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Commissions lower the return potential of a portfolio
A diversified portfolio for a medium risk profile, in the current economic global environment, has a 6% expected yield per year (on average). Thus, commissions or implicit and explicit costs will have a significant impact on the final net return.
The same “magical” positive effect that compound interest has over time on our returns by exponentially multiplying our profitability is seen from the cost side to have a perversely negative effect and to exponentially multiply return erosion.
Worst of all, most investors aren’t aware about the implicit costs that their portfolios have to support. Investment fund management fees are the clearest example: this commission is deduced directly from the net asset value and most times investors don’t know that they might be paying a 2% fixed commission (fixed commission and independent of the returns obtained).
Let’s take a closer look at a very simple example: if an investor invests 10.000 € in a fund that produces an annual 10% gross return, after 20 years and with a 2% management fee the investor will have accumulated a net amount of 46.609 €. Whereas, if a 0.5% management fee was applied instead, the amount accumulated would be significantly higher, 61,416 €; a non-negligible additional amount of almost 15.000 €.
It is very important to have knowledge of our portfolios’ costs and to keep them under control. In fact, it is part of the investors’ pyramid of priorities.
The cost menu is often served in different dishes or formats. To go over these costs we have classified them in three different groups:
1- Implicit costs
2- Explicit charges
3- Other expenses
1- Implicit costs
Investment funds: from 0.5% to 2.5%
Investment funds are commonly used by individual investors, banking institutions and asset managers. The reason why it’s considered one of the main investment vehicles is because it’s generally very well accepted as it allows their sellers to apply succulent commissions that investors hardly ever find out. Usually, conversations are derived on how well the fund has done in the past trying to avoid any explanation about the costs.
These commissions can come as management fees, success fees, subscription fees, refund fees, deposit or custody fees or current expenses (auditing, consulting…). Fortunately, nowadays they have to report the total expense ratio (TER), which is the total expenditure related to our fund’s assets. The TER gives us clearer understandings of the costs that an investor has to withstand. In the case one opts for an investment fund, we highly recommend investors to devote more time in comparing the costs (you might have to support in the future) between the similar funds you are thinking of investing in rather than comparing their past returns that tell us nothing about the future returns. Investment funds have an average TER of more or less 2%, and the lowest are the ones based on fixed income or money. It is common practice that banks are not very explicit when explaining their commissions. Many investors believe banks don’t charge you for putting money in a fund. Usually, banks own 50% of the management fee.
Inbestme never uses investment funds due to their high costs and their limited success in replicating the returns of their benchmark indices.
ETFs: from 0.05% to 0.5%
As with mutual funds, ETFs carry along a management fee without any explicit charge. However, what makes all the difference is that the majority have a passive management which means they have much lower costs. An average cost would be around 0.25%.
Inbestme’s diversified portfolios use only ETFs in order to build efficient, dynamic and low-cost portfolios. We tend to rely on the cheapest ETFs, those that track indexes. Normally, Inbestme doesn’t use complex ETFs as they require a greater management and extra costs.
There could be other implicit or hidden costs inherent in the different players involved in managing a portfolio: mark-ups per transaction, mark-ups between broker and consultants…It becomes very useful to identify all the cost sources in order to quantify the total costs one supports.
2- Explicit costs:
Advisory fee: from 0.75% to 1.5%
This is the commission range you can expect in the event that you hire a financial adviser or a portfolio manager. It should include services like financial advice, financial planning and portfolio management. The exact % is often calculated from the managed assets. Commonly, they incorporate a variable part according to the returns obtained. Renowned adviser or hedge funds usually charge a fixed 2% and variable 20% (referred as 2%’s & 20%’s). Furthermore, portfolio advisers could require a minimum investment that could range from 500.000 to 1.000.000. It is very important to identify if the advisers charge an additional rebate (participation in the commission) of the management entity so that, the total cost of the adviser and the cost/value ratio of his/her management can be correctly evaluated.
