With the recent increase in Individual Savings Account (ISA) limits and the increasing mentions  of ISA’s in the media, it is vital to understand what exactly an ISA is.

A key point to take on board is that ISA’s are strictly speaking not investments themselves, but wrappers which allow investments to be made tax-free. By putting money into an ISA it is possible to shelter various kinds of investments from the need to make capital gains tax (CGT) or income tax payments.

A failure to distinguish between the wrapper and the investment itself, causes a lot of unnecessary confusion about ISA’s among new investors. If the two things are seen as separate-although-related it is much easier to understand how they work.

When someone is putting money into an ISA, they are actually doing two things at once. They are investing in some kind of financial asset and putting a wrapper around it to protect it from the taxman.

So any investments made within the ISA are, subject to various annual allowances, tax-free. For example an investor who wanted to put money into assets that paid out income could quite legally avoid tax on that income. Any investments made within the ISA wrapper would not need to be declared to the taxman.

But understanding how the ISA wrapper works is only part of the story. The key question remains of what to put inside the ISA.

The regulations allow various types of assets to be included in ISAs. These include cash (such as savings accounts), gilts (government debt) and shares. Funds are essentially pools of assets, which, as a general rule, are run by a professional fund manager. Funds can invest in cash, bonds, shares or a combination of asset types.

It is also possible to use funds to invest in a particular geographic region or type of share. For example, there are funds that specialise in North American shares while others invest globally in technology shares. Or you could invest in funds that specialise in property or ethical issues.
The main advantage of investing in a fund – as opposed to investing directly into shares – is that it enables investors to diversify risk more easily. So, for example, if one company in a portfolio has a share price collapse it is likely to have a limited effect on the fund as a whole.

Also it is possible to diversify between sectors (such as retailers, technology companies or pharmaceutical firms) and countries. In such circumstances problems in one area, such as a fall in technology shares or the Japanese stockmarket, tend to be counterbalanced by rises elsewhere. Naturally it is not possible to guard against a catastrophe such as a total market meltdown of some sort. But most forms of risk can be managed by a sensible strategy of diversification and ensuring the portfolio matches your attitude to risk and reward.

Admittedly it is possible for investors to build up their own portfolio of shares rather than rely on a fund manager. However, all but the very rich are likely to have sufficient assets to diversify widely. Take, for instance, a relatively concentrated fund with holdings in about 40 companies. A private investor might need £1,000 in each company – or £40,000 in total – to begin to replicate such a fund.

In contrast an investor with only a few hundred pounds could easily invest in a much more diversified fund. The fund could also invest in bonds or overseas shares, which are often closed or at least expensive for private investors.

In addition, most people do not want to spend a large amount of time monitoring their portfolios. For hard-core investors, for whom investment is a hobby as well as a way of making money, it is probably preferable to invest directly into shares. But for most people, even those proficient in finance, it is preferable to hand over the day-to-day investment responsibility to a professional fund manager.

One of the best ways to review your existing ISAs or to invest for the first time is to consult an Independent Financial Adviser who can look at the whole market to ensure you get the right balance between risk and reward and also chose the right type of ISA for you.