Implementing An Investment Strategy:
The Importance Of Fees
In part 1 we selected a portfolio of 60% global stocks and 40% global bonds. Obviously, you might decide to change the ratios, add other asset classes or opt for funds with an ethical bias, for example.
My backtests are using real data from ETFs, so any fund fees are already included. A typical advisor asks for another 1-2% annually. And I’ve seen worse. I’ve also noticed that they often pick funds with higher fees. You think 1% is not a lot? Have a look at our example below!
Annual returns (CAGR) for our backtest drop from 5.6% with no extra management fees, to 2.5% with 1% annual fees paid on a monthly basis, to approximately 0% with 2% annual fees. Ouch! How is that possible? Fees also compound over time.
If you read my recommendation, Global Asset Allocation, the author’s main conclusion is also that the exact asset fix matters little over longer periods of time, but fees have a devastating effect. You can consider the time you dedicate to learning DIY basic investing skills as an extremely lucrative job.
Eliminating ETF Fees:
ETFs typically charge fees that are deducted from the price of the security. In other words, the ETF price will reflect the index it is tracking minus the fees. The so-called total expense ratio or TER is the sum of all the fees charged by the ETF managers annually.
Tracking an index can be almost fully automated, driving down management costs. The last years have seen brutal competition between ETF providers, dramatically reducing TERs. The ETFs in our examples have the following TERs:
For our global 60/40 portfolio we get a combined TER of 0.08%. And some ETF providers have even started rolling out 0% TER products. For a comprehensive list of available ETFs, have a look at the ETF Database screener.
Eliminating ETF fees:
Tracking Difference & Liquidity
Entirely focusing on the TER is not enough, as there might be hidden fees. The so-called tracking difference reflects how accurately the ETF follows the underlying index. We want low and stable numbers. You can look up tracking error here.
Another potential issue is liquidity. For less popular ETFs, the difference between the bid and ask prices, often referred to as the bid ask spread, can be significant. So when you have to buy or sell a position you will end up paying more because of market dynamics.
For the majority of small investors like us liquidity can be addressed simply by sticking to the larger ETFs for their respective asset class. For our global 60/40 portfolio, VT had at the time of writing 12.5 billion $ in assets. That’s fine. The tracking error over the last 5 years is -0.23% annually. Not great, but OK.
BNDW however only had 225 million $ in assets. A better alternative would be, for example, to replace the bond allocation (AGG and BNDW) with BNDX, a global bond market ETF with 24 billion $ in assets. The TER is 0.09% and the tracking difference 0% over the last 3 years.
Taxes And Other
I won’t go into much detail on this topic as the situation varies a lot from country to country. You will have to dedicate at least a few hours to research the best solution for your particular situation. Let’s just say that optimizing taxation issues is also crucial.
ETFs are domiciled in a specific country, like the USA for our example. Distributions (cash payments such as dividends, etc) are subject to US withholding taxes. Because of EU regulations, European investors have to buy EU-domiciled funds instead, so-called UCITS ETFs. Good news, these ETFs are also usually more tax-efficient for EU residents.
Many countries also encourage savers with some form of tax-advantaged formula, usually coming with its own set of rules and regulations. Again, it’s worth investigating these options.
Portfolio Rebalancing Frequency
Rebalancing is the process of readjusting the portfolio contents to match the initial asset allocation. Asset prices move over time, so once in a while you have to sell or buy shares of the individual ETFs. But how often?
In our global 60/40 portfolio we have so far used monthly rebalancing. But much even rebalancing just once a year is absolutely fine for most.
The annual returns are barely affected, with annual returns at 5.6% in either case. This is in line with most studies. Plus every transaction is likely to incur fees and others costs not accounted for in this model. Another aspect worth investigating is the effect of rebalancing frequency on your specific tax situation. But for most, once a year will be fine.
Buying And Selling ETFs:
Now comes the final stage: finding a broker to buy and sell our ETF shares. Many banks offer brokerage services, often with ridiculously high fees. Traditional brokers often offer “advice” and their own stock picks, which are little most than disguised marketing efforts. My advice: run!
Fortunately, no-frills discount brokers have started to challenge the established players, which in turn have begun lowering their fees too. The result? Accounts with no trading fees, and no monthly account fees.
Nevertheless, there is a catch. A little technicality called routing refers to the way a broker treats your buy and sell orders. Long story short, a broker can do this in the most efficient manner possible for you, the client. Or in way that may slightly benefit the broker. This is unlikely to much affect the performance of your portfolio, but something you should be aware of.
For US Clients
A discount broker should have little to no trading commissions and account fees. US customers have a lot of choice. Here are my picks:
- Interactive Brokers LITE. No commissions, no fees, and most importantly an excellent routing engine. US customers can get a debit card linked to the broker account too.
- Charles Schwab. Also no commissions and no fees if you use the online platform. A great all-in-one solution for world travelers when linked to the no ATM and no foreign currency fees checking account.
- Robinhood. A simple app, and again no commissions and no fees. There are plans to make the platform available to Australian residents soon.
Discount Brokers In Europe and Worldwide
Sadly there is less choice outside of the US, but things are changing.
- Interactive Brokers LITE. No commissions, no fees, and the same efficient routing. Available in most countries, this will be the best choice for most international customers stuck will greedy local banks.
- Degiro. A discount broker for European clients. No account fees, free trades on selected ETFs and otherwise very reasonable commissions. The exact pricing depends on the country of residency.
The market for discount brokers is likely to change a lot over the next years. This might be a good option too in a near future:
Going In, Gradually
Most brokers have online tutorials. Some like Interactive Brokers even have a paper trading account to give you some practice before investing real money. Either way, you will have to spend a few hours familiarizing yourself with the interface.
Then things can get real. You may start investing your hard-earned cash! A good recommendation is to do so gradually. If you go in all at once, you could initially be unlucky (or lucky). Maybe the big drawdown is just around the corner. Or the other way around.
So-called averaging, investing smaller sums regularly, reduces that luck factor. And also gives you the chance to accumulate real-world experience investing. You might be surprised at how you react to the ups and downs of your investments.
Keys Considerations For Implementing An Asset Allocation
The road to implementing your portfolio should look like this:
- Figure out your tax situation. Probably the most complex part. Are there any tax-sheltered accounts available in your country? Which ETFs or funds are the most efficient?
- Find suitable low-cost ETFs. Low TERs, good liquidity and limited tracking difference.
- Determine the rebalancing frequency. Once a year should be fine. But this can be affected by taxation issues.
- Find a discount broker. Open an account, learn how the app or platform works.
- Average in. Gradually move funds to your strategy.
In total, you can learn the basics of investing in less than 20 hours. That’s right! Basic terminology, simple asset allocations, tax optimization and how to use the broker platform. After that you can move on. Yearly rebalancing can be done in a few minutes!
And what happens during a crisis? Let’s have a look in part 3.
Something is not clear? Any questions? Get in touch in the comments below or use the contact form.