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Where does an EIS fund fit within a modern investment portfolio?

Mark Bower-Easton, Business Development Manager, Oxford Capital

Tax efficiency, diversity, and investment return. These are three factors that sophisticated investors look for from their existing investment portfolio. But are investors missing a trick by not considering an Enterprise Investment Scheme (EIS) as part of their portfolio?

Diversification comes in many shapes and sizes, but when all is said and done, most funds will predominantly invest in blue-chip companies, either by way of buying shares, or buying corporate bonds when they are trying to raise capital. However, if one fund manager or stockbroker thinks investing in a certain stock or bond is a good idea, then it stands to reason that their counterparts will think the same. Take two UK equity or bond income funds with a similar strategy, and you will likely see at least four of the same companies in the top 10 holdings of each fund. This creates something called portfolio overlap, and it defeats the object of a diversified portfolio of funds.

In recent years, the inversely proportionate relationship held between equities and fixed interest has disappeared. Historically, when equity markets tanked, fixed interest gained in value (and vice versa). We saw in March and April of 2020 that the value of the FTSE 100 dropped by 31%, yet fixed interest markets failed to deliver the positive returns investors expected. The COVID-19 global pandemic is not the only example of this happening. So how can investors avoid this happening again in the future? What investors need to find is a form of investment with no correlation to “traditional” investments. This is where an EIS fund could come in, and provide investors with true diversification.

Traditional investment funds will not provide investors access to start-ups or university spinouts, and this is where portfolios may be missing out. The UK is at the epicentre of technological advancement, and an EIS fund provides access to some of the newest, most vibrant, and exciting businesses in the UK. They are higher risk, and you are investing based on potential rather than track record, but no other type of investment gives you the tax benefits and the emotional connection of an EIS.

Companies in an EIS Portfolio

Companies in an EIS portfolio are less likely to be affected by economic shocks, or significant falls in stock market indices. Their cashflow is not driven by revenue, and as their shares are not actively traded on the stock markets, there is no correlation between how the EIS funded company performs, and how the value of a listed company can fluctuate due to factors completely out of their own control.

Some investors will be happy with the tax efficiency afforded to them through tax-free ISAs and annual CGT allowances. However, when an investment portfolio reaches a certain size, these tax breaks simply don’t cut it anymore. No other investment in the UK offers the potential generous tax benefits afforded to EIS investors:

  • Income tax relief: 30% on up to £1m invested, increasing to £2m if at least £1m is invested in “knowledge intensive” businesses. Putting it simply, if you earn £100,000 per year and invest £50,000 in to an EIS, once you have received your EIS3 certificates you would be able to reduce your income tax payment by £15,000.
  • Capital Gains Tax deferral (EIS CGT deferral): A CGT liability can be deferred indefinitely if invested in to an EIS. This gain could have occurred up to 3 years before or 1 year after the date of EIS investment.
  • Tax free gains: All gains on EIS investment are tax free if the investment is held for at least 3 years.
  • Inheritance Tax relief: The underlying assets in an EIS qualify for Business Relief (BR), which means that after holding the asset for 2 years they will become exempt from IHT if the investment is still held upon death.
  • Loss Relief: Significant downside protection, which provides relief at the investors marginal tax rate after initial income tax relief. EIS losses can be offset against either CGT or taxable income.
  • Business Investment Relief (BIR): A UK resident/Non-Domiciled investor can make use of offshore funds to invest in to EIS without having to pay the remittance charge.

For balance, it is important that I highlight the risks of EIS, as they won’t be suitable for everyone:

  • High risk: A portfolio will likely invest into early-stage companies that are relatively unknown, investing based on potential rather than track record.
  • Illiquid: EIS shares are unquoted and can’t be sold on an exchange. Once invested it is not possible to withdraw funds, and investors may not be able to access these funds again for 5-7 years, and in some cases over 10 years.
  • Concentration: You will typically be investing in a portfolio of 8-12 companies, which is far fewer than a traditional equity fund where you could be spreading your money across 250+ companies. Therefore, if one company fails within an EIS it will have a far greater effect on your capital than if one of the 250+ companies failed.

In summary, an EIS offers:

  • Greater tax efficiency,
  • Greater diversity.
  • Potential for improved investment returns.
  • Benefit of in-depth research and analysis of every company before it goes in to your EIS portfolio.

Through EIS, investors have the opportunity to invest in companies with the potential for significant growth, in a scheme with positive tax benefits. There is a long history of EIS funded companies making their investors outstanding returns on investment, but this shouldn’t take away from the fact that they are, and will always be, high risk. Therefore, it is incredibly important that any investor who considers an EIS views it as something that compliments, rather than replaces their existing portfolio, and that they work with a fund manager with extensive experience and expertise not only in EIS investment, but in the industries in which the companies operate.  For the right type of investor, an EIS is a remarkably compelling option.

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