The Hidden Costs Draining Your Investment Returns & How To Avoid Them

imagine unlocking a guaranteed boost to your investment returns year after year without taking on any extra risk this may sound too good to be true but in today's video I'll be looking at the world of hidden fees and costs that are silently draining your Investment Portfolio but rest assured I'll also be showing you what you can do to help sidestep these pitfalls and keep your money where it belongs working for you this video is sponsored by Emma sleep the award-winning maker of Premium match mattresses and Sleep Products so why do fees matter in the first place well let's take a very simple scenario which may surprise you let's say that we invest £1,000 and we patiently wait 25 years we don't look at it again and it generates 6% return over that period which is a pretty good return now if that was the case you'd expect 429,000 to be in your account at the end of that period and in total that's a gain of about £330,000 but the day comes you look at your account and you're horrified 9,000 of that gain is missing or to put it in another way a quarter of your gains somehow disappeared but what if I were to tell you that that missing money was due to a fee of just 1% per year now you may be thinking that can't possibly be true How could a 1% fee add up to a loss of quarter of your gains well the problem is that not only do returns compound over time but fees compound as well so for every penny that you're paying in terms of fees that's going to not be compounding for a long period of time 25 years in this case so if you calculate exactly how much you're losing due to that compounding fee it turns out that the longer you leave your money compounding the more the fees eat away at your return so if we think of it in terms of the percentage of your gains which you keep after 1 year you only keep 83% of your gains after 5 years that falls to 82% and so on up to 25 years when you only get to keep about 3/4 of your gains now 1% Allin fee is quite high in today's terms so let's look at it slightly differently instead of that what we'll do is we'll look at what happens if we increase our fees by just 0.1 % at a time what effect will that have on the amount of gains which we get to keep well it turns out that there's a 30 times multiplier over this 25-year period so a. 1% increase in fees results in us not keeping 3% of our gains so you can see that it's really worth obsessing about the fees that we pay and just a. 1% decrease in fees over a long period of time will certainly make a huge difference well 25 years is a long period of time what if we were looking over a decade well it's still over 2% that you'd lose for every. 1% increase in fees so still well worth keeping those fees as low as possible now the two primary fees that you'll pay as an investor the first one would be your fund fees and this is assuming that you get a fund manager to run your Investments for you whether that's a passive fund or an active fund if it's a passive fund you go for usually the fees will be very low nowadays you can get Global Equity exposure with some bonds money market funds for around .1% but you can also pay up to 2% which I think is still reasonable for a passive fund if you go for active funds well you could be paying above 1% for some of them the other primary fee which you'll pay is for your platform this is also called a brokerage but this is where you buy and sell Investments but also keep track of them to how much they're worth today and also this platform will safeguard your Investments and hold them for you now the fee that you pay for that when you're just starting out and you have small amounts invested it's kind of okay to have a percentage fee so for example several platforms have a fee that's as low as 0.15% and if that's the case and you've got £50,000 invested then you'll only pay £75 a year in terms of fees however as the amount of money that you've got scale sces upwards over time as you invest more and as those Investments grow then it switches to being more cost effective to have a flat fee this is a fixed amount that you pay every year regardless of the amount you've got invested now in the UK one of the cheapest fixed fee platforms costs about £140 a year so if you've got £50,000 invested that's a fee of. 29% but notice what happens as we increase the amount of money which we've got invested as a percentage of our overall invested amount that fixed fee Falls such that by the time we reach a million the fee as a percentage is only .1% so what you could do is start off with a percentage platform when you don't have much to invest where the fees a percentage of the invested amount and then as the amount of money you've got grows switch to one of these fixed fee platforms so I'd say overall it's possible to keep your fees at about 2% all in 0.1 maybe 0.15% for your funds and then an additional 05% depending on the amount you've got invested for your platform fee so now let's turn to some of the more subtle hidden fees and these are for the investment platforms and I think the key starting point is transparency so one way to gauge that is to use an incognito browser or a private browser that's so it's got no cookies and it's as if you're looking at the website for the first time time open up their homepage and then work out how many clicks it takes to reach the page about fees the really transparent platforms and the ones which offer you the best value for money tend to be the ones with the least clicks to the fees page ideally it should be on their front page if you find