Understanding investment

What do I need to know about investing?

You should be aware that the value of investments, and the income from them, can fall as well as rise. Returns are not guaranteed and you may not get back what you originally invested. The investments available may not be appropriate for everyone.

Past performance is not indicative of any future return. Where a portfolio contains overseas investments, exchange-rate variations may cause the value of your investment to decrease or increase.

You can withdraw cash from your portfolio when you wish but you should bear in mind that if this necessitates sales of your investments, particularly at a time when stock markets are depressed, this may result in a capital loss.

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What are traditional asset classes?

Traditional asset classes are Equities, Bonds and Cash. Over time, the real value of money is gradually eroded by inflation. However, you have a range possible asset classes that may help you to grow your investment over time.

Equities

Equities are considered the riskiest of the three traditional asset classes. Typically, their returns are volatile in the short term, but their volatility is significantly reduced over time. In fact, over most ten-year periods, equities are on average less risky than bonds and offer higher returns, although past performance is not a reliable indicator of future results. An equity (or share) gives you a share in the ownership of a company. A shareholder has a stake in the assets, decision making and profits of a company. If a company goes bankrupt, shareholders are paid last, after holders of bonds, other debt and preferred stock.
For taking on such risk, investors in equities would generally expect a higher return than from investing in the debt of the company. Most, but not all, equities pay dividends – a distribution to shareholders of a part of the company’s profits. Companies with higher rates of growth typically hold on to a larger proportion of their profits and cash flow in order to re-invest in the business, rather than paying to shareholders as dividends.

Bonds

Bonds (or fixed-income investments) are riskier than cash, but less risky than equities. Typically, a bond offers a fixed return (or coupon), payable at regular intervals (usually every six months). In addition, the principal invested is generally returned at the end of the bond’s duration. Historically, returns have tended to be higher than those from cash investments. Bonds can provide regular income while preserving the capital value of an investment. Bonds are mainly issued by governments and companies. Government bonds from developed economies offer a lower coupon than corporate bonds, reflecting the higher creditworthiness of the issuer.

Government Bonds
A government bond is a transferable security which enables a government to borrow money from investors. The bond generally entitles the holder to regular income payments and repayment of the principal on maturity. Usually government bonds are issued by a government in its own local currency. They are often viewed as free of credit risk, as most governments can print their own currency; and so many investors deem the return of capital as a near certainty.

Corporate Bonds
A corporate bond is a transferable security which enables a company to borrow money from investors. Companies may use the proceeds to finance new projects or make new acquisitions. Usually, they promise to pay investors a fixed or variable coupon at regular intervals during the term of the bond and to repay the principal at maturity. An alternative way for companies to raise money is to issue new shares on the stock market.

Cash

Cash is the least risky asset class. However, because the potential long-term rewards are lower than those from bonds and equities, cash investments are more at risk from the damaging effects of inflation. Provided that the investment can be held over at least three to five years, bonds or equities are usually preferable.

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What are alternative asset classes?

Alternative investments are typically those other than stock or bonds which include strategies such as private equity, real estate, hedge funds and commodities. They provide the advantages of potentially higher return, greater losses and less volatility than other investments.

Private Equity

Private equity is a share in a company that is privately held, not publicly listed on a stock exchange. Investors in private equity purchase holdings in privately held companies in order to tap their unrealised potential and sell the holdings for a profit, generally several years later. Professional investment companies (primarily partnerships) analyse the factors that are likely to influence the long-term success of these private companies: their products, their management, and the market environment. They provide private companies not only with financial assistance but also with their know-how and contacts.

Unlike the manager of a mutual fund (whose performance is compared with a benchmark index), the private equity manager is interested in absolute positive returns over the long term.

The drawbacks of private equity investments include:

• Illiquidity and long lock-in periods – private equity investors are asked to commit capital, which is then invested over time. This drawdown of committed capital generally stretches over three to five years. At the end of that period, the distribution of capital back to investors may have only just begun.  Hence, performance is typically negative for at least the first three years of an investment.
• Unrealised returns – in other words, they have not yet been passed on to investors. In the case of younger funds, the returns are almost entirely unrealised and based on partly subjective net asset values (NAVs) made up of the valuations of the underlying holdings (generally carried at cost). Private equity investments are illiquid, and valuations may not always accurately reflect reality. The level of regulation is low, and valuation methods may differ; there are some common principles and guidelines but no strict controls. This factor highlights the importance of conducting rigorous due diligence on a prospective fund manager so as to verify the manager’s claims and true capabilities.

