Keeping ETF trading costs low, Part I
Letter from the President
Our minimum accounts are valued at US$500,000 (MXN6,650,000), but additional investments can be of any size. Often our clients want to invest small amounts—say, of US$20,000 or less. Perhaps the market is down and we’re been urging them to bring in excess cash to buy on the dip. Or perhaps we’ve designed and are executing a financial plan for them that sweeps excess cash out of their cash accounts and puts it into the market. Transaction costs on these small investments can be onerous in percentage terms. To generate return, it’s crucial to minimize them. This blog entry is the first in a series presenting tricks for doing so.
Some background facts
Recall that we take long positions only in our client portfolios and buy mostly international ETFs and sovereign bonds.
We define a portfolio as a chunk of capital invested under a single strategy to follow a single mandate—a set of investment objectives and restrictions that drive the investment strategy and the benchmark against which our management performance will be measured. If we manage 10 million pesos for you, and your investment horizon for one of those millions is a single year and for the remaining nine is five years, you have not two portfolios but one, each with its own mandate.
In most of the brokerage houses we work with in the USA, trading commissions are fixed fees charged on each trade, regardless of its volume or monetary value.
Scenario 1: Buying on a dip at a U.S. online brokerage house with a flat fee
A savvy client notices that the market is down and calls us to say she has US$20,000 in excess cash to buy on the dip. She’s at a brokerage house in the USA that normally charges $9.99/trade. We manage three different portfolios for her under three different mandates. This US$20,000 needs to spread across eight ETFs in the target portfolio, all of which trade heavily on the NYSE. Even with the ongoing volatility, for these ETFs, liquidity is high. However, if we spread her across eight ETFs and she’s paying $9.99/trade, her average trade is valued at $2,500. $9.99 is a steep 0.4% of $2,500. How can we bring that cost down?
Three alternative solutions
If we expect the market to bounce in the short term, we can buy in in two stages. Stage one is speculative: First we put the entire $20,000 into an all-country equity ETF. We want an all-world fund so that the bounce, when it occurs, is high; the spattering of emerging market holdings in this fund will help achieve this.
Then we wait for the bounce. How long? Long enough to earn enough of an excess return over the entire portfolio’s bounce to pay for the US$100 in transaction fees incurred in the whole operation, plus the short-term capital gains tax. For an investor in the 35% tax bracket, the minimum required excess bounce is about 0.77%. Once achieved, we proceed to Stage 2: close out our entire position in the all-country stock market and allocate across our portfolio in accordance with its strategy.
For example, suppose the target portfolio bounced 3% from the day we took the speculative position. As long as the speculative position has bounced by 3.77% to about US$ 20,744, we can close it and invest the proceeds across our eight ETFs.
We made US$600 (the same 3% as our target portfolio) plus an excess $144 to cover the capital gains tax and all ten transaction costs: the opening and closing of a speculative position plus the opening of eight long-term positions in the target portfolio.
Our client’s net transaction costs were zero.
Next in the series: Buying on a dip at a Mexican brokerage house
In Mexico, trading fees are generally assessed as a percentage of transaction value and always incur a value added tax. Additionally, for non-Mexican ETFs that list on the International Quotation System (Sistema Internacional de Cotizaciones, or SIC), low dry local liquidity conditions can render transaction costs for small foreign ETF trades prohibitively expensive.
In our next blog entry in this series, I’ll explain how we might handle a scenario similar to Scenario 1 but for a client whose brokerage house is in Mexico.
Previous Letters from the President