The truth about fees that every ISA investor should see

It's the time of year (less than a month to go until the 2011/12 deadline) when many people in the UK are thinking about where to invest their ISA allowance.

If you are planning to invest in a fund rather than cash or self-selected securities, then the table on the left (produced by Vanguard - see this excellent guide "The Truth About Costs")) could be more important than any research you do into which funds are likely to outperform. It shows that a fund with high charges will underperform and disappoint in the long term almost however well the fund manager does or however clever you are in selecting a "hot" investment trend.

For the average investor who doesn't follow and track these things, the effect of fund charges are greatly under-appreciated.  0.25% or 1.6% or even 2.5% don't sound very substantial numbers.  A positive bargain actually when compared with say a 15% tip at a restaurant.

The problem is that fund charges are made every year on your cumulative investment, so over a 30 year period a fund charging 2.3% (many do) will take that % of the money you invest in year one 30 times.  And they will take 2.3% of any gains and dividends.  And all the charges they make reduce your capacity to roll up cumulative gains on the investment.

Small wonder that even a 1.6% charge rate can reduce a potential "pot" of £46k to £29k even before inflation is considered and even before tax because it is in an ISA.  And don't get me started on so called Independent Financial Advisers and their fees.  Or "funds of funds" which have two layers of charges.

If you want to find the real scandal of the City, forget about hedge funds and bonuses: it's the quiet, deadly raids that are being made every day on our savings that are the real disgrace.

What to do?

Option 1 - open a self-select ISA with no annual admin charge and pick out 5 or 6 quality stocks with your allowance (perhaps spread the timing of your investments over the year - one every two months) and forget about them.  Apart from the small commission and stamp duty* at the beginning you will have no charges to pay.

Option 2 - pick funds with low charges. Look for a TER* or Total Expense Ratio and remember the difference between 0.25% and 2.5% is enormous.  Any fund with a high TER must really justify itself.

* - note that dealing costs are not included in the TER - they are taken directly out of the fund - so that actual charges are higher than the quoted TER

Final note to anyone unfamiliar with initial charges: never pay them.  Some funds charge up to 5% simply to buy into their fund.  That's money taken upfront and which never earns you any cumulative return.  It is completely unjustified - it's like being charge commission to enter a really expensive shop and spend money there.  Avoid by going to a broker which waives or rebates the charges.

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Good news: the FTSE's falling!

For anyone thinking about what to do with their ISA allowance or are just looking for an alternative to the depressing returns available at their local building society, recent stock market events should have given plenty of food for thought. On the face of it, with the FTSE (and most world stock markets) falling, one thought would be - don't bother with shares, they are too risky. Look a bit closer though and you might come to a different conclusion.

The FTSE 100 has had a good run since the financial crisis, up 69% (84% if you include dividends reinvested). Share prices have fallen sharply though over the last few days perhaps on fears that the oil price rise, goepolitical instability and Europe debt fears will drag on markets. The Japan earthquake has taken share prices lower too. That suggests share prices have had a good run and the risks are on the downside going forward.

Maybe, and I don't propose to go into all the arguments here but I would highlight some other bits of recent news from the UK stock market concerning dividends:

** Morrisons announced it would be increasing its divi by 10% for each of the next three years and returning 1 billion £ to shareholders via a share buy back.

** Prudential announced a 20% rise in its dividends

** AMEC, the energy services and engineering company, announced a 50% hike in its dividend

If you focus on the underlying income that shares generate rather than share prices, the news is mostly excellent and actually has been very good over the last decade.

People often make a comparison with share dividend yields and bond or bank deposit interest. Currently you could get 2.5-3% from bank accounts and around 3.5% from the FTSE. The argument goes that shares are risky so they should be yielding considerably more. On that basis you should wait until share prices fall back and yields rise; in the meantime "play safe" in cash.

But I would argue that the comparison is false. Interest on bank deposits is static (or falls when unscrupulous deposit takers quietly lower their rates and hope you don't notice) whereas dividends should rise over time, if you pick shares in the right companies.

As an example, look at Tesco PLC which in 1998 was paying around 4p a share in dividends. Since then the dividends have grown 10% a year on average to stand at around 11p in 2010. Tesco yields around 3.25% but the key point is that if it continues to grow its earnings and dividends by anything like the rate it has achieved in the past, the yield (particularly with dividends being reinvested in more shares) will easily beat interest bearing accounts.

But will companies like Prudential, AMEC and the supermarkets continue to grow particularly if recession returns and some serious global crises unfold? I would argue that certain companies with pricing power (strong brands and competitive positions) and in key sectors (utilities, energy) should continue to grow their earnings even in an uncertain economy. Partly this is because they are good defensive companies we can't live without, and partly because the dividend only gives part of the picture. Back to Tesco - they may pay a dividend just over 3% but actually they earn more than twice that amount and that additional money is invested back into the business to underpin future growth.

So when you see share prices falling remember that it could just mean that a great source of growing income has just got cheaper. This certainly is the view of The Sunday Times Money editor Kathryn Cooper who wrote on Sunday: "high quality blue chips with solid dividend yields have been out of favour for three years; surely their time has come".

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