There’s been a recount, and it turns out there are three certainties in life: death, taxes, and fees for investing. Let’s see what we can do to reduce our investment costs as far as humanly possible.
Here’s the hypothetical scenario. We’ve got £1,000,000 in our ISA. [Hey, this is a Finumus-branded article – Ed.]
And we want to create a 100% global equity portfolio as cheaply as we can.
We obviously don’t believe in active management, stock picking, factor tilts, home bias, or any of the other nonsense.
We just want to get pure, market cap-weighted, global equity beta at the lowest possible cost.
What broker / platform are we going to use?
Of course, we’re first going to consult the excellent Monevator broker comparison table.
With £1m to invest, we will want a fixed / capped cost broker. (As opposed to paying a fixed percentage on all that lolly.)
I’ve decided we’re going to use Exchange Traded Funds (ETFs), rather than funds (or Unit Trusts as we used to call them). That’s because many platforms charge extra fees for holding funds, but not for shares. And ETFs – despite their name – count as shares, not funds.
Moreover I’m more comfortable with ETFs than I am with funds, just because of my own biases.
Let’s plump for iWeb. There’s no annual fees to pay, it’s only £5 a trade, and it’s owned by the sizeable Halifax, which is owned by HBOS, which is owned by Lloyds. (iWeb doesn’t charge extra fees for holding funds. Not that it will matter to us with our ETFs.)
Furthermore we’ll need our ETFs to be traded on the London Stock Exchange (to start with) and have a GBP share class (trading currency).
Let the investment costs crunch begin
If you pull up JustETF and apply a few filters, you will see that the cheapest all-in-one world equity ETF is the Amundi Prime Global UCITS ETF DR (D). (Ticker: PRIW.L).
This will be our ‘straw-person’ to benchmark against:
Now, we could stop right there to be honest. With this fund and its tiny Total Expense Ratio (TER), we’d likely outperform 95% of all other investors already.
|– All-in-one ETF
– Very low investment costs
|– No emerging markets
– No small cap stocks
– Suffers US dividend tax
Do any of those cons matter? If you’re investing a small amount, the answer is no.
Go out and enjoy the sunshine. Take your umbrella, just in case.
What about the emerging markets?
It may come as a surprise – especially to those who live there – that poor countries, according to the financial markets, are not considered to be in ‘The World’.
To City professionals, ‘The World’ only includes rich countries (developed markets, or DM). It does not include poor countries (emerging markets, or EM), or even poorer countries (frontier markets, FM).
It is only the ‘All World’ label that includes EM (but still not FM).
The ‘W’ in the ticker PRIW denotes the World, not All-World. We’re therefore missing out on emerging markets.
Sometimes you’ll see descriptions like ‘All Country World Investable Market (ACWI)’ to signify the inclusion of EM.
Does this matter? Not really. EM is only about 10% of global market capitalization. In truth we could just ignore it.
One would like to think that poorer countries have higher economic growth rates that feed into improved stock market returns. But the evidence for this is scant. Rather, so far they’ve had periods when they did really well (1980s /1990s) and really badly (2000 onwards,) compared to DM.
The best way to think about EM is probably that there are idiosyncratic risks (such as wars and coups) for which one ought to be compensated with some sort of risk premium. Theoretically.
Adding in EM
You say you want a bit of coup and war exposure? Well, the cheapest All-World ETF is 20bps:
That seems like an expensive way of adding a 10% EM allocation.
But what if we stuck with mostly PRIW and did the EM allocation ourselves? Just ETF throws up a few options around the 15 bps mark, including:
Holy Saint Scrooge! We’ve saved ourselves £1,400 by doing our own EM allocation.
Do we need small caps?
We could make a similar argument about small caps. (Though usually the only coups here are in the boardroom.) Do you really need them?
The thing about small caps is that, well, their market capitalization is small.
Again, you’d like to think that small companies grow up to be big ones. Whereas larger companies as a class have nowhere to go but down. Small caps should therefore make a better investment than large caps. And in fact in Fama-French’s famous Three Factor Model there is very much a size premium. Albeit one that once widely publicized in the early 1990s promptly disappeared.
Small caps are a lot more expensive to deal with, too. And we can only easily get DM ones.
But if we must?
Was it worth increasing our costs by 50% just to include a 10% allocation to small caps?
What about emerging markets small caps?
Seriously, you are kidding me, right?
Personally I would argue the marginal diversification benefits of including both EM and small caps only truly matter once you’re investing really substantial sums.
Distributions: sneaky platform FX charges
PRIW is a ‘Distributing’ ETF. This means it distributes its dividends to you, rather than retaining them for re-investment (‘Accumulation’). See our previous deep dive on the difference.
