We regularly provide education and information around topics such as tax efficient investing and property investing here at GrowthFunders, but we don't give financial advice. We don't make recommendations on investment products or advise on where you should invest your money.
And speaking to a professional advisor is always recommended before making any form of investment. Each will have their own advice to give and they'll all offer something different, ideally suited to your specific needs as an investor.
However, if there's one piece of advice that is offered across the board it's diversification. It's about spreading risk and not keeping all of your eggs in the one basket.
We've previously talked about property investing and how property can be particularly beneficial for portfolio diversification, but having been talking about tax efficient investing too, I wanted to take some time to explore the role tax efficient investments can play when you're looking to achieve a diverse portfolio.
Diversification is about variety
On the highest of levels, to achieve diversification you need to have variety. Therefore any new asset classes or investment types you're bringing into your portfolio is going to mean you're diversifying your portfolio to some degree.
But a lot of investors want - or are advised - to look at greater levels of variety, therefore building a portfolio that doesn't just include one or two different asset classes or a handful of investments that differ in risk, but one that is as varied as it can possibly be.
Look at it on a high level. Investors into some of our EIS-eligible investment opportunities over the past couple of years have invested into Intelligence Fusion, a data intelligence platform aimed at security professionals right around the world through to QikServe, a food tech company that delivers self-service ordering solutions. Add into this Hive H.R, an employee engagement software company, and it's easy to see how diversification can be achieved.
If we take those three companies, you could have spread a £6,000 investment allocation equally as three £2,000 investments and have an investment into three completely different sectors. Not only would these investments add diversification in terms of general risk levels (investments into early stage businesses are generally seen as a higher risk/higher return strategy), but it spreads your investment across a variety of sectors, adding even greater levels of diversification.
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Diversifying with EIS & SEIS Opportunities
As we have already covered in previous blogs, EIS is just one form of Tax efficient investing.
Looking at the tax reliefs in more detail, given early-stage startup investing is a higher risk/higher return strategy, the UK government provides tax reliefs to help mitigate the level of risk involved.
The most notable of the tax reliefs under the EIS is 30% income tax relief, based on the value of your investment. Increasing to 50% for earlier stage SEIS investments, it's clear how beneficial these can be - at the point of investment you can reduce your capital at risk by between a third and a half. That's a hugely attractive point.
But when we're looking at diversification, it's actually the Capital Gains Tax (CGT) benefits that can be most appealing.
Looking at the EIS as an example, investors are able to benefit with regards to CGT in two separate ways:
- Any returns on your EIS investments are not liable to CGT. If you invested £1,000 and your shares increased in value to £10,000, your £9,000 return would be able to be realised without any form of tax needing to be paid.
- Investors can effectively defer the payment of a CGT bill from any other source until an indefinite time in the future.
With the former self-explanatory (although you can read more about EIS and Capital Gains Tax here), the latter takes a bit more discussing, but the benefits can be particularly beneficial.
Let's imagine you had sold a commercial property and had a £10,000 capital gain. Assuming you have already used your tax free allowance elsewhere, you'd be liable for at least 18% in capital gains tax. That's £1,800 that needs to be paid to the HMRC.
However, the EIS gives you the ability to defer this amount by investing the £10,000 capital gain into an EIS opportunity - and the amount is continually deferred up until the point that you dispose of your EIS shares.
If your £10,000 investment increases in value, it could very easily mean the amount of CGT owed is able to be covered by your gain (which itself is not liable to CGT). And of course, should the investment decrease in value, you'll have deferred that gain for what could very easily be several years.
Undoubtedly beneficial, if we swap to the SEIS, things become even more favourable - not only are any gains you achieve on your investments also not liable for CGT, but if you invest a capital gain from elsewhere into the scheme, the liability that has arose on the gain is effectively halved. 50% isn't deferred until a point in the future, but completely written off.
Using the £10,000 example above and the £1,800 CGT liability it would incur, investing that £10,000 into an SEIS opportunity would allow you to reduce the liability to £900.
These types of tax reliefs and incentives simply aren't achievable in other asset classes. Lower risks and shorter return periods can undoubtedly be achieved elsewhere, but the tax reliefs are very much synonymous with early-stage startup investing, making them an attractive proposition for investors looking for diversification who are seeing capital gains.
Diversifying with Innovative Finance ISAs (IFISAs)
To further diversify an investment portfolio whilst still generating tax free returns, a more traditional type of investment that is growing in popularity are ISAs, specifically Innovative Finance ISAs (IFISAs).
IFISAs were first introduced by the Government in 2016 as means to initially support the accelerating growth of the alternative finance market. After the 2008 crash, many credible businesses were finding it harder to get the funding they required from banks who had increasingly tightened their purse strings.
IFISAs work by allowing eligible UK investors to lend money to make loans to consumers or businesses in return for a targeted interest rate return. These loans are made through peer-to-peer (P2P) lending platforms, and since their introduction have seen the IFISA market grow to over £1 billion.
As of the 2020/21 tax year - investors are able to invest up to £20,000 into an IFISA and have any returns free from income or capital gains tax liabilities.
The reasons why IFISAs have grown in popularity are no surprise given the potential higher returns of around 4% and 10% when compared to a more traditional savings product of a Cash ISA currently sitting at 1.31%.
With this in mind it is also important to realise that an IFISA is an investment product unlike it's Cash ISA sibling that is a savings product. As with all investments returns are not guaranteed and capital is at risk.
How can IFISAs diversify an investment portfolio?
Due to the varied assets that IFISAs allow investment into, and the considerable number of product options for each, an IFISA can offer diversification in a way that provides options for most investors.
Property bonds. Green energy bonds. SME loans. Consumer lending. With the four asset classes alone providing a strong set of choices, diversification can be achieved even further when exploring the actual product options.
The range of IFISA types to choose from can enable you to diversify through a variety of industries and geographical locations. This could form the strategy of building a well balanced portfolio as well as providing the freedom to support the growth of specific sectors you care about such as UK Property or Green Energy.
Download the complete IFISA Guide here, produced by GrowthFunders and MAVEN Bonds.
Achieving portfolio diversification with tax efficient investing
One of the most common traits of a successful investment portfolio is diversification. Keeping your eggs in one basket is rarely a recommendation in any scenario, and it's never more apparent than in investing.
With any investment you incur risk. Sometimes it's minimal, other times it's considerable, but the primary risk level of a portfolio is dependent on your requirements and expectations as an investor. Yet regardless of what end of the risk scale you generally sit at, diversification should always be a key consideration - and adding tax efficient investments into your portfolio can be a brilliant way to achieve it.
One of the Tax efficient investment methods mentioned above is the Innovative Finance ISA. In partnership with MAVEN Bonds, we have created the complete IFISA guide for experienced investors with all you need to know about the ways in which an IFISA can help diversify your investment portfolio.
First published 19 July 2019, updated 15 April 2020.