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Tax-enhanced products: understanding and managing the risks

At the end of May, Hardman & Co teamed up with IFA Magazine to hold a webinar for compliance managers on how to manage the risks involved in tax-enhanced products. This is an increasingly important area of financial planning as these products are likely to become more valuable as tax rates rise…as they surely will.

The following is a summary of the key points discussed during the webinar.

Every investor should consider having 5-15% of their portfolio in venture capital, whether EIS or other investments. If not, as an adviser, you may not be giving them the best advice. Using standard asset allocation modelling, Brian Moretta of Hardman & Co has shown that these products can enhance portfolio returns and provide valuable investment diversification.

Of course, if the investor is specifically in a very low risk category, EIS may not be suitable, but it is important to take a holistic view of the portfolio, and the balance between equities, bonds, property, cash and venture capital.

It is inevitable that there will be some failures in an EIS portfolio, but a good fund will also produce some very high returns from some of the companies that outweigh the losses.

That is why diversification is so important. The more companies in a portfolio, the lower the risk of loss and the better returns the investor is likely to get. Ideally this should involve targeting 100 companies or more, but this can be built up over time.

Of course, investing in tax-enhanced products is riskier than more conventional investments. That is why the government offers such generous tax reliefs, to compensate for this risk. The key is to appreciate these risks, choose fund managers carefully, and understand how to manage the risks.

Areas to consider

Past performance and understanding what it really means is important. Has there been a clear and consistent investment strategy over time? Be aware that managers who were very good at managing lower risk investments in the past, such as solar when it was allowed, may not have the same skill set to manage higher risk investments into knowledge-intensive companies.

It is also worth ensuring that the performance figures shown are exclusive of tax relief and show a blended return when there have been several funding rounds.

Fees cannot be ignored, including whether it was better to have the fees charged to the investor or the investee company. The consensus during the webinar was that a mix is sensible, but what was even more important was the transparency about fees so that they were clear and understandable.

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