Investing small amounts for the medium term (Part 2 of 3)

Genevieve Signoret

Letter from the President

This is part two of a three-part series on how we’re coping with transaction costs on small transactions. We illustrate our approach by focusing on a situation we often face: a client has a large account but, within it, one small “bucket” (portfolio). We consider the case in which the client’s investment horizon for this bucket is medium-term.

In Part 1, I summarize the whole series. In Part 2, I explain why smaller portfolios require simpler strategies, regardless of whether the brokerage account is held in the USA or Mexico. In Part 3, I lay out our simplified strategy for the medium-term bucket.

Part 2: Why small buckets need simple strategies

Even for large portfolios (“buckets”), our strategies are not terribly complex: they generally involve allocating capital across 8–14 exchange trade funds (ETFs) and perhaps one “basket” of bonds, laddered. For small buckets, however, a strategy calling for 8–14 funds constitutes too much complexity: it drives trading commissions as a percentage of the portfolio up too high.

It may surprise you to know that steep trading fees as a percentage of the portfolio plague not only portfolios held in a brokerage house in the USA, where commissions are generally fixed (for example, $9.99 per trade, regardless of the transaction value or volume), but also for those held in Mexico, where commissions are generally a percentage of transaction value. The reason has to do with liquidity.

Here in Mexico, most of the ETFs we trade for clients are international—they’re issued in some other country. Trading volumes in Mexico for a foreign ETF are far smaller than on its home stock exchanges. This jacks up the transaction cost, not through trading commissions, which are a fixed percentage of transaction value regardless of transaction size, but rather in the bid–ask spread to be endured on trades.

A bid–ask spread is the difference between the purchase price and the selling price of a security. The “thinner” the market (the fewer the buyers and sellers), the wider the spread. A wide spread means a steep discount on the price sellers receive and a large premium buyers pay compared with what both sides would face in a “thicker” (more dense) market.

Think of it this way: if buyers are scarce, you the seller must discount the price you ask for to lure a buyer; if sellers are few and far between, you eager to buy must pay a premium.

Market density or thickness is what we in finance call liquidity. It shows up in bid–ask spreads.

Liquidity is always a problem when trading foreign ETFs in Mexico, but it becomes worse when trading small volumes. Smallness drives up the premium we’re forced to pay on a buy and forces down the discount we must suffer on a sale. In other words, spreads are more punishing here in Mexico on small trades.

Of course, not all our clients hold their assets in Mexican brokerage houses—some have accounts in the USA. For these clients, liquidity is generally not a problem. Our criteria for fund selection screen out funds for which liquidity is poor (bid–ask spreads are wide). For buckets held in U.S. brokerage houses, the problem with small buckets, then, is not the bid–ask spread but rather that, for small transactions, even a small trading fee such as $9.99 per trade can translate into a high percentage transaction cost.[1]

In short, for small client buckets held in Mexican and U.S. brokerage house both, to make the most money possible for our clients, we need a way to shrink percentage transaction costs. And that way entails simplifying our strategy. In Part 3, I will lay out the simplified version of our medium-term portfolio strategies.

[1] To persuade yourself that this is true, compute a $9.99 commission as a percentage of a $10,000 transaction. Now repeat the exercise but change the transaction value to $1,000,000. See what I mean?