August 2024

It probably hasn’t escaped your notice that a range of taxes have increased over recent years, in part due to the economic effects of the pandemic. In March of this year, the Office for Budget Responsibility projected that 37.1p in every pound generated in the economy will be subject to tax by 2028. The date of the first Budget for the new Government has been set for 30^th October, and media speculation is rife, suggesting potential changes to tax legislation that could increase the overall level of tax take further.

As a result, tax-efficiency is high up the wish list for many investors. The most popular options to increase the tax-efficiency of an investment strategy is the use the annual Individual Savings Account (ISA) allowance, or make pension contributions, which qualify for tax relief. These popular choices are, however, only two of a range of options that investors can consider to reduce the level of tax they pay. Investors who are comfortable accepting higher levels of investment risk may wish to consider Venture Capital Trusts (VCTs), which have grown in popularity over recent years. A qualifying VCT investment can provide a helping hand to small and growing UK businesses, but can also reduce your Income Tax bill, and provide you with a tax-free income stream.

Tax benefits

VCTs were introduced in the Finance Act of 1995, to encourage investment into Britain’s small and entrepreneurial businesses. VCTs are collective investments, with a fixed number of shares in issue at any one time. There are restrictions in place to limit the type of investment that the VCT can make, without risking their qualifying status. These include a £15m limit on the gross assets of the investee company, which must also not have more than 250 employees. In addition, 80% of the holdings within a VCT must be invested in these qualifying assets.

VCTs raise money regularly via the issue of new shares. Purchase of new shares via an offer provides the investor with up-front Income Tax relief of 30% on qualifying investments. This tax relief is retained as long as the investment remains qualifying and is held by the investor for at least 5 years.

In addition to the Income Tax relief, dividends paid by the VCT are tax-free. Most VCTs aim to pay regular dividends, and some actively look to arrange special dividends, in addition to the regular dividend schedule, subject to the performance of the underlying investments within the VCT. Finally, any gains made on disposal of a VCT are also free from Capital Gains Tax.

The need to accept higher levels of risk

It is important to recognise that the Income Tax relief provided on investment in new shares is given as compensation for the investment risk taken when investing in a VCT. As only fledgling unquoted companies qualify for investment, investors need to be aware that individual companies could fail; however, VCT investment has helped a number of household names, such as Zoopla, Secret Escapes, Gousto and Graze, take the next step in their growth story.

Investors in VCTs also need to bear in mind that their investment may be difficult to sell, as there is a very limited primary market. As a result, most VCT managers set aside cash funds within their portfolio to permit share buybacks, where the VCT company buys back shares from investors. Such buybacks are usually set at a small discount to the prevailing net asset value of the underlying VCT portfolio, and larger and more established VCTs offer buyback opportunities regularly. That said, the availability of VCT buybacks is dependent on the trading performance of the VCT, and there is no guarantee that a buyback opportunity will be provided.

Choose the strategy wisely

Given the potential risks and range of outcomes from an individual investment made by a VCT, selecting a VCT with a portfolio approach is of key importance. Generalist VCTs usually invest in at least 20 companies, with many offering greater diversification across a wider range of positions.

There are other variables that can adjust the level of risk within the VCT portfolio. Investee companies that are already established can offer greater stability than those that are at an early stage in the growth cycle. By investing in companies across different sectors of the economy, VCT managers can try and avoid systemic risks affecting the portfolio. By their very nature, most VCT investments will be within companies involved in new technology or e-commerce; however, by adding industrial manufacturers, healthcare and leisure companies, greater diversification can be achieved.

Some VCT strategies add other investments into their portfolio, such as those quoted on the Alternative Investment Market (AIM). Whilst these investments are potentially more liquid, they remain smaller companies that still carry greater levels of investment risk.

Wide variance in performance

Analysing the performance of VCTs launched more than five years ago, shows a distinct variance in performance. Taking into account the initial Income Tax relief, dividends paid during the investment period, and the net asset value after five years, the best performing VCTs have produced an annualised rate of return of over 20% per annum, which is highly attractive; however, this strong performance is certainly not universal. There are a number of sizeable VCTs where the annualised rate of return achieved is between 6% and 8% per annum, which is barely above the level of Income Tax relief available on purchase. A handful of VCTs have fared even worse, losing money over the five year period, and eating into the Income Tax relief gained on investment.

Why advice is critical

Whilst the tax advantages are attractive, it is important to recognise that VCTs are a high risk investment, and should only be considered by investors who are willing to accept a significant risk of capital loss. Whilst many VCTs have produced strong returns over the long term, when factoring in the tax relief on investment and dividend income, others have performed poorly.

Given that this is a specialist market, we recommend seeking independent advice before considering any investment in VCTs, to assess whether a VCT investment is appropriate for your circumstances, needs and objectives.

Our independent advisers can provide you with unbiased and holistic advice to improve the tax efficiency of your investment portfolio, and the FAS Investment Committee has full access to independent expert research on available VCT offers. Speak to one of the team to start a conversation.