The problem here is that PRIW’s distributions are in US Dollars (USD). And most platforms only allow you to hold Pound Sterling (GBP) as cash. (In ISAs you’re not allowed anything else).
So when the USD dividend comes in from the ETF, your ISA platform is going to convert it from USD to GBP for your convenience. Most platforms charge an FX fee of ~1% to do this.
(Although who knows what actual rate you’re getting? I’m sure they would not specifically use an FX broker that charged an egregious spread and kicked back some of their internalization profits to the platform. Because this is not the sort of behavior you ever see in financial markets. Ever.)
Now 1% of the dividend yield sure doesn’t sound like much, does it?
Adding in the currency conversion cost is like increasing our TER from 5 to 6.8 bps.
That’s a 36% increase in costs! WTF?
What we’d really like is an accumulating version of this ETF. Luckily, Amundi actually has one…
But it doesn’t have it as a GBP share class.
Dividend withholding tax
PRIW has 63% of its exposure in the US. It’s domiciled in Luxembourg. It will be having 15% of distributions from North American companies withheld at source by the IRS in the US. The dividend yield on US equities is about 2% right now.
- 2% * 63% * 15% * £1,000,000 = £1,890
This represents nearly 19bps of annual investment costs applied to our portfolio. It raises our TER including US Dividend Withholding Tax (or as I like to call it: TERIUSDWHT) to 24bps.
Which isn’t something that ETF providers are keen to draw your attention to, surprisingly.
But can we do anything about this?
We have two options:
- Use swap-based ETFs
- Make use of our SIPP
Avoiding US WHT with swap-based ETFs
As an ETF, you can avoid US Dividend WHT by employing a financial instrument called a swap.
Exactly how they do this is beyond the scope of this post. (As you should be relieved to hear. Because I used to help structure this sort of thing for a living, and I can be a real bore about it).
For now let’s just check by comparing two UK-listed ETFs.
They both track exactly the same US index, have similar TERs, and are both accumulating. The only difference is one (from Invesco) uses a swap and the other (Vanguard) doesn’t.
We’d expect a 2% * 15% = 30 bps annual out-performance from the swap-based one.
What do we see?
The swap one outperforms by about 33bps p.a. after accounting for the fee difference.
Now it would be nice if there was a World ETF that did only the US leg as a swap, and the rest normally. Sadly, there is not. Arguably, if someone came along and created such a thing we could pay 24bps for it to be cost equivalent with Amundi’s PRIW.
There are, however, ETFs that do the whole (developed) world as a swap.
For example, Invesco MSCI World UCITS ETF (MXWS.L). Which has a 19bps TER.
Let’s just run our comparison on returns again, to make sure that what is happening in the swap is to our benefit, not theirs:
Yeap. Looks reasonable.
Notice that 63% (US Weight) * 33 bps (what the US only swap ETF saved) = 21 bps.
The only WHT saving is on the US leg; the swap trick doesn’t work in the other countries.
If you’re investing less than £1m, you could sensibly just go with this. Because we’re about to get complicated and – for smaller amounts of money saved – why bother?
An extra 12bps (19 vs 5) seems like a lot to pay to do some stuff in a swap, especially when a swap is actually cheaper for the ETF provider than either full or sampling replication.
And where is my All-World including small caps done as a swap – or a mix of swap and whatever – for, like 10bps?
There isn’t one.
Swapping that for a DIY jobbie
Can we build one ourselves? Use a swap-based ETF for the US stuff and then other, regional ETFs for the other markets?
In fact could we just add a World-ex-US ETF?
Alas, that would be too easy. There also isn’t one of those.
We’ve also accounted for dividend FX costs for those ETFs which aren’t accumulation units.
A TER of 8bps is pretty good – and that’s also the TERIUSDWHT, because we’ve avoided US WHT.
Notably, it compares well with 24bps, which was where we began with Amundi’s PRIW.
(No, I don’t know why we’re bothering with Canada either.)
Plan B: avoiding US WHT with your SIPP
The US tax authorities recognize UK pensions – including SIPPs – as tax exempt under a tax treaty.
Astonishingly UK platforms also seem to be able to handle this. Such that, if you’ve filled in the right forms and hold US stocks in your SIPP, you’ll receive the dividends tax-free (in the SIPP).
This also applies to US-listed ETFs, like, for example, the BNY Mellon US Large Cap Core Equity ETF (BKLC), which has an expense ratio of 0%.
Yep, you read that right: 0%.
