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Take a Pep in the right direction

Even before the tragic events of September 11, had not been a good year for Isa sales. The traditional tax year-end rush was marked more by the quantity of advertising than the volume of new business.

According to the latest Inland Revenue statistics, in the two years since April 6, 1999, £31.2bn was subscribed to the stocks and shares component of Isas. The Revenue&#39s statistics for Peps are less up to date but the numbers are more impressive – at April 2000, the total value of Pep investments amounted to £94.49bn.

At a time when investors are reluctant to commit fresh funds to equity markets, that value sitting in Peps – worth about six years&#39 Isa contributions – cannot be ignored by IFAs. This is the perfect time to review existing Pep holdings and make the appropriate transfers and/or switches. Pep money is money that is committed to the markets. Unless a client wants to lose their tax benefits, their Pep funds must be held in equities or bonds.

Both the alignment of Pep investment rules with those of Isas and the facility to make partial transfers have expanded the options for existing Peps. It is easy to forget that the 2001 change to permitted investments is only one of a series of reforms that have been made to Peps.

Over the years, many Peps were specifically designed to match the requisite investment limits prevailing at the time rather than meet a particular investment objective.

One obvious impact of the investment rules has been a bias towards UK holdings. The distinction between qualifying and non-qualifying funds, which has now disappeared, drove investors into funds holding at least 50 per cent in UK and/or EU securities.

This was not the only distortion to be found in the Pep market. There was a flavour-of-the-month syndrome to many Pep investments. The spring 2000 stampede into technology Isas was by no means the first time that the year-end scramble had been dominated by a particular theme or even fund.

As with the tech rush, justification was often based on recent past performance, with the result that investment was made close to the top of the market. Many Peps remain in such ill-fated funds, their investors unaware of the options now open to them.

In some quarters, there is concern that the regulators will take a harsh view of Pep transfers because a transfer can all too easily look like churning, particularly if the end result is to produce a stream of trail commission where none existed before.

It should be remembered that a transfer is no more than an aspect of the ordinary process of managing a client&#39s portfolio. In the case of Peps, there is arguably more reason to transfer funds than in normal portfolio management, simply because of the distorted portfolio structures that the old Pep rules produced.

The age factor also has to be taken into account. Peps first appeared in January 1987, so many plans have holdings that date back well over five years. It is entirely reasonable to ask whether these remain suited to your client&#39s current investment objectives.

A good example here is that there can be a strong case for moving out of index-tracking funds. In current market conditions, tracking the index is much less attractive than it was in the late 1990s, when active managers went through a difficult period. In 2001, index tracking means following the market down, more than chasing it up.

We have been in a bear market now for 20 months, the longest, if not the deepest, since the mid-1970s. In a low-inflation and low-growth world, quality active management and proven stockpicking skills come to the fore.

Even within a bear market, there are many growth opportunities to be found at the individual stock level. At the end of August, tracker funds had matched the FTSE 100&#39s one-year fall of 19.9 per cent but some sectors had performed strongly. Food processors had risen by 26.4 per cent and general retailers were up by 14.1 per cent proving there is money to made if you know where to look.

As many investors are now learning to their cost, not all index-tracking Pep funds were originally marketed as index trackers.

In fact, some active investment managers are no more than closet index-trackers, their portfolios being run against an institutional investment process with few, if any, major bets made away from the index.

Because of their investment manager&#39s paranoia over tracking error, many unwitting investors are left paying active management charges for nothing more than a glorified tracker fund.

Surely, investors paying 1.5 per cent a year should at the very least expect their fund manager to try to outperform the index and not just match it? In the Pep market there is probably more risk that investors will suffer this fate for two reasons:

Because of their inherent tax advantages, Peps have significantly greater persistency than other non-tax-wrapped products. Such inertia can be a temptation for managers to resort to index tracking.

Some groups have Pep-oriented funds which are no longer actively promoted and can exist in an index-tracking backwater without attracting too much unwelcome attention.

There is a further regulatory point which advisers should consider. The change to the Pep investment rules took effect in April. The duty of care that IFAs owe to their clients means the impact of the change ought to be considered before the next Isa season looms into view.

One final aspect of Peps that should not be forgotten is the subject of single-company plans, which, until April this year, had to hold a single share for each tax year. These Peps account for over 10 per cent of the Pep market and can now be invested in the same way as Isas.

How many of your clients have such plans – perhaps holding shares from demutualisations or employee share schemes? Are such holdings really a sensible alternative to collective investment for the majority of investors?

In summary, there are many good reasons why you should be reviewing your clients Pep portfolios.

The outlook for equities over the next five years is almost certainly a different one to the rampant bull market of the previous 10 years and different types of funds will be better suited to maximise future growth opportunities.

Pep legislation has evolved and has led to the potential existence of inappropriate portfolios not necessarily aligned to your clients&#39 current investment objectives.

Finally, the merry go round that is the UK fund management industry means the fund manager originally bought by your client is probably now working at another investment house. Now is a good time to review ahead of the next Isa season.

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