The budget of March 1998 came as something of a shock to the financial industry. The introduction of...
The budget of March 1998 came as something of a shock to the financial industry. The introduction of Isas and their implications for Peps, life assurance and Tessas were unsettling enough, but at the same time, sweeping changes to capital gains tax (CGT) regulations had product providers, financial advisers and investors debating the implications for weeks.
The relative advantages of one approach to portfolio management over another formed the basis of many of the more involved discussions. The debate turned out to be somewhat inconclusive; the relative benefits of funds of funds over portfolio management services depend very much on individual clients, how much is invested, and what other assets a client holds.
One approach to portfolio management which was a clear loser, however, was the purely stock-based portfolio service. Even before March 1998, this approach made it difficult for a manager to protect their client from capital gains tax liabilities, as every time the manager needed to sell one stock and buy another, there would be an associated capital gain or loss. Raising capital gains is obviously beneficial in some circumstances, but clients and their advisers are normally more comfortable with a structure which allows them greater control over how and when gains are realised, and in which section of the portfolio.
As a result, many clients and advisers had grown more comfortable with portfolio services based on pooled investment vehicles, such as unit trusts and Oeics. With no CGT payable when stocks are bought and sold, these vehicles enable managers to disregard tax considerations when making investment decisions. After the budget of 1998, unit trusts and Oeics arguably gained a further advantage from the introduction of taper relief on assets held over the long term. The diversification and comparatively low volatility offered by pooled investment vehicles makes them more appropriate for long-term investment, and stock-based portfolio management services have therefore suffered some competitive disadvantage.
Some managers offer entire portfolio management services which are structured as a single fund of funds. These enable clients to hold a diversified portfolio of several unit trusts or Oeics, providing exposure to a number of international markets and asset classes. This structure puts clients in control of the timing of their capital gains liabilities, as no CGT at all will arise until a sale is made. The greater diversification and relatively low volatility of funds of funds makes them yet more appropriate for investors who want to buy and hold over the long term, and they are therefore ideal for clients wishing to take full benefit of taper relief.
One generalisation which it is possible to make is that for those wishing to shelter a portfolio from capital gains, the fund of funds approach is almost always the better option. Trust funds are an obvious example of portfolios where taper relief is of greater benefit than the CGT allowance, as trusts enjoy only half the relief afforded to ordinary investors. Equally, once a portfolio has become large enough to habitually use up a client's annual CGT allowance, it makes sense for remaining assets to be committed to a fund of funds. If an investment portfolio is left in a fund of funds over the long term, all gains will eventually benefit from taper relief.
The possibility that some investors will move into a lower tax bracket on retirement is another point in favour of the fund of funds approach. As an illustration of this benefit, a 40% taxpayer raising capital gains every year would pay all of that 40% on any gains above the tax-free limit. If that investor left all their assets in a fund of funds for ten years, only 60% of the capital gains generated would be liable for CGT. If the investor also moved into a lower tax bracket on retirement (say, 22%), the total CGT payable on all the gains within the portfolio would be only 13.2%.
However, while the government still offers a capital gains tax allowance, investors will always want to take full advantage, and this is where fund of funds investors encounter a slight drawback. In an effort to restrict the practice of 'bed and breakfasting', part of the 1998 budget required investors to wait 30 days before buying back an asset they had sold in order to raise a capital gain or loss. For an investor whose investment portfolio is structured as a fund of funds, this would mean selling a proportion of the entire portfolio.
Ideally, then, a portfolio management service should offer a combination of the fund of funds structure, to offer access to the benefits of tapering relief, and the flexibility to raise gains and losses as and when required, and from the most appropriate section of the portfolio.
A portfolio management service which is based around a series of different funds of funds offers both these advantages, and leaves clients or their advisers in the driving seat when it comes to tax planning.
This is particularly important, as individual clients will have very different requirements, meaning that it is almost impossible to structure a service in such a way as to offer maximum benefits to all clients.
If each separate section of the portfolio, divided by geographic region or by asset class, is structured as a fund of funds, advisers will be in a position to sell whichever element of the portfolio will provide the greatest benefit. They will also be able to control which part of the portfolio will be uninvested for the required 30 days.
For instance, if the US market declined in a given tax year and an adviser considered that it might fall further, this section of the portfolio would be an ideal candidate for providing a capital loss. This could then be set against gains from the more successful section of the portfolio, or against gains from any other assets a client might hold. However, if a client o
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