A reader, C.H., writes in with an ETF query:

“Is it cost-effective to invest long-term in Exchange Traded Funds (ETFs)?”

C.H. explains he has decided upon a passive investing strategy but is dismayed by the feeble choice of index funds in the UK.

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:

1. Get the best deal.
2. Invest the largest sum you can per trade.
3. Minimise the number of trades you make.
4. Or avoid ETFs like a cost-riddled plague.

Let’s look at each strategy for low cost ETF investing in turn.

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 (%)
150	1.50	1
300	1.50	0.5
600	1.50	0.25

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 drip-feeding
Less rebalancing
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,

The Accumulator

My weekly reflection, plus the week’s top links.

Quick! Sell any shares you were foolish enough to buy, hoard gold and government bonds, and avoid paying taxes because Government quangos will only flush your money down the toilet while singing Don’t Cry for Me Argentina.

Heck, if you can’t beat them, join them.

At the start of the year I wrote Britain was booming – a slightly hyperbolic title I admit, but also a deliberately provocative one that turned out to be right. Back then, nobody had anything good to say about the UK economy, and the spectacular rise in share prices in the months prior was blamed on cheap money.

It’s been the same story all year here, in Europe, and in the US, as I’ve chronicled on my Stock Tickle blog (now on hiatus, due to time constraints).

Yet people far prefer to read doom and gloom disaster stories from people who sound wise by not sounding happy.

As I’ve written before, the bear case always sounds smarter. Writers – particularly bloggers and newspaper columnists – can’t tell us enough how the US recovery is a limp-wristed thing that will end in President Obama selling California to the Chinese to make interest payments on the US deficit.

Yet in reality, this is actually on some measures the strongest US recovery for 25 years, as the FT reports:

The current US economic recovery is widely perceived as the weakest ever, syncing with the popular idea of a “new-normal” economy. Although this recovery is not as strong as those of the 1970s, on many metrics its first year anniversary has proven stronger than either of the last two recoveries during the previous 25 years.

Despite a significant slowdown in the second quarter of this year, real GDP growth in the first year of this recovery was 3 per cent compared with first year recovery gains of only 2.6 per cent in 1991 and 1.9 per cent in 2001. Persistent private job creation took 12 months once the recession ended in the early 1990s and it took 21 months after the 2001 recession.

This recovery began producing persistent private job gains only six months after the recession ended. Moreover, in the first 14 months of this recovery, 205,000 jobs have been lost. While this is surely disappointing, it compares with 220,000 and 935,000 cumulative job losses respectively at this point in the 1991 and 2001 recoveries.

Obviously if you’ve not got a job or you fear losing the one you have, things are terrible. But that’s always the case – not just at the end of recessions. Besides, as I’ve stressed many times, unemployment is a lagging indicator.

I’m not blind to the problems. The US house market crash has led to permanent wealth destruction, and we still look overdue a proper correction in the UK. (I rent, but hedge my bets with Lloyds shares). The US is still growing, but more QE is mooted in the US because inflation remains stubbornly low. I’ve been wrong about government bonds all year for the same reason.

Consumer confidence also remains miserable – not surprising perhaps, given the torrent of bad news hurled at them daily through the press and on the Internet.

In reality though, investors make money when they buy companies at cheap prices that go on to do well, not when some bloke in the pub thinks China is a friend not an enemy, or when his sister feels happy enough to buy a buy-to-let property in Torremolinos again.

And corporate profits have been soaring as the global economy has continued to expand. S&P 500 company profits will  be up about 45% in 2010, and are forecast to rise 15% next year.

Companies are so financially sound – and debt is so cheap, due to low interest rates and perma-bearish investors preferring to buy Microsoft bonds with the lowest yields on record, instead of its cheaply rated stock – that they’ve begun to snap each other up like ladies who lunch buying Jimmy Choo’s back in the boom.

None of this puts shares in the bargain basement; on a P/E basis they look good value, but on a capital cost replacement they look a bit expensive.

The time to really snag bargains was last March, at the height of the bearmania. Unfortunately for those who followed the gloomy consensus, such opportunities come once a decade at best.

[continue reading…]

I was asked by one of my fellow financial bloggers if I could remember my first time.

“I remember it well, but it’s none of your business!” I said, after the dreamy music and the flashback sequence was over.

Then he clarified that he meant my first time investing.

So I punched him. Sex is one thing, but a man’s first time contemplating the luscious beauty of compound interest? That’s a private matter.

I’m joking, of course – though I’m sure I’m not alone in having found both of my first times somewhat nerve-racking.

In each case I thought I knew what to expect, and in different ways I couldn’t have been more wrong. I’d done a lot of reading beforehand (and looked at a lot of pictures – graphs, I mean!) but both experiences still seemed pretty surreal.

I think it was partly the sense of passing over some threshold.

