Share-based Child Trust Funds

If you are deciding where to invest your child's Child Trust Fund (CTF) voucher, there is a strong possibility that you may want to invest in a share-based account.

Investing in a share-based CTF account means placing your money in a so-called 'pooled' fund that buys shares in a number of companies on your behalf and that of all other policyholders. The fund manager will be hoping to deliver good returns by using a number of strategies aimed at identifying the best possible shares for his or her fund.

The aim of pooling is two-fold. By putting your money together with that of many other investors, the fund manager has more financial firepower. He or she can buy more shares in more companies.

In turn, by buying shares in more companies, the manager is also pooling - and hopefully reducing - investment risk, the possibility that the value of your shares may fall as well as rise.

Investing in shares: the advantages
The key advantage is that your potential returns could be far greater than simply leaving all that money in a savings account. Historically, over most periods of 20-25 years or more, shares have delivered higher returns than any other investment, including both cash and property.

The Treasury's own research, published on its CTF website, suggests shares have outperformed cash over any 18-year period (the CTF investment horizon) in the past 40 years. Part of the reason for this growth is the effect of so-called "compounding":

- Assume you invest £100 a month into a share-based CTF over 18 years, a total of £21,600, and that your returns are 3% higher than inflation after all fund management charges are included

- In today's money, the amount you get back would be worth £28,940. If you include the £500 paid in by the Inland Revenue at birth and at age 7, total returns would come to £29,711

This figure, by the way, is considered a "realistic" target by most experts nowadays - although after the past few years it may be worth looking at such claims with a pinch of salt.

Investing in shares: the disadvantages
There are two potential dangers that apply to people who invest in shares.

The first is that they may end up investing in the wrong shares, or the wrong fund. The fund manager, for whatever reason is unable to deliver decent returns even though the market is doing well overall.

The general rule is that "a rising tide floats all boats". What is more likely to happen is that a fund manager will deliver lower returns than the average in that period: you may be unhappy with your fund's performance, but have not actually lost any money.

The second possibility is that the market falls and all shares do badly. Under those circumstances, the best a fund manager can usually do is hope not to lose as much as everyone else.

How likely is it to happen?
It is true that for every 18-year period in the last 40 years money invested in shares has grown more than the same amount left in a savings account. However, it is equally true that over shorter periods of time, investing in shares has sometimes left people nursing heavy losses.

Indeed, one of the interesting, if not-too-often mentioned fact about references to 18-year time horizons, when shares did better than cash, is that once upon a time similar claims were made for 7- and 10-year time periods.

What has happened is that the share price fall of the past 5 years was so dramatic - with values dropping by up to 50% - that even some people who remained fully invested have still not recovered back to the point they were in over a decade earlier.

What to look out for if you invest in share-based CTFs
More details of what you should be focussing on are available in other sections on this site. However, here are a few tips:

- Don't focus simply on top performance: funds will often do well for certain periods of time, only to slip back later. Look for consistency

- Watch out for risk: there is a danger that their effort to achieve relatively marginal outperformance, a fund manager may be taking significantly higher risks with your money

- Don't ignore volatility: if, for the sake of argument, a fund rockets up by 20% in one year, only to drop 15% in the next, not only are your average returns on the low side, you face the possibility that any fall could happen just before maturity

- Keep an eye out for charges and transfer penalties: non-stakeholder funds don't have to apply a fixed charging system. They can also levy exit penalties if you move your child's money elsewhere. This can impact seriously on your chosen CTF's final value