Any long term investment strategy will enter stormy waters from time to time, with the Covid-19 pandemic, Russian invasion of Ukraine and inflationary spiral amongst the factors that have made for a bumpy journey over recent years. Since last November, market conditions have felt considerably calmer, with investors enjoying a period of solid returns. Over recent trading sessions, however, the swell has picked up again, with volatility increasing across global equities markets.

Why have markets outperformed?

The gradual decline in inflation and prospect of easier monetary policy, corporate earnings reports that have largely beaten expectations, and stronger-than-expected economic data have proved the catalyst for the positive market conditions over the first half of this year.

After the hangover from the Covid-19 pandemic, and the Russian invasion of Ukraine, central banks around the World were forced to raise interest rates to head off an inflationary spiral. With inflationary pressures now easing, investors have been eagerly anticipating a change in direction from central banks, as rate cuts are generally perceived as being positive for both companies and consumers alike.

Corporate earnings have also supported the rally seen through the first half of the year. According to Factset, 78% of US quoted companies reported better than expected second quarter earnings, with earnings reports from technology giants reinforcing the positive market sentiment.

The final factor behind the strong performance had been the continued strength of the US economy. Investors have been increasingly hopeful that the Federal Reserve manage to steer a course where inflation moderates, without tipping the US economy into recession.

Reaching the pivot

Recent economic data has, however, stoked fears that central banks could have left their restrictive policies in place for too long. The European Central Bank cut rates by 0.25% in June, and the Bank of England followed suit this month. The Federal Reserve has been keen to ensure that inflation remains in check, and are yet to cut rates, potentially increasing the risk of recession.

Recent US unemployment data has been much weaker than expected, and market consensus now expects that the Federal Reserve may need to take more drastic measures over coming months, to avoid a stall in economic growth.

Where strong earnings reports propelled markets higher over the first half of the year, forward guidance from a handful of tech giants over recent weeks has painted a more mixed picture. The valuations on major tech players are somewhat challenging, and earnings disappointments are likely to weigh heavy on market sentiment.

Away from the tech sector, the first signs of a rotation into more traditional industries have emerged, and renewed focus on value and mid-cap stocks could be a dominant feature over the remainder of 2024.

Seeking value globally

Whilst the performance of US markets sets the tone for global equities, there are always regional variances that provide opportunities. The outlook for the UK remains modestly positive, with an improving picture for growth over coming quarters, and UK equities continue to look inexpensive when compared to global peers. European markets also remain mixed. French stocks remain under pressure due to recent political instability, and general sentiment not helped by tepid Eurozone growth figures.

After a strong start to the year, the Nikkei 225 index of Japanese stocks has seen significant volatility of late, largely due to the strength of the Yen against the Dollar and the impact this may have on exporters. Despite the sharp technical moves in recent trading sessions, Japanese stocks remain attractively valued.

Chinese equities have struggled over the first half of the year; however, there are increasing calls for further stimulus, with additional Government intervention to help boost economic growth becoming more likely. The continued weakness in the beleaguered property sector may however, keep any outperformance in check, at least in the short term.

Geopolitical risks remain

Perhaps the biggest risk to global markets is the outcome of the US election in November. Investors have been weighing up the potential impact of the Trump-Harris showdown with the withdrawal of President Biden closing the gap in the polls. Markets had priced in a convincing Trump victory over recent months; however, the early surge in support for Harris could lead to an increase in market volatility, should momentum for the Harris ticket be sustained as election day draws closer.

The election result is likely to have implications for the conflict between Russia and Ukraine, which remains an ongoing risk to global stability and commodity prices. The US election result will also dictate the future path of US-China relations, where trade tensions continue, and the ongoing threats over Taiwan remain.

Conflict between Israel and Gaza, and wider unrest in the region, have yet to have any material impact on market sentiment. Any wider escalation could, however, push oil prices higher, damaging global economic prospects and fuelling inflation. Any surge in prices could, however, be tempered by weaker global economic growth.

Bond rally to continue?

Weaker economic data over recent weeks has seen bond yields fall (which pushes bond prices higher), and with markets now expecting a series of rate cuts by Western central banks over the next 12 months, the outlook for bonds appears broadly positive. Bond investors will, however, need to consider credit quality, in the event that economic growth slows significantly. The additional yield offered by sub-investment grade bonds does not appear to offer sufficient additional return to compensate for the increased risk of an economic slowdown.

A broadly positive outlook

After enjoying a calm and positive first half of 2024, we have seen greater levels of volatility over recent weeks, and we expect this to continue through the remainder of this year. US equities continue to offer good value over the longer term, although the short-term performance may well be dominated by actions taken by the Federal Reserve. UK and European markets remain cheap when compared to the US, and any renewed focus on value equities could shrink the performance gap between the UK and US.

Diversification remains ever important, and whilst equities markets may see further volatility in the short term, holding an allocation to other asset classes can aid stability. After being adversely affected by the inflationary pressures of recent years, government and corporate bonds look attractively priced, given the monetary easing expected over the next few quarters. Lower interest rates may also prove positive for both commercial property and infrastructure investments, which have underperformed since 2022.

