Choose the funds that make perfect partners

ISAs, VCTs and other tax breaks can help you spread risk, says David Prosser

Many investors are distracted by the fact that a tax break is available every 12 months and forget that each ISA or PEP is simply part of what could be a large investment portfolio.

Good portfolio strategy means you construct a spread of investments that will perform in good times and bad. By ensuring that you have a mix of holdings, with exposure to different asset classes, countries and industries, you reduce the risk of being hit by a downturn in any one area.

Patrick Connolly, a partner at independent financial adviser John Scott, says far too few people spend time thinking about asset allocation. As a result, they end up with investments heavily skewed towards the UK stock market, often with additional incongruous holdings bought because a particular fund was flavour of the month.

"We try to build up diversification for people as they go along, rather than starting with the UK," says Connolly. As a result, John Scott's current ideal asset allocation breakdown for a typical investor who is aiming for good long-term capital growth is far more diverse than most people would imagine.

Connolly suggests that investing 13 per cent of your savings in the UK, split between large and small companies. Europe, the US, Asia and Japan should represent a further 5, 11, 9 and 9 per cent, he suggests, with an additional 9 per cent invested in emerging markets. He would also suggest holding 20 per cent of your money in gilts and bonds and 20 per cent in commercial property. The remaining savings could be held in cash.

Investors don't have to be quite so exact and they do have the option of investing in one of the growing number of multi-manager funds run by groups such as Credit Suisse, Fidelity, New Star and Jupiter.

These funds give you exposure to a wide range of managers' funds and therefore a more diverse asset allocation model than you could build for yourself. But if you are choosing individual ISAs, at least think about whether you are putting all your eggs in a single basket.

"Experienced investors should already have well-rounded portfolios, but might be prepared to add specific industry-sector funds or even single-country equity exposure," says Paul Ilott, a senior investment adviser at Bates Investment Services. "This could give them the extra style bias they want to help them to achieve additional growth potential during the next phase of the economic cycle."

Asking investment experts to recommend specific funds for investors seeking diversification is difficult, because their existing portfolios will differ. But advisers do have some suggestions for investors seeking to diversify beyond a core portfolio of funds that invest in blue-chip shares in developed markets.

"AXA Framlington Nasdaq invests mainly in US technology, internet, biotechnology and healthcare stocks that have strong management teams, leading products and above average growth potential compared with the rest of the market," says Ilott. "This is a particularly high-octane fund for experienced investors who already have some exposure to the world's major stock markets and who are prepared to tolerate a high level of risk."

Andrew Denton, from Chelsea Financial Services, suggests a relatively newly-launched fund for investors keen on exposure to emerging markets. "Allianz BRIC is an interesting addition to the fund universe," says Denton.

"This equally weighted portfolio is a play on the four emerging economies of Brazil, Russia, India and China," he explains. "The Brazilian and Russian elements provide resources exposure, India provides an outsourcing play and China offers a manufacturing play."

Finally, Ben Yearsley, of Hargreaves Lansdown, suggests a specific focus for investors who already have emerging markets exposure, but who are now prepared to take on some additional risk.

"Russia has been one of the best areas for investment, but even so, the market is still trading on a prospective price-to-earnings ratio of about 12 to 13," Yearsley says.

"Neptune Greater Russia is one of the only funds where you can get direct exposure, but it is very highrisk - it can go up or down 20 per cent in a month."

After your ISA allowance: consider VCTs...

Venture capital trusts (VCTs) currently offer two tax breaks. First, you get 40 per cent tax relief on contributions to the funds, so investing £1,000, say, costs just £600.

The tax relief is payable upfront in the year you invest, though if you sell your VCT shares after less than three years, it is repayable. Second, income and capital gains from VCT shares are tax-free.

VCTs buy into small companies, sometimes in high-risk sectors, so don't invest money you can't afford to lose simply to get a tax break. That said, this year is the last in which VCTs offer such generous tax reliefs - from April 6, the upfront relief will fall to 30 per cent and you'll have to hold VCT shares for five years.

Broadly speaking, the funds fall into four categories. Generalist VCTs invest across a number of industry sectors, mainly in unquoted sectors; specialist funds invest in a specific industries - examples include media, health and wind farms; technology funds concentrate on unquoted hi-tech businesses; and AIM funds invest in companies quoted on the Alternative Investment Market.

Ben Yearsley, of Hargreaves Lansdown, suggests a portfolio approach, in order to spread risk. But if you are considering a single VCT, start with a generalist or AIM fund. He adds: "You also need to find a trust that is not so popular that you can't get in - around four VCTs are already closed to new investors - but not to unpopular that the backers will decide to cancel the launch."

Yearsley recommends four VCTs in particular: Aberdeen Growth Opportunities, First State AIM, Northern 2 and ProVen Growth & Income.

...or even the silver screen

The most generous tax breaks for investors in British film will no longer be available from next month on, but there are still schemes that enable investors to back the industry. For example, Scion Films, which has previously backed successes such as Pride and Prejudice and The Constant Gardener, is currently marketing the Premier Deal. For a minimum investment of £100,000 investors get access to a portfolio of films.

It's a complicated partnership arrangement, so investors must take professional advice. But using existing tax laws and loan agreements, investors will get tax relief on their investment and the first 15 per cent of returns will effectively be tax-free.

Taylor says investors need to have time horizons of at least five to seven years. Scion backs films before they go into production, and it can be two years before they appear.

Then there's a four-month cinema run, followed by DVD sales, pay-TV sales a year after the film hits the cinema and then two years of sales to free TV channels after a further 12 months.