Yet equally, maybe it was the sense of anti-climax – the realization that this was just the first step on the journey of a lifetime.

Be gentle with me

It’s no easy thing to take cash worth 25% of your good but unspectacular annual income – money you’ve saved the hard way, by not doing all of the fun things your friends have been telling you about for years – and to move it into the stock market.

By 2003, I’d amassed around twice my gross annual income by saving for half a decade or so, and I was ready to redeploy much of it from cash into shares.

Luckily, as teenage advice columns stress about losing your virginity and I’d urge when it comes to starting investing, I choose sensibly and with a time horizon longer than the day after tomorrow.

No wild punts on a tech tiddler for me! I’m pleased to say my first investment was a lump sum purchase of a UK index tracker fund, provided by Legal and General.

Yes, like those faithful teenage sweethearts who promise the world to each other in school before their heads are turned the moment out of sight is out of mind in college, my young heart was pure.

Nowadays I hold variously traded shares, investment trusts, ETFs and VCTs alongside my core index holdings. But to start with, I was a pure index investor. Just like the data says we should be.

What was I thinking?

I’ve got a memory like a sieve – but they say you never forget your first time, and it’s true in my case.

Especially because I kept copious trading notes in those days!

Below is my actual entry from August 2003. You’re seeing an investing obsession finally getting turned into real money after two years of reading up on the subject – and long before I imagined I’d ever blog about it.

31/8/03: I think that we are about to see the market tick up again. I think terrorism is priced into the market, that after three years the worst is over, and that now is a good time to invest, particularly for the long term. I can’t keep writing touchwood, so assume that’s a standing thing for this entire log!

I am going to put the bulk of my money for the next few years in trackers looking at various Indices, but very biased to UK All-share (which includes plenty of international exposure). For the ISA, I will take a few more risks and include some Japan and Far East, and maybe a bit of technology.

I accept total tracker strategy may prove flawed, just because it is only one technique. After five years, I may try something different for a year or two as a hedge. Maybe a high yield portfolio, commercial property, buy-to-let or individual shares. I can’t imagine paying for a managed fund though – the stats are too unanimous.

Finally, there are some who think there’s no point in holding trackers outside of UK Index, due to KISS approach, cheaper dealing costs, and indices tending to follow each other over time. I am not sure what I think about this, but it doesn’t seem right (say you’d been in Japan for 20 years?)

On the other hand, diversification also equals exposure to new risk/mediocrity. But I will be so overweight in the UK that I think some spread is desirable.

Well, there you go – I guess I am a born waffle-writer. Hemingway’s position in the canon is secure.

Also, that was just seven years ago, but it feels like a different era. I think perhaps it always does in the stock market – even though it’s never really different from a longer, cyclic perspective.

Steady as she goes

I still hold the L&G tracker fund today. It’s made a reasonable return.

When I bought it the FTSE All-Share index was about 20% lower than today, so I’ve benefited from the rise in the index over time.

But at least as helpful is the fact that it’s an accumulation fund, which means the All-Share’s dividend income has been automatically reinvested (minus some expenses) over the years to buy new units in the fund.

This steady reinvestment of dividends is a modest method of pound-cost averaging. With the UK market a relatively high-yielder – typically delivering 3 to 4% every year in income – after a few years reinvesting dividend income can add up to a substantial component of your returns.

While I’ve kept hold of this fund, I’ve more generally chopped and changed a lot over the past seven years. Unlike new contributor The Accumulator – who is a sworn low-cost index man – I’m a self-confessed dabbler. I don’t recommend it, but I do it.

Perhaps you’re the same. Everyone sets off with a plan – whether it’s to stick with passive funds, to hunt for the best managers of active funds, or even to try to beat the market by timing or buying individual stocks.

But as George Soros has written in a slightly different context, reflexivity is ever present in investing. Your outcome and the market you experience will change you.

• It was easy to have faith in index funds in the late-1990s, for instance, when shares had gone up fairly steadily for nearly two decades.

• Buying tech shares looked a great idea in 1999, right up until it didn’t.

• More recently, many private investors have made fortunes buy backing oil explorers and mining companies. Others have found buying bonds has delivered better returns in recent years then equities, and with lower volatility.

At any one time, some people think they’ve found the route to riches. They’ll write about it, tell you about it, and drive around flaunting the proceeds of it.

But precious few first loves last a lifetime, and nothing lasts forever in the markets.

Ideally, have a plan and stick to it through thick and thin. Alternatively, stay footloose and fancy free, and don’t mistake a short-term infatuation – with small caps, with bonds, with gold, with whatever – for the big one.

Want to hear more investing debuts? Green Panda Treehouse has written about his first time, while Tom of the Canadian Finance Blog reflects that he should have bought a tracker. Or alternatively, why not share your first time investing with us in the comments below?