The previous chapter showed why exchange traded funds and online brokerage services are theoretically more efficient than customized private client services. Now we can now look at the actual numbers. The result? Buying ETFs through an online brokerage should generate far superior performance than a full service brokerage account for a wealthy individual. Here are the numbers in their gory detail:
Assume a $10 million account. A full service broker may charge you, say, 1% of assets per year, or $100,000. But now you also have to factor in that most brokers will only recommend and sell you their own mutual funds, and (without naming names) many of those funds have lousy relative performance. The funds typically charge about 1.2% of assets per year, and let’s conservatively say they under-perform the market by another 1%. If you park your $10 million in your broker’s mediocre mutual funds, you could thus be paying a total of over 3% per year (1% of assets in brokerage fees + 1.2% mutual fund fees + 1% under-performance), or $300,000 per year.
Now look at the ETF/online brokerage option for a wealthy investor. I’ll use the core portfolio discussed earlier, assuming that all trades are through an online broker.
Let’s say a basket of ETFs costs you a weighted average (conservatively) of 0.25% in annual fees. Let’s say it takes 30 trades to sell all your old stuff and buy the ETFs, and another 15 trades to rebalance the portfolio and realize some tax losses at the end of the year. An online broker may bill you about $900 for those 45 trades. (In practice the online brokers often offer free trades to new customers to attract new accounts, so actual trading costs may be lower than this.) You also move any cash in your portfolio to a higher interest earning bank money market account linked to the brokerage account, earning say 2.25%, versus the bulge bracket firm’s 0.85%. Net cost: probably less than $25,000 per year ($25,000 per year for your ETF fees, $900 in trading fees, minus your improved interest income), vs. $300,000 for the bulge bracket firm. And for those fees, you probably get better diversification, better control, and better tax management.
That’s a difference of $275,000 a year on a $10 million account! It’s a no-brainer.
What’s remarkable is not that you can manage a sophisticated and diverse $10 million portfolio for under $25,000 a year using ETFs and an online brokerage. It’s that most investors who have $10 million in a “full service” brokerage accounts have no idea that they may be paying an extra $275,000 a year in fees and relative underperformance.
Beneath the surface, there are two reasons the online brokerage account with ETFs beats the pants off the full-service brokerage account, wrap account, or managed account. First, the ETFs themselves outperform alternative investment vehicles due to their efficiency and low annual costs. Second, and more importantly, with an online brokerage account you avoid asset-based brokerage account fees. The account fees you pay do not scale with your assets.
Asset-based-fee accounts will likely turn out to be a lousy deal for investors. Many stock market “strategists” currently predict that total returns from the US stock market over the next decade will average 4-10% per year. (Many companies have also cut the assumed return on their pension funds to this range.) If that’s correct, then paying 1% to 2% of assets per year in fees could equate to 25% to 50% of your total return.