that you have to kind of dig around for that fee information then the chances are that's a red flag and it's not going to be one of the competitive platforms now many of the platforms today are commission free in other words when you buy and sell Investments they won't charge you a fee to do so however that doesn't mean that trading is free far from it and that's because there's a difference between the buying and selling price in any Market the counterparties that you'll be dealing with market makers will always charge you a higher price to buy than to sell that's the bid offer spread between the buying and selling price now some Investments are IL liquid in other words there's a big difference between that buying and selling price the bid offer spread is very wide I got burnt by that recently I made a video about it and one of the stocks that I was trading had a huge bti off a spread and you can see it here so let's say that today I decided to buy this stock and let's say it cost me £238 to do so and then I immediately sold it the price hadn't changed at all but the selling price is192 so I would have immediately made a 19% % loss and every time I cross that bid off a spread I'd lose another 19% how can you avoid that well you can avoid things which are IL liquid which have that big bid offer spread and you can always check on your broker's site to see whether the bid offer spread is large or not most of them will give you that information in the UK you can also look on the London stock exchanges website to see the bti offer spread during the open hours ideally you should stick to stocks where the bid offer spread is tight where there's High liquidity for example if you look at one of the very liquid stocks on the London Stock Exchange this is astroica you can see that the bid offer spread is absolutely tiny in this case it's only 0.2% so if you're trading something like a large ETF any of the large ones would be comparable but another way to avoid the bid offer spread is simply not to trade very often at all personally I tend to buy an investment and hold it for years the Brokers will hate me but I pay them less of this fee another hidden cost is to do with currency so let's take a look at an ETF which is very popular it's very large it's this ishares msci aqu ETF AI just stands for all country World index and this is a global stock index tracker now on the I shares website if you scoot down to the page on the exchanges where this ETF trades you'll see two entries for the London Stock Exchange one of them has ticker ssac and that trades in Sterling the other one has ticker ISAC and that trades in US Dollars on the London Stock Exchange now you might think this is exactly the same index which we're tracking it's the same asset manager surely it shouldn't make much difference which one you buy but it turns out that on many Platforms in order to buy something denominated in dollars you have to convert your Sterling in order to do that and the platform May charge you very high fees so it's usually best to trade in your local currency the reason for that is that the fund manager if you buy it in your local currency will then convert it into whatever currencies it requires to buy the Assets in the fund and they can do that using institutional fees which are much lower than those we pay as retail investors so if you can possibly find a local currency version of your fund that's what you should go for it'll be cheaper in the long run now sometimes people get confused about what the currency of the fund is you can always check because when you go onto your brokerage platform it'll be quoted in that currency alternatively again in the UK what you can do is look at the actual exchange to see what the quoted price is so if I do that for the London Stock Exchange for those two ETFs notice the top one says gbx which is in pennies and the bottom one is in Us doll our video today sponsored by Emma sleep which is a creator of high-end sleeping products that ranges from mattresses to duvet to pillows really anything to do with sleep technology and I've become a bit of a sleeping technology nerd since I've been using their mattress it is incredibly comfortable it's very well sprung so if you do toss and turn at night you're not going to wake up your partner now the product we chose was the emux cooling mattress and that's broken down into layers Each of which has some function now the top layer is the one that regulates temperature and it Wicks away moisture so you don't end up having a sweaty night there's also temperature regulating foam so you don't feel too hot and a layer of Halo memory foam ensures that the shape of the mattress adjusts to your body shape underneath all of that you've got 12 CM aoflex pocket Springs that Ure sure you have breathability and also greater comfort so if you want to try out Ms products for yourself they come with a 200 day risk-free trial that means that you can return it within that 200 day period furthermore if you do decide to keep the product as we did then it comes with a 10-year guarantee now until 5th of July Emma sleep is running its early summer sale and this will provide you with discounts of up to 35% off their products Al also if you use our discount code which you'll find in the description below then you'll get an additional 5% off your orders so to claim that discount simply go to the link in the description below or use our promo code which is pensioncraft now let's turn to the hidden fees for funds now one thing people aren't usually aware of is the domicile of their fund now this is not the same as your