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Specialist Investments


What are they?

These are investments that tend to be less appropriate and/or accessible for mainstream investors (and don't really fit into the other categories!).

That's not to say you should ignore them. They could be relevant and, in the case of hedge funds, some of the investment techniques are finding their way into more mainstream investments.

We'll look at four types of investments. Hedge funds and life settlements both offer interesting approaches to investment while venture capital trusts (VCTs) and enterprise investment schemes (EISs) offer potentially attractive tax benefits.


Hedge Funds

Hedge funds have traditionally been viewed as those that try to deliver positive returns irrespective of markets (known as 'absolute return'), but nowadays the name also seems to apply to funds where the manager can invest in pretty much whatever they want (regardless of whether they're striving for an absolute return).

The idea behind hedge funds is that by giving very talented managers lots of freedom to invest how they see fit, the manager should be able to deliver either steady positive returns or much better overall returns than conventional funds. In practice, some succeed and some don't. One thing's for sure, it's rare to find hedge funds that always deliver positive returns during turbulent markets - that remains a pipedream for most.

It's common for hedge funds to have minimum investment levels of £100,000 or even £1 million, and most charge high performance fees meaning the manager will cream off a chunk of profit if they make you any money. Many hedge funds also borrow money to 'gear' your investment, e.g. you invest £100 and the fund borrows £40, giving you £140 exposure. This means that small movements in underlying investments can translate into a bigger gain or loss for the fund.

There's a number of common investment strategies that hedge fund managers might use, with some of these techniques finding their way into more mainstream investment funds. We'll split them into lower risk and higher risk:

Lower Risk Strategies

Long / ShortMarket Neutral

Short Selling The most popular strategy. Managers buy (known as 'long') shares they think will rise in price and 'short' shares they think will fall in price. 'Shorting' means borrowing a share and then selling it in the hope you can buy it back in future at a lower price before you're due to return it to the lender. This is a popular way to make money from falling share prices.

The idea is that a good manager can make money whether the market is rising or falling. These funds still tend to have some market exposure, i.e. they have more long exposure than short, and returns will ultimately depend on how good the manager is at picking shares.

Some conventional unit trusts are starting to use long/short strategies to try and deliver absolute returns, with varying degrees of success.

Higher Risk Strategies

Global MacroDistressed SecuritiesMerger Arbitrage

A very wide ranging strategy where managers aim to profit from global events and situations using any available type of investment. The risks can be high, as managers might be placing big bets on expected interest rate movements, economic events, political changes and government policies.

Managers often increase their exposure by borrowing and/or using 'derivatives', adding yet more risk to their bet. By using derivatives such as 'options' and 'futures' the manager can get exposure to a much greater amount of investment per £100 invested than normal, known as 'leverage'

The bets tend to be on a particular price moving in a certain direction (known as 'directional') or on a pair of assets where the manager expects the price of one to move relative to the other (known as 'relative value').

Perhaps the most famous global macro bet was when George Soros bet the UK would be forced out of the European Exchange Rate Mechanism (ERM) in 1992. He placed a relative value trade by shorting £10 billion of Sterling and buying German Deutschmarks and French Francs. Sterling fell relative to the other currencies, allowing Soros to buy back the original £10 billion stake for £9 billion, netting him a cool £1 billion profit.

Ways to Invest

Because investing directly in hedge funds is not really practical for most investors, you'll probably need to use another route if you're keen to invest in this style of fund.

Funds of Hedge FundsUnit Trusts

These are funds, normally investment trusts, that invest in a range of hedge funds. Their advantage is that they spread risk across several funds and, in the case of investment trusts, it's practical to invest a few thousand pounds.

Their downside is high charges, as you'll be paying both the fund of hedge fund manager and all the fees on the hedge funds held within the fund. The investment trust structure also adds extra risk. Because an investment trust is a company listed on the stock market, the value of the fund based on its share price may be different from the value of all the underlying investments. So even if the underlying hedge funds do actually deliver absolute returns, you could still lose money if the investment trust's share price falls relative to the investments held within. Of course, this could work to your advantage if the reverse happens, but the point is it adds risk to an investment whose main appeal should be consistent returns with less risk.


Venture Capital Trusts (VCTs)

Venture Capital Trusts (VCTs) are a type of investment fund (similar to an investment trust) that invest in very small companies. Because this can be high risk, the Government offers tax incentives to encourage investors in the hope that the resultant investments will help small companies grow and boost the economy.

What are the tax benefits?

There are three tax benefits:

  • Income tax relief - is given at 30% on annual contributions of up to £200,000 provided the VCT is held for at least five years.
  • No tax on gains - regardless of how long the VCT is held for.
  • No income tax on dividends - regardless of how long the VCT is held for (although remember dividends are effectively paid net of basic rate tax).

Income tax relief is the main attraction for investors (e.g. a £10,000 investment effectively costs £7,000 after the tax rebate). However, bear in mind that you cannot claim tax relief beyond your annual income tax bill.

