The FT Money supplement on Saturday ran a big article on Venture Capital Trusts which was headlined “Are VCTs worth the risks for higher earners?”. As a long-standing investor in such companies, having first invested in some in 1995 soon after they were launched, it made for interesting reading.
It seems that wealthy investors are flocking to these funds due to the generous tax breaks and now there are few other good alternatives so the amount invested in them reached near record levels in the last tax year. The article suggests that performance can be volatile but that’s not my experience – at least in terms of share prices. I now hold over 15 different VCTs. Some have certainly performed better than others over the years and in the early years of VCTs there were some absolute stinkers as fund managers seemed to lack experience of investing in early stage companies and investors focused primarily on the tax reliefs that were even more generous than now.
But in recent years, a portfolio of VCT shares would likely be less volatile than a portfolio of FTSE shares. This is for two reasons. First the managers of these trusts try to smooth out the dividend returns which are a big component of the returns from these trusts and secondly the valuations of unquoted companies in which they mainly invest are driven by trade prices of companies rather than stock market hysteria. When stock markets plunge on depresssion, or spike upwards on euphoria, as seen recently in the impact of Brexit politics, VCT share prices can remain very stable.
VCTs do have major tax benefits. They offer 30% tax relief on the amount invested and all dividends are tax free. Capital returns are also tax free after 5 years but the chance of much capital growth is low. In reality capital is often turned into dividends as such trusts can pay out the profits on realisations while ignoring the losses. In effect capital invested (at a 30% tax discount in real terms) is recycled into tax-free dividends so investors need to reinvest the income generated regularly into new share offerings. VCTs therefore do regular new share issues to meet that demand and maintain or grow their assets under management.
It’s not difficult for an investor who puts the maximum £200,000 a year into a VCT portfolio to after a few years be generating a tax-free income of over £30,000 a year based on the current dividend yields. Grossed up at 40% for higher-rate taxpayers that’s equivalent to an income of £50,000 per annum. However as the FT article suggests it might be unwise to hold more than 10% of your overall investment portfolio in VCTs.
What have been the real returns from such trusts? The AIC gives figures for most VCTs and they give the overall share price total return from “Generalist” VCTs over the last ten years as 157%. For example a couple of such better trusts I invested in 24 years ago and still hold returned 207% and 201% over the last ten years. But those figures grossly under-estimate the real returns achieved by investors because they ignore the tax reliefs.
There are risks of investing in such trusts the biggest being the chance that any future Government would change the tax reliefs, perhaps even retrospectively affecting current holdings. But VCTs have been very successful in developing a vibrant small company investment scene. Growing small companies is the key to developing employment in the UK economy. The other big risk is that the recent change in VCT rules mean they might be investing in more-risky earlier-stage companies rather than “asset-backed” or “management buy-out” ones. How that pans out remains to be seen and many VCTs have said that dividend returns might be more volatile in future. But what I have seen so far gives me hope that past mistakes will not be repeated.
How do you pick the best VCTs in which to invest? Certainly look at their track record by using the AIC web site. Don’t invest in any newcomers until they have proven their investment experience over more than 5 years, i.e. they have been through more than one investment cycle – there are plenty of established VCTs so why bother with newbies?
Secondly look at their management and overhead costs which can be very high in VCTs. They usually have management performance fees that can be both very generous and impossible to comprehend due to complexity. Particularly avoid those that are based on dividend payouts as dividends can be paid out by VCTs even when there are losses being made on their investments. In other words, managers can be paid a performance fee even though they are reporting overall losses!
Thirdly beware of glowing prospectuses covering past performance written by VCT managers, particularly where the company has been subject to restructuring in the past or a limited time period is selected for the performance figures. Some VCTs seem able to raise more equity even though they have poor performance records simply because of recommendations by IFAs and other promoters. Inexperienced investors in this sector tend to look at the tax reliefs and the “name” on the fund rather than the important factors. Those who bought into the Woodford funds will know the latter syndrome well.
In the same edition of FT Money there was another interesting article on the growth of 40-year mortgages. Over 50% of mortgage product offerings now offer such terms. As house prices have risen, buyers have apparently looked to reduce their mortgage costs by repaying the capital over a longer period. When mortgage interest rates are so low the focus is more on the capital repayments it seems.
This might make sense if there was any certainty over the future value of property and interest rates over the next 40 years but another article in the FT on Saturday tells you that is a dangerous assumption. People are obviously expecting to repay these long-term mortgages by selling their house and downsizing when they retire. But house prices do not always go up. They can stagnate over very long periods or drop sharply in the short-term. Hence the FT showed how house prices in Dublin fell by nearly 50% from their peak in 2012.
I suggest 40-year mortgages are positively dangerous and should come with a “health” warning. This looks like another “mis-selling” scandal unregulated by the FCA which will come home to roost in the future. When you borrow money, you should pay it off as soon as possible. A house you buy to live in should be considered to be just that – an operating cost not an investment, and cutting your operating costs should always be a priority.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
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