domicile the country in which you live it's the legal domicile of the fun so let's say for example that you buy a fund which is domiciled in Ireland many UK ETFs are either domiciled in Ireland or in Luxembourg then the Irish tax treaty with the United States determines the amount of dividends which are withheld by the US government in what's called withholding taxes 15% of any dividends paid on US Stocks will be kept by the US tax Authority in contrast if you go for a fund which is domiciled in Luxembourg the tax treaties there will mean a 30% withholding tax so in this table which you can see beside me this was based on an article from Morning Star they looked at two funds both are managed by the same fund manager UBS they track exactly the same index which is msci world it's a developed Market stock tracker both are distribution funds they pay out an income and both of them have exactly the same fee of 3% and yet you can see that the total return over a 1-year period over a 3-year period over a 5-year period is consistently different the fund which is domiciled in Ireland has a higher return of 22% over one year. 21% over 3 years and 0.13% over 5 years so where's this difference coming from well yes this is the withholding tax and Morning Star does a few sums they show that there's a 15% tax advantage that's 15% in Ireland versus 30% in Luxembourg multiply that by the amount of US stocks in the index that's about half and then finally multiply it by the dividend yield of US Stocks which is around 2.3% and the answer is .7% difference so while strictly speaking this is not a fee what it means is less money for you because of taxes so if you want to minimize your withholding fees make sure if you're a UK investor that funds domiciled in Ireland particularly if it's going to be buying a lot of us assets which is the case if you're going to buy a global Index Fund if you want to avoid withholding fees Al together what you can do is buy something called a synthetic fund the idea here is that the fund manager doesn't buy the stocks itself it enters into a derivative agreement with some investment Banks all of which hold the stocks on their own balance sheet they then pay the returns to the fund manager as if it owned the basket of stocks but the beauty of this Arrangement is that those investment banks will sit on the stock exchanges around the world themselves they don't pay a withholding fee and that tax benefit is transferred to you directly so if you do want to avoid this withholding fuel together then a synthetic fund is a way to go some people don't like them because they introduce some kind of counterparty risk with those investment Banks the fund manager will sometimes enter into two or three swap agreements in order to mitigate that risk but it is a risk nonetheless however the risk of an investment Bank failing is pretty low and these Agreements are collateralized and Mark to Market so personally I'd be quite comfortable with it however these swaps don't come free themselves and the reason why this could be a hidden fee is that if you look at the ongoing charges figure it won't include the cost of the swap here for example is a fact sheet from Invesco on one of their S&P 500 trackers the ticket for this is spxs and this one doesn't pay any kind of withholding fees at all and the ongoing charge seems ridiculously low it's just 05% however if you look at the fact sheet you'll see that there's an additional 0.4% which is the cost of the swap so all in you'll be paying 9% still pretty low but you could easily miss that swap fee unless you read the fact sheet now some people at the moment are thinking about currency hedging their Holdings of US Stocks because they think that the US dollar could be about to weaken and if that's the case if you're a sterling investor then that's going to reduce the Returns on the index and on the US Stocks you hold so why not get rid of that risk all together with another derivative a currency hedge well the problem is that you end up paying for that and in slightly subtle ways the most obvious way as we saw previously is that you pay some kind of cost for the swap in this case the ongoing charges figure is just 05% again but the swap fee is. 3% so that adds considerable cost which comes out of the returns of the fund you don't pay it physically but it does reduce your return however there is an additional thing to consider here sometimes it acts in your benefit sometimes it doesn't and that's the way these currency Hedges are priced and that's because the cost of the derivative itself will depend on interest rates in the two countries so you might be thinking if I hedge out the currency risk all I'll be left with is the return of the S&P 500 as if I was a US investor well that's not true the actual return you receive also depends on interest rate differentials between the two countries so let's say you go for a sterling hedged s&p500 tracker it turns out that what you'll receive is the S&P 500 return as you'd expect but you'll be paying the US dollar interest rate and receiving the Sterling interest rate now most of the time those are quite similar monetary policy tends to be quite similar in developed markets but sometimes they get out of sync and that was particularly painful for people who are investing from Europe I had a client in Europe and we sat for a long time trying to work out why his fund had underperformed by so much given that it had a currency hedge the reason why was that he was receiving the Euro interest rate at the time and paying the US dollar rate which was much higher so if we