Part of what makes index investing a profitable option for the do-it-yourself investor is the low fees. Since index-tracking products like exchange traded funds (ETFs) and unit trusts (UTs) use a formula-based investment strategy, they cost less to administer. This cost saving is passed on to us.
The South African ETF environment continues to grow, with more ETFs listing every year. One of the greatest outcomes of the growth in the market has been greater availability of similar products at different price points. Since we know we have to deduct the price from the performance to get to our actual investment growth, we are growing more and more price sensitive.
Price sensitivity is a great first step to maximising our finances, but it’s not the full picture. In this post we are going to discuss three “fees” that eat away at our wealth, even though you will never find them in a fact sheet or on a statement.
If it weren’t for inflation, investing would be unnecessary. Inflation is when the price of goods and services go up over a period of time due to a range of economic factors. If prices always stayed the same, cash savings would have been enough to cover our expenses in the future. A lump sum of money sitting in a bank account stays the same (or increases by the interest rate) every year, so it doesn’t seem like we’re getting poorer. However, over time the number of items we can buy with that amount of money decreases.
We have a level of control over our personal inflation. You might switch to a cheaper brand of toothpaste to keep your grocery budget the same two years in a row.
Aside from keeping a close eye on your monthly spending, inflation is an unstoppable force. Unfortunately it’s a force that we tend to forget about, because the bank doesn’t indicate your inflation-adjusted balance on your statement. Secondly, inflation numbers are usually reported for the year, and not compounded.
If you had to invest an amount of money in cash for a period of two years, what your money can actually buy you is:
Year one: The money you put in, minus the first year’s inflation.
Year two: The money you put in, minus the first year’s inflation, minus the second year’s inflation.
For your wealth to grow, your ETFs need to grow above the compounded inflation rate from when you made your first investment.
Total expense ratio (TER)
Most of us keep this cost in mind when we select our ETFs, but then forget about it. This fee is the cost of administering your investment product and is declared on the minimum disclosure document (MDD) that ETF issuers are legally required to publish.
The TER gets deducted from your dividends before they are paid out to you, but you will never see the payment go off your account or declared as a line item in a statement. For that reason we tend to forget it exists. It’s also worth noting that the TER disclosed in the MDD is for the preceding period, it’s not a quote for any investments going forward. It’s important to regularly check the MDDs of ETFs you hold to ensure that you are still paying what you thought you would.
In this video, Nerina Visser explains exactly how the TER is calculated.
If you had to buy an ETF and sell it right away, you would immediately lose money. That happens for two reasons. The first is brokerage—the transaction fee you pay in order to buy and sell shares. The second is spread. There is a difference between the price you pay and price you receive when you sell. In the case of ETFs, a market maker determines both the buy and sell price. That little amount that makes up the difference is how the market maker makes money. It’s a cost to you.
Spread is a tricky one to understand, because if you don’t sell right away it seems not to affect you. However, those few cents of every share that the market maker takes would have been yours had there been no market maker, even when you sell later. If you only sell a few shares, it might not seem like a big deal, but the more units you hold, the bigger that amount.
When buying and selling ETF units, in addition to the TER, it’s worth paying attention to what the ETF units cost and what they are selling for to work out what the market maker is costing.
Remember, your true return is your overall return for the period, minus inflation, your TER and the spread.
At Just One Lap, we are big fans of passive investment using ETFs. In this weekly blog, we discuss ETFs on the local market and the factors you need to consider when choosing an ETF. If you have wondered how one ETF differs from another, this is where you can find out. We explain which index each ETF tracks, what type of portfolio could benefit from holding each ETF, and how the costs will affect your bottom line.