Property

Commercial property is property that is used by businesses rather than for housing. It can be divided into three major sub-classes: office, retail and industrial. These sub-classes are influenced by different factors and each have distinct risk and return characteristics. As a whole, the commercial property market is driven by different factors to the housing market. Hence, events in the housing market have only indirect implications for commercial property. Investments in commercial property can be made directly (through buying property which is used commercially) or indirectly (for example, by buying shares in listed property companies).

Because of commercial property’s low correlation with traditional asset classes, it can help to reduce the overall level of risk in an investment portfolio and diversify your portfolio.

Hedge Funds

At least 9,000 hedge funds are now in the market, with reportedly over $1.9 trillion under management. Even so, hedge funds remain one of the most complex – and hence, most misunderstood – asset classes. Many investors wrongly assume that:

• investing in hedge funds is risky;
• the primary goal is high returns;
• hedge funds perform at their best when stock markets are falling;
• the asset class is only available to clients making large investments.

In fact, hedge funds were originally created to provide a low-risk way of achieving consistent returns in any market conditions.

Most hedge funds are private investment vehicles and are not publicly traded. They are set up as limited partnerships, in which the general partners invest a significant amount of their own assets. Unlike most traditional funds, hedge funds can use a variety of tools, such as derivatives and leverage, in order to implement their often complex investment strategies.

The prime objective of hedge fund managers is to generate positive returns regardless of market conditions. They aim to do that by focusing on opportunities that they believe are worth exploiting, while neutralising the risks to which they do not wish to be exposed. During adverse market conditions, they may prefer to hold cash to preserve capital. Hence, hedge fund managers can be seen as risk managers, not just as generators of returns.

Investors often worry about hedge funds' use of leverage or gearing (the amount of borrowing used to finance investment positions).  Yet many hedge funds use no or very little leverage. The majority of hedge funds can use leverage, but most hedge funds have leverage ratios of less than 2:1. Leverage is an acceptable part of an investment strategy, but it requires an understanding of the associated risks and stringent risk control mechanisms to be in place.

Commodities

Commodities are the raw materials used to create the goods we buy and the food we eat. As an asset class, commodities are divided into the following sub-sectors:

• Energy, such as oil and gas.
• Industrial (or base) metals, such as copper and aluminium.
• Precious metals, such as gold and silver.
• Agricultural commodities, such as grains (wheat, corn etc.) and soft commodities (cotton, coffee etc.).
• Livestock, such as live cattle.

The key difference between commodities and financial asset classes (such as stocks and bonds) is that commodities are tangible, physical, useful assets. That is an important distinction, because it affects the way commodity prices react to changing economic conditions.

As stand-alone investments, commodities look reasonably attractive, judged on their performance over the past ten years. Yet, as with equities, it depends to a large extent on the timing of investments during this period.

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What are the benefits of diversifying my portfolio?

Diversifying your portfolio means not putting all your eggs in one basket.  By spreading your investment between different types of asset classes, you can reduce the risk of a sudden loss in capital value.  

Most investments have two main types of risk: market (or economic) risk and specific risk.

Specific risk is the risk attached to a particular security.   For stocks, it will include the company’s profitability, quality of management and demand for products.  Unlike market risk, specific risk can be reduced by diversifying within the market.  By investing in a wide range of stocks, investors can increase the chances that losses in any one stock will be offset by gains in others. 

A portfolio diversified across asset classes gives you greater flexibility while reducing overall risk.  You could keep a proportion of cash investments for short-term requirements, while maximising your growth potential by investing in equities for the long term.  If you also required regular income, you could add some bonds.  For most investors, a mix of equities and bonds can provide optimal returns with minimum risk.

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What is asset allocation?

