Bill Jamieson: How to avoid the crunch of fees that bite into vital yields

Published on Friday 3 September 2010 21:30

How can investors take advantage of the gap that has re-appeared between the dividend yield on shares (currently 3.25 per cent on the FTSE All-Share Index) and the low level of yields on government or gilt-edged stock? Yields on ten-year gilts last week were standing just below 3 per cent.

The return of such a gap has historically been seen as a major "buy" signal for equities. As if on cue, the UK market surged last week, with the FTSE 100 gaining 4.3 per cent to 5,428.1. A fickle fillip, perhaps, on the basis of one set of better than expected US employment numbers, and liable to be knocked back down on any new disappointing data - of which there has been no shortage in recent months.

A second problem for investors is how to find a cost-effective and accessible way into the higher yield end of the market without those higher than average yields being eaten away by management fees and charges.

Today I highlight one solution which may appeal to those terrified at the volatility of today's equity markets but also concerned at being over-exposed to bonds. How can we find a way to capture the yield gap in favour of equities in a way that spreads risk and avoids high fund management fees and charges?

Such is the high degree of uncertainty in financial markets that by now many self-invested personal pension (Sipp) pots have been scattered to the four corners of the investment universe. Deflation worries have encouraged a lurch into bonds and government or gilt-edged stocks, while longer-term inflation worries have brought an exposure to gold and precious metals. Small equity fund holdings are scattered over developing country markets, so-called growth funds and old favourite income-orientated investment trusts. There will still be holdings in commercial property funds and doubtless some esoteria - green energy funds which are about as revenue generative as a wind turbine on a breathless day; moribund smaller companies trusts and agricultural funds where a B&Q potato barrel in the back yard might offer a better yield.

A decade or so ago the consensus wisdom was that a long-term savings plan would be predominantly invested in shares as these offered the prospect of better performance than gilts over time. Most long-term studies of asset performance showed this, including the Barclays Equity Gilt Study. This out-performance was particularly pronounced when dividends were re-invested. An investment of 100 in shares in 1945 would now be worth 241. Had the dividends been re-invested that 100 would have grown to 4,011.

Now, after two market crashes, scary levels of volatility and a troubled outlook for the economy, the appeal of equities has waned and private investors no longer trust equity markets as once they did.However, after very substantial reductions in equity exposure by pension funds and institutions as well as retail investors, we have come to a critical test-point.

Ten-year gilt yields are about 0.2 per cent below the dividend yield on UK equities, a pattern that, as Citigroup UK economist Michael Saunders reminds us, was briefly seen in early 2009 but previously had not occurred for about 50 years. Saunders said: "Over time the growth of corporate profits and dividends tends to roughly track nominal GDP growth. Hence with similar yields on gilts and equities, plus the prospect that dividends and profits will show future growth, returns from equities (and other assets for which returns are linked to nominal GDP growth over the medium term) are likely to greatly exceed returns from gilts over time."

With this in mind, I am considering an equity income vehicle that seems to offer a spread of risk across the larger company universe and with low entry and management charges. I am grateful to independent financial adviser Tom Munro for drawing my attention to a vehicle called the iShares FTSE UK Dividend Plus. This is an exchange traded fund (ETF) that aims to track the performance of the FTSE UK Dividend Plus Index. This offers exposure to the 50 highest-yielding UK stocks within the FTSE 350, excluding investment trusts.

These iShares ETFs are managed by BlackRock. They are transparent, cost-efficient, liquid vehicles that trade on stock exchanges like normal securities. Their total expense ratio is 0.4 per cent and they are free of entry or exit charges and performance fees. The shares in this 314 million fund - which is Isa and Sipp compatible - are selected and weighted on the basis of the one-year forecast dividend yield. The distribution yield is currently 4.4 per cent, with quarterly distribution. The biggest holdings include Man Group, Resolution, National Grid, R&SA, BT, Scottish & Southern Energy and Catlin. As to performance, the fund closely matches the FTSE UK Dividend Plus Index, which is up 11.3 per cent over one year. It will not exactly set the world on fire, but provides investors with a low-cost exposure to an investment vehicle that efficiently captures the yield attractions that equities currently offer.