Debunking the myths around tax-efficient investing
Tax-efficient investing is a poorly understood market.
This was evident in a recent poll of 2,200 people by national financial planning firm Fairstone, which found that just eight per cent of people are aware of venture capital trusts (VCTs), and a tiny four per cent are aware of the enterprise investment scheme (EIS).
With the vast majority of investors clearly in the dark about these types of investments, there’s a risk that people could miss out on the benefits. But part of the problem is that misconceptions about these schemes cause people to steer clear of them entirely.
So let’s get to the bottom of some of these myths.
They are only for the super wealthy
One of the biggest myths around these schemes is that they are designed for people with an abundance of money.
The government has arguably reinforced this popular misconception by doubling the EIS annual allowance to £2m. “This gives the impression that the schemes are the preserve of the ultra rich who would make multi-million pound investments,” says Hugi Clarke, director at Foresight.
But the average investment is smaller than many people think. At Octopus Investments, the average amount of money in one of its VCTs is closer to £18,000, while the minimum investment is £3,000.
Clarke says: “the more people see these schemes as a normal part of a portfolio, rather than something you buy when you’ve got some money left over once you’ve bought your yacht, the more investment we will see flow through them.”
Actually, these schemes are becoming far more useful to less wealthy people, as the government shrinks the amount of tax-free money you can take out of your pension.
Alex Davies, chief executive of the Wealth Club, says headteachers, civil servants, doctors, university professors, lawyers, business owners and bankers are now all turning to VCTs. “Yes, all of them are probably well-off. But VCTs are far from being the preserve of the super wealthy.”
They represent a great opportunity to lose money
The attraction of both the VCT and EIS models is the 30 per cent tax relief they offer, but unfortunately people often think the losses on the investment will completely override the tax savings.
This belief derives from the early days of these schemes, when asset managers piled into the market to get a piece of the action when it wasn’t really their area of expertise. Clarke says: “these non-specialist providers often massively underperformed, leaving many investors with a poor experience that they are reluctant to repeat.”
Over the years, the fittest managers have survived, and the returns look healthy as a result.
Figures from Foresight show that an average VCT returned 82 per cent from the end of 2008, outperforming the FTSE 100 index, which grew by 65 per cent over the same period.
“The reality is that where investors go with reputable managers, they have delivered a really attractive return,” says Clarke, pointing out that this is not something investors expect or are led to believe.
They are insanely risky
Another line of thinking is that VCTs are so risky that you’re ultimately gambling your money.
It’s true that the young companies that comprise VCTs are going to be riskier than big companies, because fledging firms are statistically more likely to go bust, says Davies.
However, investing in VCTs isn’t as risky as some think.
The Wealth Club founder points out that VCTs will typically invest in 30 to 70 companies, which provides plenty of diversification.
“While new investments must go into younger and smaller companies, the VCT will typically hold a decent portion of more mature investments from previous years, before the introduction of stricter rules. New investors get access to these,” Davies says.
“And the tax breaks on offer, which include tax-free dividends and growth, also compensate for the greater risks involved.”
Each represents the same quantum of risk
But the misconception about risk does not end there, because some people wrongly assume that all of these tax- efficient investment schemes bear the same level of risk. And yet, there’s a huge difference between the schemes that are taking the most risk, and those that are more conservative.
For example, Clarke points out that Foresight runs an EIS at the high end of the risk scale in that it invests in companies that are not only pre-profit, but are very commonly pre-revenue.
But at the other end of the spectrum, the asset manager runs a VCT that almost exclusively invests post-revenue, and will very commonly invest post-profit.
“These are companies that have established themselves, proven they know what they’re doing but have significant opportunity for growth. I’m not trying to say they are not without risk, but the risk these companies represent is completely different.”
They are a tax dodge
With the increasing scrutiny on tax avoidance, and the perceived view that tax-efficient investment schemes target the super wealthy, some people think the VCT and EIS models simply present another way for rich people to wriggle out of paying tax.
But while tax avoidance is about bending the rules to find loopholes in the system, this is not the case with tax-efficient investment schemes.
As Davies points out: “venture capital trusts are an extremely tax-efficient way to invest. A tax dodge isn’t. VCTs play a key role in facilitating access to finance for smaller businesses with growth potential.”
And of course, these companies ultimately create jobs. In fact, according to figures from the Association of Investment Companies, each company created 60 jobs on average after receiving VCT investment.
It’s clear that these schemes ultimately benefit the economy, and not just a wealthy individual. The same can’t necessarily be said for tax avoidance schemes.
Their only goal is to provide capital
Yes, these schemes are focused on helping young companies financially, but some people wrongly assume that dishing out capital is their only goal.
In reality, these companies get a lot of support from the fund managers – or at least they should do if they’re worth their salt.
“Invested companies that receive the capital say the most valuable thing they have got from the experience is knowledge, experience, guidance, networks, and someone who can help make the business a success,” says Clarke.
“We have got companies that could have raised the capital through the banks, but have chosen to opt for this route because they see the value of the expertise and the relationships.”
If a company fails, you will lose money
Again, this ties in with misunderstandings about risk. It’s common sense to assume that, if a company you’re invested in collapses, you will lose money. But actually this isn’t the case when it comes to tax-efficient schemes.
Clarke points out that an EIS will typically invest your money into 10 different companies, and roughly half of those are expected to fail.
“But for the companies that succeed, you can expect 10 times the return. There will be companies that have lost money, but if you’ve got two in the portfolio that succeed, you have more than doubled your money.”
And if a company goes bust, it will have a limited impact because of loss relief, which actually means your maximum exposure to loss is 40 per cent.
Ultimately, these are schemes that exist to benefit both business and investors. They’re not that overwhelming once you’ve separated the fact from the fiction.