Not all the CATs get the cream

As we approach the first birthday of the Individual Savings Account (ISA) it's worth remembering that the centre-piece of the ISA legislation was meant to be the Government's "CAT mark" scheme. This stands for Cost, Access and Terms, a Government stamp of approval for low-cost ISAs that represent "value for money".

As we approach the first birthday of the Individual Savings Account (ISA) it's worth remembering that the centre-piece of the ISA legislation was meant to be the Government's "CAT mark" scheme. This stands for Cost, Access and Terms, a Government stamp of approval for low-cost ISAs that represent "value for money".

Sounds a great idea, but the table on this page reveals that the formula used for assessing a fund's charges and awarding it a CAT mark isfundamentally flawed. Some of the cheapest ISAs are not getting the accolade of a CAT mark though they offer better value than many CAT-marked rivals.

ISA funds take charges in four ways. First there's the initial charge which is mainly used to pay commission to advisers: these can be as high as 5.25 per cent. CAT mark funds must have a nil charge.

Second, there is an annual management charge to pay the investment manager to run the portfolio. Annual charges range from 0.3 per cent to 1.75 per cent but CAT mark funds are capped at 1 per cent.

Third, there is usually a difference between the price you buy the fund at and the price you get when you sell. This difference is called the "spread". Although a fund's initial charge is usually contained within the spread, the spread is often higher and therefore a cost you will incur when you decide to cash in your ISA. To receive a CAT mark a fund must have no spread.

Finally, many funds have hidden additional costs which cover audit fees.

So, how can investors assess the overall impact of these charges on their investment? The answer is a simple formula, used by the investment industry and called reduction in yield. RIY takes account of all of the costs - initial, annual, spread and "other" - over a 10- year period and annualises this to show the typical erosion of your annual return. It is a sensible measure for looking at the way charges will effect yourreturn on a long-term investment scheme such as an ISA.

Our table shows the ISA funds with the lowest reduction in yields. It also reveals that the four cheapest ISAs (M&G Index Tracker, Alliance Trust, Second Alliance Trust and Anglo & Overseas) fail to receive a CAT mark though their total costs are a fraction of the much more expensive, but CAT- marked Virgin UK Index fund.

The problem stems from the odd requirement of CAT mark funds to have no spread. This is daft, because all investments incur buying and selling costs such as brokerage and stamp duty. If a fund doesn't have a bid-offer spread it means costs are being hiked elsewhere to subsidise it. And no investment trust share can qualify for a CAT mark, because all shares traded on the Stock Exchange have bid/offer spreads.

Nil buying and selling costs may sound great but are useful only if you intend to hold the investment for a short period. This clashes with the point of ISAs which are meant to be long-term savings vehicles.

What really matters is the overall impact of charges during the period you are likely to invest in the scheme and, in this context, low annual charges are going to be the most important consideration. It seems amazing that the non-CAT mark M&G Index Tracker has an annual charge of just 0.3 per cent and the CAT mark Virgin UK Index Tracking fund is three times as expensive at 1 per cent. But they are index trackers, that mimic movements in the stock market.

The other problem with the CAT marks is that one set of criteria is used to assess very different types of investments with wildly different costs. For example, an index tracker fund has very low operating costs because it just replicates the general ups and downs of the stock market by buying a collection of shares which represent the current composition of the index. Because there is no "judgement" required about which shares look attractive, trackers do not need research teams nor is there much buying and selling activity.

Funds investing in corporate bonds also have low running costs. In contrast, actively managed funds require teams of managers, researchers and economists.It is very difficult for an actively managed fund to operate within a 1 per cent annual fee but this is a high price for a tracker or a bond fund.

The "one suit for all sizes" approach means good value-for-money active funds don't qualify while some expensive trackers and bond funds do. CAT marks will be a fair and useful measurement of "value for money" only when the criteria compare like with like.

Until the Government fine- tunes CAT marks, the badge of approval can't be trusted for accuracy and the boasts of fund groups that their fund is "CAT marked" aren't worth a thing.

Jason Hollands is deputy managing director of BEST Investment. Free guide to ISAs is available on0990 112255