Don’t buy an Emerging Markets ETF if your portfolio is small

I want to invest around 100€ per month and considering investing 80% in the iShares Core MSCI World ETF and 20% in the iShares MSCI Emerging Markets ETF. What do you think about it?

If you portfolio is small, you should buy the fewest amount of funds possible.

Minimum brokerage fees and the need to buy whole shares make it impractical to have small portfolios with many funds. In this article I also explain a rule of thumb you can use to decide if your investment amounts are high enough to justify buying an Emerging Markets fund.

If you want to invest in world equities you have two options:

  • Single index fund – Hold a single fund tracking the whole world. Alternatively hold a single fund tracking the developed world;
  • Two index funds – Hold 88% of a fund tracking the developed world and 12% of a fund tracking emerging markets. Small variations on the percentages I presented don’t make a significant difference.

If you have a small portfolio you should only consider the “single index fund” option. Therefore, you should not buy an emerging markets index fund. If you want exposure to emerging markets you should get it through a whole world index fund (e.g. Vanguard FTSE All World).

Minimum transaction fees

Minimum transaction fees make small transactions prohibitively expensive.
Last time I checked, Interactive Brokers (IB) charges a minimum of 4€ and DEGIRO a minimum of 2€.

Let’s revisit the example from above: total investment of 100€; 20% (20€) into emerging markets and 80% (80€) into developed world. If you use DEGIRO, the minimum fee would account for 10% (!) of the total investment amount in the emerging markets ETF. If you use IB, the minimum fee would account for 20% (!) of the total investment amount in the emerging markets ETF. That is a lot to spend in fees.

Brokerage fees are initial costs. Initial costs are costs you only pay once. For example, you only pay the brokerage fee when buying (and selling) the shares but not while you hold on to it. While holding costs are costs you pay every year (e.g. TER).

Ideally we would specify all costs as annual costs in order to get a better sense of their impact in investment. Holding costs are already specified in annual terms but initial costs typically aren’t.

In order to annualize an initial cost you need to use a technique called discounted cash flow valuation. Covering that technique is outside the scope of this blog post. But that technique provides a good rule of thumb: you can annualize a one-time annual fee over 30 years by dividing it by 20. That gives us the following formula

total_annual_cost = (initial cost / 20) + holding costs 

You can learn more about the background of this technique in the book Smart Portfolios.

If we take DEGIRO as an example we can get a total annual cost of 1.18% for the portion that invests in emerging markets!

initial cost = 10%
holding_cost = TER = 0.68%
total_annual_cost = (10% / 20) + 0.68% = 1.18%

I am not accounting for Interactive Brokers’ maintenance fees or DEGIRO’s exchange connectivity fees in this post but they can be annualized using the same process.

To make this comparison fair I am going to calculate the total annual cost in multiple scenarios:

  • iShares Core MSCI World ETF with a minimum transaction fee (2 €);
  • 80% iShares Core MSCI World + 20% iShares MSCI Emerging Markets ETF with minimum transaction fees (2 €);
  • iShares Core MSCI World ETF without minimum transaction fees. This ETF does not pay commissions in DEGIRO;
  • 80% iShares Core MSCI World + 20% iShares MSCI Emerging Markets ETF without minimum transaction fees. These ETFs do not pay commissions in DEGIRO;
  • 80% iShares Core MSCI World (without transaction fees) + 20% iShares MSCI Core Emerging Markets IMI ETF (with transaction fee of 2€). The iShares MSCI Core Emerging Markets IMI ETF has a lower TER than the commission free iShares MSCI Emerging Markets ETF in DEGIRO.

The estimated “total annual costs” in the table below are for a minimum transaction fee of 2€ and a monthly investment of 100€. A few observations from the table:

  • If you have to pay the minimum transaction fee and invest in two funds you end up with an annual total cost of 0.416%. If you instead use a single (developed world) fund you end up with an total annual cost of 0.22%. You cut your expenses by (almost) half by using a single fund.
  • If you don’t pay the minimum transaction fee, you only spend 0.296% in total annual cost for holding two funds. The main issue is that the chosen MSCI Emerging Markets fund is very expensive: it has a TER of 0.68%. I prefer the iShares Core Emerging Markets IMI ETF which has a TER of 0.18% and is not commission free. When using this cheaper ETF you also end up with a total annual cost of 0.296% because of the minimum transaction fee. This shows that choosing expensive ETFs in order to save on brokerage commissions does not save you much money in the long run.

Minimum transaction fees are only a problem for small investment amounts. Their effect is negligible in the total annual cost when the investment amount is large.

The estimated “total annual costs” in the table below are for a minimum transaction fee of 2€ and a monthly investment of 3000€. A few observations from the table:

  • The total annual cost does not change much when comparing cases with and without minimum transaction fees. For example 0.2006% vs. 0.2% for investing in the iShares Core MSCI World ETF. Or 0.3% vs. 0.296% for investing in a combination of the iShares Core MSCI World ETF and the iShares MSCI Emerging Markets ETF. This shows how large investment amounts make (small) brokerage fees almost irrelevant.
  • Investing using the iShares Core MSCI Emerging Markets IMI ETF is cheaper than the iShares MSCI Emerging Markets ETF despite requiring paying transaction fees (0.1933% vs. 0.296%). This shows how optimizing for brokerage fees without looking at ETF TERs can lead to spending more in the long run.

You can run these calculations for your specific case using this spreadsheet I used. 

The rule of thumb I use is: Your portfolio is large enough for buying an emerging markets ETF if you can invest at least 300 times the minimum transaction fee on that ETF. If your minimum transaction fee is 2€, you need to be able to invest at least 600€ in any ETF. This rule of thumb ensures the impact of the transaction fees on your annual costs is low. I got this from the Smart Portfolios book too.

For the example above, the portion of Emerging Markets (EM) is 20%. If you want to invest 600€ in EM you need to be able to invest 2400 € (the other 80%) in developed markets: your total investment amount needs to be 3000 €.

Whole shares

A share is a unit of ownership. In most brokers you need to buy a whole share, you can’t buy just part of it. If the share prices are high, you won’t be able to buy a whole share with a small investment amount.

At the time of writing the iShares Core MSCI World ETF has a share price of 55,93 EUR and the iShares MSCI Emerging Markets ETF has a share price of 36,34 EUR. It is cumbersome to invest a total of 100 € with a 80/20 split given these share prices. You won’t be able to buy a share of the MSCI Emerging Markets ETF with 20€ so you’d have to wait another month to invest. 

In my opinion it is better to focus on a single ETF. You may still have to accumulate money over months in order to buy whole shares, but you’d only have to coordinate a single ETF.

Savings rate

I understand that you are just starting out and you want your portfolio to look perfect. Investing in two funds covering the whole world sounds better than investing in a single fund covering only the developed markets right?

Don’t worry: The developed world accounts for around 88% of the allocation of the whole world therefore, it is a “good enough “ approximation. In fact, as the graph below shows, From December 1998 to October 2019 these two portfolios had similar returns when recurring contributions of 100€ are considered.

Source: Backtest

Also, in the beginning of your investment journey how much you save matters more than the specifics of your portfolio. It is still important you invest in low cost, diversified funds. But increasing your investment contribution from 100€ a month to 200€ a month will have a larger impact to your returns than adding an investment in emerging markets.