actually look at those policy rates for the US for Europe but also for the UK notice how they do tend to move up and down together but sometimes they get out of sync and in the period where I was discussing this with my European client notice how the Euro Zone had a very low interest rate compared to the US the US had come out of the Global Financial CR prices sooner than Europe had and while policy was still very low in terms of interest rate in Europe the US started to hike its interest rates so gradually what was happening was the Hedge was becoming more and more of a drag on the returns of this client so just be aware of this hidden fee this hidden cost if there is an interest rate differential and you're going to be currency hedging your funds I notice that as I make this video the Euro area still has an interest rate that's lower than than that in the US for Sterling the differential is not so big the final hidden cost we'll consider is a little bit of a tangential one I think because it could act in your favor or it could act against you and this is called tracking error remember that the job of a passive index tracker is simply to copy the index if it goes up 1% then so does your fund if it goes down 1% so does your fund and the difference between those two numbers The Benchmark and your fund is the tracking error a big tracking error can happen because the fund doesn't buy exactly the right stocks in order to match the Benchmark some of them have a bit of leeway as to when they buy and how much of each of the individual stocks they buy Now One Fund which is a global index tracker which is quite popular because it's got low fees is the HSBC footsie allor tracker however some people criticize that fund because it tends to have a fairly High tracking error if we look at returns of the Benchmark and the fund you can see that there are sometimes quite big discrepancies for example in 2018 if you look at the index it fell by 3.4% whereas the fund itself fell by considerably more 4.8% compare that with a fund like vanguard's vwp and if you look at the Benchmark and the fund returns they tend to be closer together over time it hasn't been around for that long so we can't really compare over the same period period and its start and end dates are different so the returns are different but the tracking error tends to be lower however I don't think this is a huge problem for one of these large and reputable fund managers and that's because over time I'd expect the tracking error to either help you or hinder you roughly an equal measure for example if we take three of these Global index trackers including that one from HSBC and the one from Vanguard and we also include one from Invesco notice how they track each other very closely over this period it hasn't quite been a year since fwg was created but the cumulative difference in return is around 1% over this period if we exclude that fwg fund we can go a bit further in time for the comparison and the annualized returns are 99.7% that's for the Vanguard fund and 10.1% for the HSBC fund so the tracking error this case was in your favor I think it could equally well have gone the other way so if you are worried about the tracking error then sure you could go for a fund which has a smaller tracking error historically but I think this is not something I'd be worried about for a large and reputable fund manager I think the best way to do the comparison is to do something like I've done here simply plot the returns because remember that the numbers that you can see here are net of fees and also include any tracking error and if your fund is pretty much in line with the other Global trackers I wouldn't lose too much sleep over this so in summary then the things I'd be looking for on my platform would be is it transparent is it easy to find what the fees are and are they reasonably low are the Allin fees less than about. 2.3% in which case you're probably okay it's usually best to stick to liquid Investments whether that's single stocks or funds because that way you'll be paying unless bid offer spread and that is not going to be a charge to you effectively and of course trade as little as possible because bid offer spread only affects you when you buy and sell if you have the choice try and avoid foreign denominated funds and Investments because you may have to pay a currency conversion fee and then for funds be aware of the domicile of the fund because that can make a difference to things like withholding tax synthetic funds avoid this all together but they sometimes come with a high fee if you are going to be currency hedging your Investments then also think about the swap fee when you do that also be aware of the interest rate differential between your currency and primarily the US dollar which is where most Investments are and then finally and this is the one I think matters least look at the tracking error for your fund if it is a passive fund if it's too high for you then maybe consider an alternative now don't forget our offer from Emma sleep don't forget they've got their summer sale and also you get an additional 5% off if you use our promo code or the link which is in the description below and as always thank you for listening

Channel: PensionCraft

Views: 12,786

Keywords: investment fees, brokerage fees explained, broker fees explained, platform fee, index fund fees, Trading fees, stock market, investing, pension craft, bid offer spread explained, tracking error in index funds, synthetic etf, withholding tax

Id: xKLBd_WMSBg

Length: 24min 10sec (1450 seconds)

Published: Sat Jun 08 2024