Asset allocation is the way in which your investments are divided between different asset classes. The aim is to balance risk and create diversity within the investment portfolio.  The asset mix can also refer to the geographical mix of equities and bonds.

Strategic asset allocation is the key long-term framework for portfolios, enabling us to create an optimal mix of assets with an appropriate balance between risk and reward. But the near-term prospects for each asset within a portfolio might change, for better or for worse. So we regularly adjust portfolios to reflect our short-term views of opportunities and risks. This is known as tactical asset allocation.

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What are ISAs?

An Individual Savings Account (ISA) is a tax-efficient savings scheme designed by the Government to encourage you to save. With ISAs you can invest up to a maximum of £7,200 in any tax year, up to £3,600 of which can be invested in a Cash ISA.

Cash ISA

With cash ISA saving, your money will accrue interest as it would in an ordinary bank or building society account, but this interest is tax free. Cash ISAs are useful if you want short-notice access to your money.

Stock and Shares ISAs

Stocks and shares ISAs, like all stock market investments, should be considered as long-term investments. A stocks and shares ISA will invest in the stock market and in bonds, so, although any gains will not be taxed, the capital will also be exposed to the ups and downs associated with shares.

What you can invest

The amount subscribed must not exceed the overall subscription limit of £7,200 in a tax year.

If you don't have a lump sum to invest, you can make regular payments into a stocks and shares ISA.  Please bear in mind that the favourable tax treatment of ISA saving might not continue and that the value of tax relief depends upon your personal circumstances.

Please note: Barclays Personal Investment Management (BPIM) ISAs are invested in stocks and shares only.

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What is risk?

All investments carry risk, and returns can never be fully guaranteed. So it is important to choose an investment that suits your circumstances. If you are prepared to accept a higher level of risk, you will probably wish to hold more equities, as they offer the greatest long-term potential. If you have a lower appetite for risk, you might prefer the income produced by bonds and cash, which tends to be more reliable than equity returns.

As a rule, higher returns can be expected for investments which tie up money for longer periods. A bank deposit account with a withdrawal notice period will generally offer a higher rate of interest than an instant-access account. Similarly, longer-dated bonds tend to offer higher coupons than short-dated bonds. And equities, which confer a permanent (but transferable) share in the ownership of a company, are effectively an open-ended investment and therefore have historically offered higher returns than both cash and bonds over the long term.

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What are Income Tax, Capital Gains Tax and Inheritance Tax?

Income Tax

Income Tax is a tax levied on your taxable income i.e., earnings, investment income, trading profits etc. You may reduce your taxable income by the entitlement to certain allowances. The personal allowance depends on your age, and is increased at age 65 and age 75. The amounts for 2008/2009 are £5,435 (under 65), £9.030 (age 65 to 74) and £9,180 (age 75 and over). The higher allowances for those aged 65 and over are subject to an income limit of £21,800. After deducting your personal allowance, the amount of Income Tax you pay will depend on the level of your taxable income and the source of that income.

Capital Gains Tax (CGT)

CGT is paid on assets (such as property, shares, antiques, etc) sold or given away that have increased in value in the time that you have owned them. CGT is not payable on personal goods that are worth under £6,000 or, in most cases, your investment property.
From 6 April 2008, a flat rate for CGT of 18% applies to almost all taxable gains.  The annual exemption for individuals has increased to £9,600 for the tax year ending 5 April 2009.

Inheritance Tax (IHT)

Inheritance Tax is a tax levied on the estate of the deceased. It is beginning to affect increasing amounts of people, as tax thresholds have not risen in line with housing prices.  The current ‘nil rate band’, or tax-free allowance for inheritance tax, is £312,000.  Taxable assets worth over this amount are taxed at a rate of 40%, which is paid by the executors of the will of the deceased.

There was a further, and very welcome, change to the IHT provisions on 6 April 2008.  Any nil rate band that is not used on a person’s death can now be transferred to their spouse or civil partner. The new provision applies where the second death occurs on or after 9 October 2007 but the first death may have been at any time. For many married couples, this now means that joint estates of up to £624,000 will not suffer IHT.

Please keep in mind that Barclays Wealth are not tax experts, and that you are encouraged to seek advice from our tax partners Ernst & Young.

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