Hidden Costs of ISA Investing

Hoodless Brennan explains the hidden costs of ISA investing and tells us why it is important to invest at the start of a tax year.

Originally published in Shares Magazine 24th February 2005.

Leading Fund Manager Fidelity Investments recently released a survey that stated 42% of the UK adult population intend investing in an Individual Savings Account (ISA) in the next tax year 2005-6. Gordon Brown has over the last few budgets been clawing back the tax advantages on ISAs.

Brown has reduced the tax relief on dividends into an ISA, imposing a 10% level and from 2006 the amount you may invest will be reduced from £7000 to £5000 per year, causing many to view investing this year as a ‘use it or lose it’ year.

Despite the numbers planning to invest in an ISA this year, some investors remain skeptical about the value of investing given the current three year stock market high around 5000 and the Government’s uncertain attitude to the future of ISAs.

ISAs currently offer generous tax breaks and whilst it is important to remember that tax rates and concessions can change, it is generally a good idea to use the tax breaks the Inland Revenue allow you.

Investments in an ISA can be sold at any time you want, they are not untouchable like pension savings, therefore they are a good medium-term saving scheme. Investing in an ISA allows you the flexibility to tailor the degree of risk according to your own circumstance or preferences. There are numerous options available which allow the investor to set their own investment strategy.

Two main issues affect how your investment grows; the Initial & Ongoing costs of investing and crucially When you invest.

The need to minimize the initial and ongoing cost of an investment is a well-known theme. Over the last few years the general public has increasingly sought out providers that have lower or rebated charges. However, less understood or acknowledged is that when you invest has just as much affect on the outcome of your investment return than just limiting the charges you pay.

To ensure the maximum growth potential of any investment you need to consider both these issues.

Initial and Ongoing Costs

Costs vary depending on the type of ISA. With a Cash ISA, there are usually no upfront or initial charges as with a Stocks and Shares ISA. At its most basic, the Cash ISA is a simple savings account that pays interest gross.

For Unit Trust investments in a Stock and Shares ISA, investing £7000 would incur a typical initial charge of around 5%. At 5% therefore the initial charge would be £350 and would be deducted from your investment leaving only £6650 invested.

An Annual Management Charge (AMC) is also paid per year, usually 1.5%. The AMC at the start of year two would be £108 if the fund after one year had grown at 9% from the initial £6650 invested to £7139. Initial charges can be reduced if you use a broker that offers to rebate the initial charge. But a major disadvantage is that costs can still mount under the AMC as it grows with the portfolio as a percentage and not all of the £7000 ISA allowance is invested initially – losing compounded growth over the period of the investment.

With a Self Select ISA if you invest £7000 the AMC can be paid separately outside the £7000 allowance in most cases. Some discount stockbrokers offer a fixed AMC so avoiding a percentage-based fee eating into your investment growth as the portfolio value increases over time.

Hoodless Brennan offer an Online Execution Only ISA with a flat rate AMC of £50 and low trading commission of £7 per trade. If the full £7000 was invested in four shares of equal value the Trading commission would be £28 and the stamp duty £35. In total you would have paid £113 in charges to invest in a Hoodless Brennan Self Select ISA; of which only £63 is deducted from the £7000 as the AMC is paid outside the investment.

In comparison to a Unit Trust ISA the charges were £350 for the initial investment compared to £113 for the Self Select ISA, a saving of £237. If this money grew at 9% and remained invested for ten years the lost growth would be £561 (£237 x 10 years at 9% growth = £561)

You can invest in IShares or Exchange Traded Funds, offering diversified risk as they follow a basket of shares e.g. FTSE100. This provides a lower risk overall in the same way the diversified investments of a Unit Trust does by investing in several hundred companies, but at a lower cost through a discount stockbroker as IShares are listed and traded as a share.

IShares are also frequently traded; the S&P 500 IShare is the most frequently traded share in the world according to Barclays Global Investors. Trading costs are low due to tight spreads because of the volume of trading and this helps avoid any disadvantage you can encounter when selling a Unit Trust where the price set by the fund manager to buy your units back from you can be much lower if they want to dissuade sellers.*

The main advantages of a Self Select ISA are that they can be cheaper to initially invest in than a Unit Trust ISA and also give you control of the investments and allow you to tailor the degree of risk according to your own circumstance or preference through numerous investment options and combinations.

The Self Select ISA AMC can also usually be paid outside of the ISA, thus allowing you to invest more of £7000 from the outset and over five to ten years this enables the investor considerable extra growth potential. One disadvantage with a Self Select ISA is that trading costs can mount up if you trade frequently and do not restrict your costs by using a discount stockbroker to more than the initial Unit Trust costs.

Why Timing is so crucial to your investment

Maximizing the growth of your investment can be achieved by reducing initial and ongoing costs by seeking discounted initial charges, avoiding percentage based AMCs and by using a discount stockbroker for Self Select trading.

However it is important that you maximize growth by investing at the start of each tax year not the end of the year – Timing is crucial to ensuring the maximum return of your initial investment in the medium to longer term:

• If you invest early in the tax year, compounded growth takes place earlier and its effects grow more over time. The more you invest initially and the earlier you invest, the bigger it will grow as interest and growth occurs on more of your investment over time. Over ten years this can be a significant additional growth factor in the investment.

• After five years if you invested £7,000 at the start of the tax year and it grew continuously at 9% per annum with any dividends being re-invested, the investment would have grown to £10,770 – 54% growth overall. However if you delayed your investment until the end of the tax year, at the end of the fifth tax year the investment value would be only 42%, and you have lost £889 of capital growth. That is 12.7% of your initial investment lost by investing at the end of the tax year not at the start. 

• The effect of investing at the end of the tax year instead of the start of a tax year is even more evident if the investment is left to grow for ten years. An initial £7000 investment at the start of the tax year, again growing at 9% per annum, would be worth £16571 at the end of tenth tax year – 136% growth overall. However if you delayed your initial investment until the end of the tax year, the value would only be £15203 - 117% growth overall. By investing at the end of the tax year ten years before you will have lost £1368 capital growth or 19.5% of your £7000 initial investment.**

Investors not only need to be careful at the outset to minimize the initial costs of investing and the ongoing costs over the whole life of the investment, but also act early and invest at the start of the tax year to maximize their long term growth potential and not miss out on compounded growth.

Risk Warnings

Click here to see full Risk Warnings.

*For more information on ETF’s and IShares please see the London Stock Exchange website at www.londonstockexchange.com

**Figures quoted assume investment dividends are re-invested and the investments grow at 9% per annum for the purpose of illustration. (Average return on UK shares is 9.6% since 1900 as quoted on thisismoney.co.uk on 22 Feb 05)