the asset whose acquisition or development they were issued to fund.
However, even if an IFISA is asset backed, an economic downturn could affect returns and you may not get back the amount invested. In the event of default the security held doesn't guarantee the return of your capital. Enforcing your security may take time and your returns may be delayed. Investment isn’t covered by the Financial Services Compensation Scheme (FSCS).
As to the best type of ISA investment, that depends on your portfolio strategy. It’s advisable to achieve a diversified spread of investments. This way, not only will you limit your exposure to one type of asset, but falls in the value of one can be compensated by rises in another. The variety of types of ISA accounts available presents great opportunities for tax efficient diversification.