Passive investing: I hate fees and so should you!
A few days ago, I was discussing passive investing with a couple of neighbors during our annual neighborhood party.
And so we spent time discussing what is probably the most critical topic when it comes to investing:
The fees (or commissions) that are charged by traditional banks for the services they provide.
As it turns out, the amount of fees charged on an investment product is probably the most significant determinant of an investment’s success in the long run.
That’s right.
The level of fees charged to an investment fund may well have a more significant impact on investment performance than the ups and downs of the stock market.
Here is a short story to illustrate that.
Three friends and three outcomes
At age 35, three childhood friends, Olivia, Marie, and Helen decide to get started with investing in the stock market. They each have savings totaling USD 100,000.
As none of them have much experience with investing, they walk down to their respective banks to speak to their relationship manager.
After that, each of them invests their hard-earned savings in the actively managed investment fund recommended by a so-called financial advisor from the bank.
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Fast forward 30 years, and the three friends are now entering retirement. They meet again to celebrate and take this opportunity to compare the performance of their respective investments.
As it turns out, all three investment funds had a similar performance averaging 7% per year. However, when they look at how much they have in their respective bank accounts, the figures look a lot different.
Olivia invested $100,000 growing at 7% per year (minus 3% in annual fees) = $324,340
Marie invested $100,000 growing at 7% per year (minus 2% in annual fees) = $432,194
Helen invested $100,000 growing at 7% per year (minus 1% in annual fees) = $574,349
All other things equal, just because of the difference in fees, Helen ends up with nearly twice as much money as Olivia.
How frustrating.
Just 2% here, only 1% there. It may not sound like much, but at the end of the day, fees have a material impact on investment returns, especially in the long run.
And in addition to management fees, other fees can creep in traditional investment products, such as issuing and redemption fees, transaction fees, safekeeping fees, and currency exchange fees.
This means that a fund with an annual management commission of “only” 1.5% can easily reach total fees of 2.5% each year.
So what are the alternatives for investing in low-cost investment solutions? Well, luckily, we have a couple of options available.
Passive investing option 1 - ETFs
A great way to invest at a low cost is investing in Exchange Traded Funds (ETFs).
An ETF is a type of investment fund that invests in securities traded on the stock market.
The portfolio is constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index.
The S&P 500 is an index of the 500 largest publicly-traded companies in the US, each weighted proportionally to their market value.
So instead of having a portfolio manager buying and selling shares or bonds on behalf of the fund, the portfolio is automatically invested to reflect the composition of the index it is tracking.
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What's great about it
As the investment process is automated, there is no need for an expensive portfolio manager.
This is why indexing, also known as passive investing, results in much lower management fees, usually ranging from 0.02% to 0.60%.
To invest in an ETF, you need a brokerage account, which you can open with a low-cost online stock broker such as Interactive Brokers or DeGiro.
What's NOT so great about it
There are also a few downsides, though.
The first one is selecting the right ETF(s). There are thousands of different ETFs, and you pretty much have to figure out by yourself which one to choose.
Also, every time you want to invest, you have to log in to your brokerage account to place a trade. This means that you can’t invest automatically on a monthly or quarterly basis.
This is an issue because if you have to place a trade every time manually, chances are you won’t do it consistently, or you won’t do it at all.
Another problem with investing in ETFs is that you have to pay transaction fees every time you invest new money into them.
So what should you do?
Fortunately, there is an answer to these headaches: robo-advisors. These are online investment platforms that automatically invest on your behalf in a basket of ETFs using an algorithm.
They tackle many of the issues of investing directly in ETFs. So much so, that I am preparing a review of the robo-advisors out there. So have a little patience and watch your mailbox!
Passive investing option 2 - index funds
Index funds are very popular in the US and are a lot similar to ETFs in that their portfolio is designed to track a specific index.
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What's great about it
As with ETFs, the management fees for index funds are low and typically range from 0.02% to 1.00%.
Unlike ETFs, though, index funds require a minimum upfront investment. For private investors, the minimum can be anything upwards of USD 2,000.
But once you have invested the initial minimum amount, you are free to add smaller amounts to that investment anytime you want. And you can do it without any transaction costs.
You may also be able to automate your contribution. For example, you could set an automatic monthly transfer from your salary account into your investment account.
This sounds great, right? Yes, but there is a catch for us Europeans.
What's NOT so great about it
The catch is that here in Europe, there are few alternatives available for investing in index funds.
Although more and more local financial institutions have started offering index funds, many only provide them to institutional investors or very wealthy people.
And when a local financial institution gives you access to them, they typically would charge you transaction fees, issuing fee (= entry fee), and redemption fees (= exit fees).
It’s almost like all these fees defeat the very purpose of investing in index funds!
And most of the time, you cannot automate payments.
An alternative could be to open an account in the US, with a low-cost online investment platform such as Vanguard with many index funds on offer.
But assuming they would accept someone based in Europe, you would have to transfer your money from Europe to your US investment account.
And this would likely translate into international transfer fees, which is less than ideal.
So how best to minimize fees when investing?
Yes, I believe the best way to get started with low-cost passive investing is through robo-advisors.
This is why I am reviewing the robo-advisors out there and will share my findings (including how they dramatically reduce the investment fees) in a future blog post!
(Update: an article on robo-advisors is now available: ‘How to Start Investing with Online Robo Advisory Platforms‘ )
