Feeding a flyaway fund

Unit trusts and trackers can be beneficial if you are saving for something in the long term, write Tony Lyons and Ken Welsby

In the space of less than four hours, Peter Walsh was transformed from a smarter investor to a smarter dresser, spending his entire windfall from Alliance & Leicester on suits, shirts, ties and shoes.

"It seemed the obvious thing to do," said the 39-year-old computer consultant from Reading. "I'd been promising myself some new clothes for ages and how better to buy them than with free money?"

His girlfriend, Cheryl, who qualified for a separate share allocation, took a different view. She has put her shares into a self-select PEP which she will top up from an expected summer bonus.

It's the latest addition to her "flyaway fund" with which she plans to take 2001 off and travel the world, flying first class, or at least club class, all the way.

It was a chance conversation with a work colleague almost three years ago that put Cheryl on the PEP investment trail. "I saw him looking at share prices in the FT and we got talking about the money to be made on the stock market."

What Cheryl learned was that share prices have easily outstripped the returns from building society deposits or any other fixed-interest investment over the long term, which is five or more years.

She had been putting her savings into her A&L account, but in the past three years has channelled most of her savings, including twice-yearly bonuses, into PEPs. While the gain from a building society account over the past five years is around 20 per cent, Cheryl would have made a near 80 per cent profit if she had invested in the FTSE 100, the most widely used index of stock market performance.

The past few years have seen the emergence of tracker funds which mirror the performance of the leading stock market indices, usually the FTSE 100. Traditional unit trusts spend large amounts of time and effort on asset allocation and stock selection, choosing which companies in which to invest. Tracker funds simply match the index, either investing in all the companies on the list or a carefully constructed sample, so their overheads are much lower.

There are a number of trackers to choose from and all will accept Halifax and other windfall shares in exchange for units. All carry low management charges, usually nothing for buying or exchanging shares for units and an annual charge typically around 1 per cent a year or less.

Among the leading tracker funds on offer are those from Virgin, Marks & Spencer, Norwich Union and Legal & General. All of them can be used in a general personal equity plan, enabling investors to take advantage of the tax- free dividend and capital gains status of PEPs.

Some of the managers have brought out special PEP packages for those prepared to invest long term. Legal & General, for example, has a post- election PEP which will return 140 per cent of the gain in the FTSE 100 after five years while HSBC offers a guaranteed full return of capital plus a minimum bonus of 20 per cent and all the additional growth in the index.

Tracker funds are ideal for those who want to invest but know little about the stock market or are cautious about investments. In fact, they have outperformed the majority of more traditional unit trusts, proving a stock market saying, the "75 per cent rule". This states that over any given period, three-quarters of all funds fail to perform as well as the index.

If you want to outperform, however, you will need to take greater risk and invest in one of the more specialist funds. There are more than 1,500 unit trusts and 100 investment trusts to choose from, most of which can be sheltered in a PEP.

Some are general funds looking for capital growth or rising income or a combination of the two. Others specialise in business sectors or different regions of the world. You may need to consult an independent financial adviser to help you decide which of the many funds will suit your long- term aims.

Like tracker fund managers, most of the groups will accept your windfall shares. While many will ask you to exchange them for units, others will allow you to retain ownership of the shares within a general PEP as long as you purchase other units. The latter includes Fidelity, M&G, Save & Prosper, Mercury, Perpetual and Jupiter.

Whether you decide on a tracker or one of the more specialist funds, always remember equity investment should be long term to reap the benefits. Short term, share prices can rise and fall with rapidity, which can affect the value of your capital.

All funds, including tracker funds, invest in shares whose prices can be volatile. Past performance, however, does not tell us what to expect in the future. While the indices have shown a sparkling growth rate in the current bull market, like the share prices that they are based on, they can go down as well as up.