Make a fortune with your ISA!

Want to grow your wealth with a stocks & shares ISA, but don't know where to start? Here's everything you need to know.

Are the rates on cash ISAs doing very little to inspire you? I can't say I'm surprised. After all, it's pretty hard to get excited about returns of less than 3%.

Having said that, I don't think these tax-free savings accounts are quite as appalling as they seem, as I explained in Don't fall for the ISA rip-off lie. But if you're after a far healthier return, you may be better off putting some of your ISA allowance in stocks and shares.

Is stock market investing right for you?

Before we look at how to invest your ISA, you need to decide whether stock market investing is right for you. Not everyone is comfortable taking a gamble on the stock market. Find out if you're ready to invest by joining our Make money from the stock market goal.

If you're risk-averse, it's absolutely fine to stick with cash ISAs where your capital will be safe. But if you want something a bit more adventurous let's take a look at the basics first. Then I'll show you an easy way to get started.

Stocks and shares ISAs - the basics

This tax year - which ends on 5th April - you can invest up to £7,200 in a stocks and shares ISA. If you're over 50 by 5th April 2010, you'll be able to invest a maximum of £10,200. (All investors will be entitled to the higher annual limit from 6th April).

If you prefer, you can split your allowance between stocks and shares and cash, with no more than £3,600 going into cash - or £5,100 if you're over fifty. You can also decide on lump sum or regular investing, or a combination of the two as your finances allow.

Choosing a cash ISA provider is pretty easy since your decision will be largely influenced by the highest rates. But shares are more complicated since there's a vast array of different ways you can invest your money.

Unless you're an experienced investor and you want to pick your own shares via a self-select ISA, most investors will choose one or more investment funds. All investors' money is then pooled and invested on their behalf by the fund manager, who will attempt to maximise their returns.  

But choose badly and you could end up with a very poor performer - or what's known in the investment world as a 'dog fund'.

How should you invest your ISA?

To stop this from happening I think it makes sense for new investors to start off with index-tracking funds - or trackers. A tracker invests in all the companies quoted on the index it's based on. So a FTSE 100 tracker, for example, will invest in all FTSE 100 companies, and then mirrors - or 'tracks' - the performance of the index as closely as possible. If the FTSE goes up by 5%, your tracker will rise by 5% (or thereabouts allowing for charges and a tracking error). But equally, if the FTSE falls by 5%, your tracker will drop by 5% in value too.

Trackers versus managed funds  

The great thing about trackers is they tend to be cheap because you don't have to pay for the stock selection expertise of a fund manager. With a managed fund you pay extra in the hope that the manager can beat the market, but this doesn't often happen. So another way of looking at it is trackers cost less and regularly outperform managed funds.

To give you a better idea of how trackers measure up against managed funds, we should think about how they perform within their sector. All investment funds fall into sectors which categorise the type of assets they hold. UK index-trackers are part of the UK All Companies sector which means they invest the majority of their assets in UK shares with the objective of achieving capital growth.

In the performance table below you should pay particular attention to the last column - '5 year sector ranking out of 321 funds' - which shows how well trackers have performed over five years compared with every other fund in the UK All Companies sector.

Right now there are 321 funds listed in this sector. You can see that the HSBC FTSE 250 Tracker fund has outperformed 289 of them with a ranking of 32/321 over five years. Meanwhile the Halifax UK FTSE All Share Index Tracker has produced a higher return than 251 funds, with a ranking of 70/321. Note that the difference in ranking between the two is significant because the HSBC fund tracks the FTSE 250 index, while the Halifax fund tracks the FTSE All Share index.

Now let's take a look at how the top ten trackers funds have performed. Figures for returns over one, three and five years are shown, but the table is ordered on the '5 years % growth' column:

Top 10 trackers

Source: Trustnet, as at 1 February 2010.

It's true that the returns from trackers can be volatile as the market peaks and troughs. An investor who opened a tracker three years ago will still be nursing a loss. But in the last 12 months performance has been particularly strong with UK indices rebounding. This has resulted in the HSBC FTSE 250 Index posting a return of more than 50% in the last year. Compare that with the current best return of 2.65% on new money held in cash ISAs, and you could be almost 19 times better off all things being equal!

Meanwhile the top performing FTSE All Share trackers - the Halifax UK FTSE ALL Share Index Tracker and the L&G UK Index tracker - posted returns of 34% and 30.6% respectively in the last year. This proves trackers are capable of far healthier returns than cash could ever muster.

I'll finish off by saying that, of course, past performance is no guide to what might happen in the future. But if you fancy taking your chances, a cheap tracker is a good place to start. For a more in depth look at selection of the top funds, check out Three cheap index trackers.

If you're still not sure what to do after reading that, take a trip over to Q&A and ask the lovemoney.com community for help.

Compare ISAs at lovemoney.com

More: The top 10 cash ISAs for 2010 | Top 10 ISA myths