Venture capital trusts have become popular thanks to the tax breaks they offer. But before you dive in, Phil Oakley explains the risks of investing in them.
With central banks squeezing savings and the government threatening to crack down on tax breaks on pensions and even individual savings accounts (Isas), it's little wonder legal tax shelters are more popular than they've ever been.
Venture capital trusts (VCTs) now have a record £2.9bn invested in them, says the Association of Investment Companies (AIC), as high earners try to cut their tax bills. But do the breaks offset the risks?
What are VCTs?
VCTs are similar to investment trusts in that they are closed-end funds, and trade as shares on exchanges so the price of the shares won't always reflect the value of the underlying investments.
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A good VCT will spread its money across lots of companies. Some VCTs have no end date, but others come with a pre-determined exit date when the underlying assets will be sold off and the money repaid to shareholders.
Clearly, investing in early-stage companies is high risk. So there's a big incentive for anyone who invests a big chunk of tax relief. To get this, you have to invest in a fresh issue of VCT shares, rather than buy existing shares on the stock market.
But if you do so, you can get tax relief on 30% of your investment, up to a maximum of £200,000 a year. (In other words, the maximum tax relief is £60,000.) You can claim this via your self-assessment form.
However, there are strings attached. You can only get tax relief up to your annual income-tax liability, and you cannot carry it forward to future years. You must also hold the shares in the VCT for at least five years, otherwise you will have to repay the tax relief.So don't invest in a VCT if you might need to get your hands on your money at short notice.
Another benefit is that the dividends paid from VCTs do not count as taxable income. This may make VCTs an extra source of tax-free income on top of any generated from Isas, or to supplement money from a pension. The money raised from selling shares in a VCT is also free from capital gains tax, as long as the VCT was approved by the taxman when the shares were bought and sold.
Can you bear the risk?
Also, because it can be difficult and time-consuming for the VCT to sell its investments (the companies it has bought aren't quoted, remember, so selling them isn't a matter of just hitting a button on a computer screen), the share price of a VCT will usually trade at a discount to the value of its underlying assets.
Some VCTs buy back shares to prevent the discount from getting too big, but illiquidity is a risk to remember. In fact, a VCT itself can be difficult to sell, particularly if not many brokers trade it. Watch out for big differences between the buying and selling prices of the shares (the bid-offer spread).
VCTs are expensive
Management fees are high too total expense ratios typically range from 2.5% to 3.5% a year, which makes VCTs very pricey even by fund standards. There may also be performance fees on top. Your fund manager will have to be very good at picking winning companies to offset these high costs.
Is now a good time to buy in?
The last five years have been tough, particularly for smaller companies, but while a few VCTs have lost money, others have done well, showing decent growth in their net asset values (NAVs), as shown in the table below.
That said, it's worth noting that the FTSE 250 index has risen by 145% (excluding dividends) over the same period, with a lot less risk involved.
When risks are this high, you might sleep easier by having your money with someone who has a reasonable long-term track record so if you do invest, check the manager's pedigree.
It makes sense to use your Isa and pension allowances first before putting your money in a VCT. Putting any more than 5%-10% of your total savings pot into VCTs would only be suitable for very adventurous investors who have a high appetite for risk.
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Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.
After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.
In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for MoneyWeek in 2010.
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