With more volatile conditions seemingly set to return, we feel this would be a sensible time to review the investment strategy within pension or investment accounts that you hold. Speak to one of our experienced advisers to discuss your existing portfolio strategy and consider whether any changes would be appropriate.

Commercial property has traditionally played an important role in portfolio diversification. Direct Property funds that invest in UK physical property assets, such as warehouses, office and industrial space, has traditionally found a place in many portfolio strategies, as it tends to produce consistent returns, that show little in the way of correlation with other assets, such as Equities (shares).

Challenging markets

It is fair to say that the commercial property sector has faced a number of challenges over recent years. Many property holdings experienced void periods during the Covid-19 lockdowns, with the office and retail sectors particularly badly affected. In the aftermath of the lockdowns, commercial property has, again, struggled to spark interest from investors due to the spike in inflation which led to the rapid increase in interest rates during 2022 and 2023. The graph below shows the performance of the Investment Association UK Direct Property sector over the last eight years. Consistent returns were enjoyed until the Covid-19 outbreak, and following a rapid recovery as the economy reopened, the sector has faced serious headwinds as inflation and interest rates climbed.

Improving outlook

There is, however, increasing evidence that the prospects for the commercial property sector are improving. The Bank of England appear ready to press ahead with the first of a number of base interest rate cuts in the coming months. This could well prove positive for commercial property assets, as the returns achieved from property investments are particularly sensitive to monetary policy decisions. As base rates fall, and inflation settles around the Bank of England’s target, the rental income received from commercial property becomes relatively more attractive.

Further evidence of the improvement in sentiment can be found in the Royal Institute of Chartered Surveyors (RICS) UK Commercial Property Monitor, published earlier this year. The RICS research indicated that demand for retail and office space – two of the sectors of the property market that have been hardest hit – had seen the first tentative signs of increased demand. Furthermore, there is growing confidence amongst those surveyed that rents will increase over coming months.

Liquidity issues

Aside from the pressures of lockdown and adverse monetary policy, collective funds investing in direct property have also had to face liquidity issues that first surfaced immediately after the Brexit decision to leave the EU in 2016, which led to increase demand from investors wishing to sell their investments. As direct property funds hold large bricks and mortar property investments, that cannot easily be realised, increased demand from investors at the time exhausted liquid funds, and as a result, leading commercial property funds managed by the likes of M&G, Janus Henderson and Legal & General closed their doors to withdrawals temporarily.

Most funds reopened after 2016, and could be traded without restrictions, until the Covid-19 pandemic caused a further round of suspensions and liquidity concerns. Several funds have limped on, but a number of leading players in the industry have taken the decision to wind-up their property funds. M&G announced the wind-up of their Property Portfolio last October, with the process ongoing. Janus Henderson sold their entire property portfolio to a single buyer in 2022 and repaid investors, and St James Place’s property fund remains gated since the decision was taken to suspend withdrawals in October 2023.

Evolving strategies

Despite the loss of a number of funds within the sector, investors can still select from a range of direct property funds; however, those that remain open typically hold a higher allocation to cash, to mitigate against liquidity concerns. One of the largest funds in the sector, Legal & General UK Property, has taken the decision to make more fundamental changes to their portfolio, and have asked shareholders’ permission to alter the asset allocation, in an attempt to provide adequate liquidity and avoid holding excessive levels of cash, which can dilute returns. The Legal & General fund will continue to hold direct property assets; however it will also aim to hold an equal allocation to Real Estate Investment Trusts (REITs). These are quoted companies that hold a portfolio of direct property, from retail parks to student accommodation. As the shares are quoted and actively traded on the London Stock Exchange, their inclusion should alleviate future concerns over liquidity.

Additional considerations

There are, however, significant differences between a REIT and a direct property unit trust, which investors need to consider carefully, as the introduction of REITs changes the risk profile of a commercial property fund.

Firstly, a REIT can borrow money to purchase securities. This leverage is not present with a direct property fund and does introduce additional risk. Secondly, the buying and selling price of a REIT may not reflect the value of the underlying property portfolio, and the shares can trade at a discount or premium to the underlying value of the portfolio. Currently, many REITs stand at a discount to their net assets, reflecting the difficult conditions seen over recent years; however, an improvement in the fortunes for the sector could see these discounts narrow.

Is a hybrid approach the answer?

We wait to see the response to the changes made to the Legal & General Property fund, and whether other property funds may consider similar changes to their portfolios. It is clear that the ongoing liquidity concerns have cast a shadow over the sector and any measures taken that remove barriers to investment should be seen as a positive step. Investors will, however, need to carefully consider the impact of any changes within the asset mix within property funds.

Diversification remains the key

Commercial Property investments have traditionally helped diversify investment portfolios, and the improving market outlook, together with changes being made within the sector to alleviate investor concerns, may see fund inflows improve. We always recommend that investors adopt a diversified approach to investment, and hold a precise mix of assets that match your objectives and tolerance to investment risk. This is where our experienced advisers can add significant value, by considering your exact circumstances to determine the correct asset allocation for your investment or pension portfolio. Speak to one of our independent advisers to start a conversation.