The best cash ISAs – August 2023

For investors who have used up their annual Isa allowance, venture capital trusts (VCTs) are another tax-efficient option to consider. In fact, VCTs offer more generous tax breaks than Isas, as well as a larger annual investment allowance; the flip side is that the underlying investment is higher risk.

VCTs are funds run by a professional manager who chooses a portfolio of qualifying companies. These must be businesses that are less than seven years old, have assets of less than £15m, and fewer than 250 employees. Often, they will be privately owned, though some Aim-listed firms do qualify.

Such businesses – small, early-stage ventures – inevitably come with more risk attached than their more established counterparts. There is potential for exciting growth if the business takes off – famous VCT alumni include estate agent Zoopla, holiday company Secret Escapes and the meal-kit firm Gousto – but there is also a very real danger of complete failure. VCT managers mitigate this risk by building portfolios of companies rather than putting all their eggs in one basket. But investors also get some protection from the generous tax reliefs the government offers to encourage the support of this part of the economy.

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Best of all, investments in new VCT shares – as opposed to those trading on the secondary market – come with 30% upfront income-tax relief and you can invest £200,000 a year. All income and capital gains earned from VCTs is tax-free. The only caveat is that you must keep your VCT shares for at least five years; otherwise, the upfront tax relief has to be repaid.

Be sure to choose the right fund

The fact that only new shares offer the 30% relief compels VCT managers to launch new issues each tax year. Sometimes, managers launch completely new funds; in other cases, they launch new share issues on their existing funds, enabling them to expand the portfolio or top up investments already made.

Either way, it is important to understand that even with the generous incentives attached, you’re taking on a high-risk investment when putting money into a VCT. And that makes it imperative to choose the right fund from the right manager. In practice, VCTs come in different shapes and sizes. The most common funds are generalists – they invest across the economy according to where the manager sees opportunities to back exciting businesses. Then there are specialist VCTs, launched with a mandate to focus on particular sectors. These include funds investing in technology companies, healthcare businesses and – for the first time in the 2021-2022 tax year – firms with a sustainability theme. Finally, there are also a number of VCTs focused purely on Aim shares.

The right fund for you, then, depends partly on which of these categories has most appeal. The generalist funds can be a good starting point, while the more specialist funds carry greater risk. Aim-focused VCTs come with the advantage that the underlying portfolio is straightforward to value, since each investee company has a publicly available share price. Unquoted company valuations, by contrast, are more opaque, so it can be harder to assess the performance of these VCTs.

Still, the most important determinant of all for the success of a VCT is the manager’s capabilities. This is an area of the investment market where specialist expertise really does count. Most obviously, you need a manager who can pick out businesses that offer the best possible combination of exciting prospects and a realistic chance of success. But in addition, managers need to have the skill to work with the businesses they back; VCTs tend to be hands-on shareholders. A manager’s firm must also have strong networks and contacts in order to find good businesses in the first place. This latter capability is particularly important in the current marketplace, with VCTs on target to raise record sums this year. The strength of a firm’s “deal flow” will determine whether it has enough good opportunities to invest all that money.

On the basis of all these criteria – and the performance of VCTs in the past – specialists in the sector favour several managers as worth backing. The investment platform Wealth Club, for example, picks out the Albion VCTs, Pembroke VCT and the Northern VCT. Bestinvest adds Unicorn Aim VCT to that selection.