A reader, C.H., writes in with an ETF query:
“Is it cost-effective to invest long-term in Exchange Traded Funds (ETFs)?”
On the other hand, ETFs continue to spawn like Tribbles, filling every gap in the market from Azerbaijan to Vietnam.
C.H. is tempted to buy ETFs, but he is worried about ETF trading costs eating away his returns, as any investor should be.
The problem stems from the broker’s dealing fee, which takes a bite out of your investment every time you buy or sell an ETF (around £10 for an online trade).
At that price, a £100 per month investment would incur 10% in upfront costs every time – a ruinous penalty that flies in the face of low cost ETF investing.
But there are steps you can take to cut these costs:
- Get the best deal.
- Invest the largest sum you can per trade.
- Minimise the number of trades you make.
- Or avoid ETFs like a cost-riddled plague.
1. Get the best deal for your ETF trades
Cheaper trading means using online brokers. There are tons out there, but the cheapest I’ve found yet for a single trade is X-O.co.uk.
X-O charges £5.95 and no ISA admin fee.
I don’t use X-O personally, but the Motley Fool broker board is a good place to go for word-of-mouth.
£5.95 is cheap, but you can do even better than that. You can slash costs to £1.50 per trade by using a regular investment service.
These services enable you to invest from £20 monthly in any ETF you like. The cost is low because you’ll trade on a set day that enables the broker to bundle up many small trades into one big trade.
- Check out Interactive Investor’s portfolio builder – it doesn’t charge ISA admin fees and you can reinvest dividends automatically.
I use TD Waterhouse’s regular investment ISA. Again, ISA admin cost is zilch, but the dividend reinvestment fees are cheaper than Interactive Investor for my portfolio size.
Both service providers allow you to skip some monthly contributions. You can also change which ETF you plan to buy at any time. Each service has its own little wrinkles, so it’s worth investigating both to get the best fit.
Takeaway: Research online brokers to get the cheapest deal.
2. Invest the largest sum you can each time
The larger your trade, the less impact the trading cost makes because it’s a fixed fee.
Think of trading costs as a percentage sliced off the sum invested. The table below shows how increasing your contribution size reduces this percentage loss:
|Sum invested (£)||Trading cost (£)||Sum lost (%)|
Use this charges impact calculator to see how cost-cutting saves you big bucks.
- Scroll down to the investment calculator section to have a play (apologies there’s no direct link).
- The longer you hold the fund, the more you can save by shaving costs.
- Marginal cost reductions make less difference in pure £ terms when the contributions are small.
The calculator helps gauge whether you should bother sweating the difference. I aim for dealing costs of 0.5%.
Smaller costs are even better, while it would sting to pay over 1%.
Takeaway: Only trade when you’ve saved enough to invest to keep the costs down to a reasonable level.
3. Minimise trades
With ETFs, less is more:
Less buying and selling
= more money saved
So save up your money and invest quarterly, semi-annually or annually.
Diversifying your portfolio slowly also helps. If instead of buying four ETFs in a year you buy only two, you instantly halve your trading costs.
The simplest passive investing portfolio contains only two funds – a total domestic stock market fund and total domestic bond market fund.
That’s a decent starting point for a small investor getting into low cost ETF investing. You can build up your position from that base, expanding into other assets at a later date.
You can also rebalance with new money to further cut costs, particularly in the early days of your portfolio.
Most rebalancing advice recommends you sell a portion of your outperforming funds and spend the money raised on topping up the laggards. But you can avoid the selling costs by instead moving back to your target allocations using just new contributions.
Later, when your portfolio is much larger than the new money you’re trickling in, you’ll probably need to reconsider selling holdings when you rebalance. But by then the frictional cost of trading these larger sums will be much diminished.
It also helps to restrict rebalancing to an annual event. Even then, you might only alter allocations when they have swung by more than 10% from target.
Don’t get too hung up on precise rebalancing. Rebalancing techniques are legion, but the evidence suggests that choosing any particular strategy makes marginal difference. The important thing is that you do it at all, so simply plump for a system that suits your style and needs.
Takeaway: Emphasise the ‘passive’ in passive investing.
4. Avoid ETFs altogether where possible
Do you really need ETFs, even though the stingy choice of UK index funds would embarrass a North Korean greengrocer?
Index funds are generally free of trading costs and the cheapest compare very favorably with ETF Total Expense Ratios (TERs).
The two-fund solution mentioned above can be done with UK index funds. And you can diversify some distance further before resorting to ETFs, too.
Track down index funds using this fund screener provided by the Investment Management Association (IMA). It’s the only fund screener I know of that sports an index fund filter. Just tick the tracker box.
Note, the IMA doesn’t list the super-cheap Vanguard index funds – that’s a whole new kettle of complicated fish that I’ll deal with another day.
You can compare index funds versus low cost ETFs by using a fund cost comparison calculator (scroll down to the investment section).
Treat the dealing cost as an initial charge. The TER goes in annual charge.
Takeaway: Only use ETFs where a viable index fund alternative does not exist.
Personally, I do employ ETFs as a long-term investment, but only to cover a few niche sectors. Index funds are simpler to handle and generally cheaper. If only there were more of them!
Take it steady,