But in a typical piece of joined-up thinking that will surprise nobody, you likely can’t buy this ETF in your SIPP. Why not? Because under the EU’s PRIIPs regulations, unless you are a ‘professional’ or ‘High Net Worth’ investor you can’t buy a fund that doesn’t issue a PRIIPs Key Information Document (KID), which US ETFs don’t.
Now, you might have thought that having left the EU, the removal of this pointless restriction for Brits might be the one tiny silver lining to the Brexit debacle.
Of course not.
You might also think that you’re a professional / HNW investor. And you may well be.
Sorry, most platforms don’t support declaring yourself such as part of their business model. At least in my experience Hargreaves Lansdown, AJ Bell, and Interactive Investor don’t. Others do, but in any case you’re going to want to save more than a few hundred quid for it to be worth the hassle.
But let’s say for a minute that you’ve got enough money to make this a worthwhile exercise, and you’ve somehow extricated yourself from PRIIPs.
We might have our US Equity ETF in our SIPP, and all others in our ISAs. Or else some mix of this arrangement and using a swap-based ETF in the ISA.
Either way it’s a little messy:
On a bright note, we’re truly crushing our investment costs.
And since we’re all about marginal gains here, let’s fix Canada:
Ladies and gentlemen, I give you the world – for 3bps.
You might immediately decide to spend some of those gains on adding back emerging markets and small caps. (This is called the ‘bounceback effect’).
For bonus points, if you were including small caps you might observe that the US makes up about 60% of global cap weight.
In my PRIIPs-free SIPP I could buy the Schwab U.S. Small Cap ETF (Ticker: SCHA) with a 4 bps fee, and then roll-my own regional small caps. But we are getting seriously diminishing benefits here.
The nice thing about having everything in a single ETF like PRIW is you don’t have to worry about rebalancing. Conversely, once we’ve separated everything out we have to do rebalancing ourselves.
But not much. This is because – contrary to what the ‘index investing causes bubbles’ people will tell you – market moves do your rebalancing for you.
If Europe outperforms the US by 10% in a year, then my target Europe weighting will be 10% higher. But the value of my Europe ETF will be 10% higher too. So long as I update my target weights to current market cap weights then no rebalancing is required.
On the other hand if I fix them forever then active rebalancing is required. As does any weighting scheme that is not market-cap weighted.
Distribution units also complicate this somewhat. Over time I’m going to be underweight those and overweight my accumulation units. But we can probably just do one or two trades a year to bring things back into line. Call it £20 of trading costs (and the spread).
Not all platforms carry all ETFs
It’s not clear to me why, but platforms generally don’t carry all London-listed ETFs. Not even the plain vanilla ones.
Indeed as a rule of thumb, once you’ve identified the cheapest ETF for a particular asset class and you log onto your broker to grab a bagful, you’ll find they’ll deny its existence.
Strangely, they’ll be happy to point to the one that costs twice as much. Or they’ll only carry the USD trading currency one.
Whether this is…
- Cock-up: they used the ISIN as the Primary Key in their systems, and so can only support one traded currency listing per underlying ETF.
- Conspiracy: If you buy the USD one, you’ll have to pay them a load of FX fees.
…I’m not sure. In general their excuse is that they only carry ‘the most liquid one’.
High investment costs are optional
Summing up, let’s run through what we’ve learned, Rain Man style:
- We can track global equities for 5 bps p.a. (but add in paying our platform FX fees on distributions, which brings it up to 6.8 bps)
- If we add a small EM allocation ourselves it’s 6 bps. That’s a lot cheaper than using the ‘All-World’ ETF (20 bps)
- US dividend withholding tax is a (19 bps) problem that we can get round:
- It requires us to get a bit messy rolling our own.
- But can save up to 10 bps (without SIPP)
- If you’re not investing a lot of money buy PRIW.L or MXWS.L and go play outside
- The perfect global equity ETF doesn’t exist (in Europe). If it did it would:
- Do US equity exposure as a swap to avoid US dividend WHT
- Have appropriately weighted EM and small cap exposure
- Have an accumulating / GBP traded share class
- Cost about 10 bps, to be competitive with rolling our own
- (Over to you, Blackrock!)
- If you’re only using your SIPP and can avoid PRIIPs, you could just buy Vanguard Total World Stock Index Fund ETF (VT) – which both avoids US WHT and includes EM, for 7 bps.
- If we hyper-optimize using a SIPP and somehow bypass PRIIPS, we can actually get the full global+EM+small-caps down to 7 bps and avoid US WHT
- Some things we didn’t mention:
Finally, it’s worth noting how cheap all this is compared to other investments.
For example, the managing agent for my London buy-to-let charges me what amounts to 1.34% of its capital value per annum. That’s about 20 times more than this fully-diversified global equity portfolio.
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