Inbestme charges a fixed 0.5% plus a variable 5% according to the returns. The total charge is limited to a 0.99% and the average is typically about a 0.75%. Inbestme’s services don’t include personal financial advice or financial planning. We don’t charge any rebate regarding any fund manager or ETFs. Within this amount Inbestme includes all the transaction costs of the diversified portfolios, which are zero for the customers. We also offer free information to all those customers that want to build their portfolios for free.
Transaction costs: from 0.10% to 0.5%
This is a fixed or variable fee that banks or brokers charge for buying and selling. In this case, there’s usually much more variability between costs: banks typically have very high commissions (that could be conveniently negotiated) and that could make some transactions prohibitive. There are more and more online brokers with very competitive costs. We recommend reading the annual report Barrons. You can see the 2015 report here.
Precisely, Inbestme uses Interactive Brokers (IB) because it has been nominated several times as the best platform. It stands out not only for having by far the most competitive costs, but also because of the guarantees it offers as a custodian and the technology they apply. In our diversified portfolios, customers don’t have to support any transaction costs as they’re included in our management fee. In our customized portfolios these commissions are supported by the client taking advantage of IB’s competitiveness (see here more details about the commissions).
Custody fees: from 0.5% to 1%
Generally, banks charge an additional commission for custody over the client’s values. In many commercial banks, these fees often tend to be prohibitive and depending on the number of assets they might rise to between a 0.5% -1%. However, it’s very variable.
Inbestme (IB) doesn’t charge any custody additional costs.
3- Other expenses:
Transfer fees: fixed 20 € to 35 € or from 0.10% to 0.20%
Banks imposing fees to their customers for any reason has become increasingly frequent. Most of the time, they have fees for transferring money to another bank. Sometimes, they even charge their customers for transferring money to their account, especially in the case of checking accounts. We recommend you check if your bank has these commissions and try to conveniently negotiate their removal.
Inbestme (IB) doesn’t charge their customers to deposit money or to withdrawal money (once a month).
In this field, what we’ve learned from experience is that there are many ways to take money from customers. Among all them: liquidation of dividends, lack of account activity (in IB the minimum is 60$ per year), buying or selling investment funds, being able to rectify an order…and so on and so forth. It’s simply impossible to make a list with all the possibilities.
Finally, if we add up all costs we realize that our portfolios can withstand from 2.5% to 4% per year. This could mean 50% of our gross returns! Our recommendation is to be very careful and ask the financial service you want to hire to make clear all the implicit and explicit commissions that the portfolio will have to support. These high costs over a lifetime of investments can make a real difference in cost: it could suppose the difference between retiring comfortably or simply surviving.
Unfortunately, many traditional financial services are still concerned about their own success and not that of their clients’. With this focus they charge very high costs (often fixed costs) and use a lack of transparency to hide costs that have a significant impact on portfolios.
Fortunately, there are many new services emerging in the world, like Inbestme, where customers are the first priority and transparency is a core value.
If you wish to create a simple but very efficient portfolio in a short time, Inbestme will help you for free to build your first portfolio based on ETFs (the TPCDE).
If you prefer, we can do it for you. In Inbestme our customers can find efficiency, dynamism and transparency. For our diversified portfolios, we only charge a fixed 0.5%. We are totally committed to maximizing our customer’s returns, so we’ve tied the other part of our commissions to your success. Inbestme retains another 5% over the profitability obtained (for example a 5% over a 6% profitability equals a 0.3% extra commission) but always limiting the total fees up to a 0.99% (including transaction costs). To this end, we select, combine and dynamically manage portfolios based on passive ETFs. We declare with complete transparency the portfolio’s implicit costs (charged by the ETF manager) that tend to be on average 0.15%, if they come from American ETFs, and 0.25%, if they have a European origin.
Lower costs mean more net profitability for our customers.