Current and historic VCT tax benefits are as follows:

Tax Year(s) Contribution Tax Relief Capital Gains Tax Deferral? Minimum Holding Period
1995/96 - 2000/01 20% Yes 5 Years
2001/02 - 2003/04 20% Yes 3 Years
2004/05 - 2005/06 40% No 3 Years
2006/07 onwards 30% No 5 Years

Once launched, a VCT must invest at least 70% of its money in 'qualifying assets' within three years (the remaining 30% is usually left in cash and corporate bonds to reduce risk). A qualifying asset is basically a UK based trading company with fewer than 50 employees and gross assets of less than £7 million at the time of investment and no more than £8 million immediately afterwards (and have raised no more than £2 million from venture capital schemes over the previous year).

There are several investment styles adopted by VCTs:

Private EquityAiMGeneralistAsset BackedSpecialist

The focus is on investing in privately owned companies that are not listed on any stock exchanges, very similar to the traditional venture capital industry (a bit like 'Dragon's Den' on a larger scale).

VCT managers tend to become actively involved in the running of the company, hoping they can build it up and sell out at a profit a few years later. It can often take the managers six to nine months just to purchase a company, due to all the research and checks involved. Because the private equity investment cycle can be quite long, investors in these VCTs should be prepared to sit tight for up to 10 years or more.

As private companies are not listed on a stock exchange there's no way to value the shares on a daily basis. They're usually valued periodically and quite conservatively, meaning their value can jump when the company is eventually listed or privately sold to someone else.

Is the tax benefit worthwhile?

Given the main reason for investing in a VCT is the income tax relief on your contribution, is the relief worthwhile? The table below shows how much the tax relief can affect your potential return.

Potential VCT Annual Returns with 30% Tax Relief
Investment Period Change In Value
-40% -20% Nil 20% 40%
5 Years -3.0% 2.7% 7.4% 11.4% 14.9%
7 Years -2.2% 1.9% 5.2% 8.0% 10.4%
10 Years -1.5% 1.3% 3.7% 5.6% 7.2%

Use the Candid VCT Tax Benefit Calculator to see how much the tax relief might be of benefit to you.

Should I invest in a VCT?

Probably not. Although once quite appealing, the tax benefits are not as attractive as they once were and rule changes in April 2006 have forced VCT managers to invest in even smaller companies than before, further increasing potential risk. There's also a danger that when you come to sell there won't be many buyers, meaning you could struggle to get a reasonable price. With higher charges than conventional funds and generally disappointing performance to date, it's hard to get too enthusiastic about VCTs.

This is not to say VCTs are a bad idea for everyone. If you've used up the more mainstream tax reliefs and are comfortable with the risks and potential pitfalls of VCT investing, then with very careful selection you might make worthwhile investment returns after the tax benefits are taken into account.


Enterprise Investment Schemes (EISs)

Enterprise Investment Schemes (EISs) are similar to VCTs in that your money must be invested in very small companies, but the tax benefits are a little different and you must buy individual shares rather than funds.

Only companies not listed on a recognised stock exchange may be held within an EIS (AiM is allowed) and the company size limits are the same as for VCTs.

What are the tax benefits?

There are five tax benefits:

  • Income tax relief - is given at 30% on annual contributions of up to £1 million provided the EIS is held for at least three years.
  • Capital Gains Tax (CGT) deferral - If you owe CGT on gains made on another investment they can be deferred indefinitely, as long as disposal of that investment was less than 36 months before the EIS investment or less than 12 months after it.
  • No tax on gains - provided the EIS is held for at least three years.
  • Loss relief - if you sell EIS shares at a loss (taking into account the tax relief), then the loss may be offset against you income tax or CGT bill in the year you sell, or the previous year.
  • Inheritance Tax (IHT) exemption - if you've held an EIS for at least two years within five years of your death it will usually fall outside of your estate, hence no IHT.

Should I invest in an EIS?

Almost certainly not. The risks can be very high and, even if the company does well, you may find it hard to sell the shares, meaning you'll have to wait until the company is sold as a whole or is floated on a stock exchange.

If you will benefit from the tax breaks, don't mind tying up the money for what could be a long time and, at worst, can afford to lose it then you might take a look at EISs. However, tread very carefully and make sure you really appreciate the potential risks involved.


Jargon

Here's some of the more common specialist investment jargon you might come across:

JargonMeaning
Absolute ReturnA type of investmet fund where managers strive to deliver positive returns regardless of market conditions.
Distressed SecuritiesAn investment (hedge fund) strategy where managers seek out companies that are in big trouble, often on the verge of bankruptcy, in the hope they can improve matters and make a profit.
EISEnterprise Investment Scheme. A scheme that allows you to enjoy tax benefits when buying shares in very small companies.
Funds of Hedge FundsFunds, normally investment trusts, that invest in a range of hedge funds. Easy way to access edge funds but can be expensive.
Global MacroAn investment (hedge fund) strategy where managers aim to profit from global events and situations using any available type of investment.
Hedge FundInvestment funds where the manager can invest in pretty much whatever they want, although some strive to deliver positive returns regardless of market conditions.
Life SettlementsInvestments that involve buying a life insurance policy from someone in the latter stages of their life. The seller gets money while they're still alive and the buyer pays less than the sum assured.
Market NeutralAn investment (hedge fund) strategy where managers try to remove all market risk, so that overall market movements have no impact on the fund's performance.
Merger ArbitrageAn investment (hedge fund) strategy where managers aim to buy shares in companies being taken over (below the acquisition price) where they believe they can make a profit.
VCTVenture Capital Trust. A type of investment fund that invest in very small companies. Potentially high risk but benefits from tax advantages.