The Total Expense Ratio is a method of calculating how much you pay for management of an investment or a portfolio of investments. Fantastic returns can often be greatly undermined by charges and mediocre returns are thus crippled. Having a better understanding of how you are remunerating the investment/fund/portfolio manager is necessary starting point when assessing the bit that everybody is happy to focus on- the returns.
This ratio is ordinarily expressed as a total percentage of the average daily value of the investment/portfolio, calculated over the financial year. This ratio has come to be standardised and is now readily available to provide an easily understandable indicator of what you’re paying. That being said, the TER is but one of many ratios and it does have its limitations. Have a look at the following to see what is, and importantly, what isn’t included.
|In the TER||Not in the TER|
|1. Management fees (including performance fees)||1. Costs of entry to an investment, i.e. Initial fees.|
|2. Fixed operating costs:||2. Initial and ongoing costs for financial advice – if applicable.|
|Custody and Trustee fees||3. Other costs incurred directly by the investor, because of the investment, e.g. bank charges.|
|Audit fees||4. Exit costs.|
|Bank charges, other than those charged by an investor’s bank||5. Costs that are related to specific products, where these products invest in collective investment schemes, such as some life and LISP products. An example of this would be the cost of a Retirement Annuity which invests in collective investment schemes.|
|3. Value Added Taxes|
|4. Liquidity costs: Net negative interest charges (this is applicable in the unlikely event of a fund owing interest to a bank as a result of temporary liquidity pressure)|
|5. For investments in other funds:|
|Weighted portion of the underlying portfolio’s TER (for fund of funds)|
|Exit fees or reduction of redemption|
|6. Where income is earned by the providers ofscrip lending services and if this income is not passed back to the that is retained by the provider must be included.portfolio, such an amount|
The un-included costs do not feature because they may be one-off, not part of the investment itself (i.e situational costs- e.g. brokerage fees), or are better addressed /disclosed separately.
A common mistake is to confuse the Annual management Charge (AMC) with the Total Expense Ratio. The AMC is the charge that is levvied by the fund manager for managing the fund whereas the TER includes the expenses actually paid out of the fund, along with the AMC. Due to this the TER will always be higher than the AMC and offers a more holistic reading.
So how can this permit better decision making? Somewhat whimsically, a high TER does not necessarily indicate a bad investment- especially not if the investment outperforms its peers. It’s important to look at the TER in the context of performance and like-for-like. For example, a fund-of-funds (FoF) will likely have a higher TER owing to the structure complexity of its incorporation, as opposed to a broad index-tracker. Larger funds will also usually have lower TERs due to the economics of scale meaning a lower cost-base per-unit.
As is often the case, it is best to use the TER alongside other relevant ratios and metrics to get a conclusive picture of an investment before you make the decision to invest. Information is the cornerstone of intelligent investing, irrespective of what market you’re in.
– Mutual Fund Fees Around The World, Khorana, Servaes, Tufano (Jul 23, 2007), HBS Finance Working Paper No. 901023
– Securities and Exchange Commission: Investing Wisely; An Introduction To Mutual Funds