ISAs prepare to enter the AIM game

Someone in the Treasury clearly has a soft spot for the Alternative Investment Market (AIM), the junior market of the London Stock Exchange.

Earlier this year, the Chancellor abolished stamp duty on AIM share purchases with effect from 2014. He has now confirmed plans to make AIM shares eligible holdings for investors' ISAs this autumn.

The announcement means investors will be able to buy up to £11,520 of individual AIM shares (in the 2013-14 tax year) within a self-select ISA, meaning there is no additional tax to pay on future dividends or capital growth.

ISA option

The Treasury bills the move as an incentive to get investment flowing into the type of small and medium-sized enterprises listed on AIM. And there's no faulting its commitment to the cause, because in many cases investors in AIM shares will now get a double tax break.

ISA investments are tax-free for as long as they are held, but normally they are counted as part of the investor's estate on death and may generate an inheritance tax liability. Many AIM shares, however, qualify for business property relief, which takes them out of the inheritance tax net after two years of ownership.

That extra slice of tax relief will no doubt be attractive to many, but independent financial advisers are quick to warn of the dangers of investing for the wrong reasons, particularly in an asset class where returns can be volatile.

"The risks of investing in shares are multiplied when investing in small companies, particularly those where reporting requirements are not as stringent, such as shares listed on AIM," says Patrick Connolly, head of communications at Chase de Vere. "There is potential to make big gains, but also the risk that you could suffer major losses."

That's certainly been the experience on the junior market, where the FTSE AIM All-Share index peaked at 2,925 in January 2000. More than 13 years on, the index stands at 694, still more than 75% down on the high-point. Moreover, AIM's fortunes can change dramatically over a very short period. In 2010, for example, the market rose 44% over the year. On the other hand, during the second half of 2008 alone, AIM dropped 62%.

Bear in mind too that the downside of holding AIM shares in an ISA is that losses can't be set against other profits for capital gains tax purposes. Some investors may therefore miss out on an opportunity to reduce their tax bills.

Nevertheless, Catherine Penney of Barclays Stockbrokers expects AIM shares to be a popular choice for investors who use ISAs to trade directly in equities rather than funds.

She says: "In our research among Barclays Stockbrokers' ISA investors, 25% said they would definitely invest in AIM shares within their ISA and a further 29% said they would seriously think about it. While small and medium-sized company shares can be expected to be more volatile than other ISA-eligible investments, as part of a balanced portfolio for experienced investors, they may enhance the overall return."

Helal Miah, an investment research analyst at private client stockbroker The Share Centre, agrees. "Equity transactions in AIM-quoted companies already make up nearly a third of the activity of execution-only investors, and we anticipate a groundswell of demand for ISA-wrapped AIM shares," she says.

Speculative choice

Seasoned market experts suggest treading cautiously when looking at AIM companies to invest in.

One problem is that AIM makes far fewer demands of companies that want to list on it than the main market of the London Stock Exchange. There is no expectation, for example, that companies will demonstrate a trading history of a certain duration or offer a minimum proportion of their stock for public trading.

Instead, the market relies on companies' nominated advisers (nomads) to certify they are above-board. Since AIM launched in 1997, nomads have been at the centre of a number of scandals. That has resulted in tougher rules for such firms, but insiders say standards are still not always as high as they should be.

Moreover, many companies listed on AIM are engaged in highly speculative business activities. In particular, a disproportionate number of natural resources companies have used the market to raise money for exploration and development. If these ventures come off, the returns may be spectacular, but it's very difficult for investors to gauge their chances of success. The same is true of biotech companies that claim to be on the verge of breakthrough drug discoveries - another common theme on AIM.

One option for wary investors is to avoid these speculative plays by steering clear of all but the largest companies on AIM. That may mean limiting their potential universe dramatically. Just 80 or so of AIM's 1,100 constituent companies are worth £250 million or more - though these do account for more than half the total value of the market - but the larger stocks are at least established businesses. They include a number of household names, from online retailer Asos to restaurant chain Prezzo.

Be especially vigilant before investing in the many international businesses that have chosen to list on AIM. There may be perfectly valid reasons why these companies have opted for AIM rather than their domestic markets, but it is much harder to investigate such businesses from a distance.

Investors attracted to AIM but nervous about making their own selections might consider some highly rated collective funds. The Cavendish AIM fund, Marlborough UK Micro Cap and Standard Life UK Smaller Companies trust all hold significant chunks of their portfolios in AIM-listed stocks and can be held in ISAs. Managed respectively by Paul Mumford, Giles Hargreave and Harry Nimmo, all three funds have strong long-term performance records.