Total Expense Ratios (TERs) - Some Explanation

The term Total Expense Ratios (TERs) is frequently raised in connection with the costs of ETFs and Unit Trusts. What does it mean and which costs are included or excluded from such TERs?

What Costs Are Included In TERs?

According to the Standard on the Calculation and Publication of Total Expense Ratios, released by the Association of Savings and Investment in SA (ASISA), the TER of a Collective Investment Scheme measures the expenses paid for services used in the management of a portfolio. These measured expenses include asset management and administration fees, custody costs, trustee fees, audit fees, bank charges, taxes, interest rate charges, costs of buying and selling units from investors and scrip lending costs. Collective Investment Scheme (CIS) funds also have a management charge which goes to the fund manager (Manco) to cover the costs of marketing, advertising, staff overheads, etc. these are included in the TER.

Performance fees, which are charged by an increasing number of actively managed funds, must also be included in TERs. This also applies to multi-tiered funds (fund of funds, white label funds, etc), where performance fees may be deducted at different levels of fund management.

What Costs Are Not Included In TERs?

Brokerage Costs

The ASISA Standard allows the Collective Investment Scheme (CIS) to make their own decision on the inclusion or exclusion of the brokerage charges associated with the acquisition of assets for the portfolio. Where a CIS manager actively “churns” the assets in a portfolio in an attempt to generate outperformance of a benchmark, these brokerage charges can be substantial. Most index tracking CIS products, like Exchange Traded Funds (ETFs), tend to include such brokerage charges in their ETFs, because they only change their portfolios, when required to do so by changes in the index, so have relatively small brokerage charges.

Distribution Costs

Collective Investment Scheme products have to be purchased or sold directly through the issuer (in the case of unit trusts); through investment platforms that typically offer a selection of CIS products (both unit trusts and ETFs); or through stockbrokers (in the case of ETFs). Also, many investors use the services of financial advisors, whose services are paid for by the deduction of upfront fees or through trailing commissions (sometimes both). These distribution costs can vary considerably from client to client, depending on the client size and distribution channels utilised, so cannot be aggregated for TER purposes.

Scrip Lending Income

CIS funds can lend out the scrip in their portfolios to earn additional income. This income has, in terms of the Collective Investment Schemes Control Act, to be used for the benefit of investors, so the manager typically uses such income to reduce the TER. The ASISA Standard on TERs, stipulates that the expenses incurred in scrip lending must be included in TERs, but not the income generate by such scrip lending. As a result, CIS funds that engage in scrip lending, normally ETFs, sometimes disclose two TERs, one before scrip lending income, and the other with the benefits of scrip lending to reduce TERs. These figures are disclosed in the quarterly fact sheets published by such product issuers.

Deduction of TERs

The ASISA TER Standards require that the administrators of the CIS fund (often a company independent of the CIS issuer) accrue all expenses (TERs) on a daily basis and apportion these on a per unit basis. In practise, these TERs are paid for by the income received in the CIS funds (typically dividends and interest earned from the assets in the portfolio) and the net impact of such expenditure is displayed in the daily Net Asset Value (NAV) figures published by all CIS funds.

At the end of each quarter, the CIS funds, whether a unit trust or ETF, will distribute any cash in the portfolio to unit holders. The extent of the distribution is impacted by the level of expenses in the quarter, so such distributions are net of TERs, and other expenses. Generally speaking, the lower the TER of a CIS fund, the greater the proportion of dividends that are distributed to unit holders at the end of the quarter. This helps explain the growing popularity of Exchange Traded Funds with low TERs, which pay a greater proportion of the dividend yield to investors.

Disclosure of TERs

The CIS Fund is required by the ASISA Standard to disclose the annualised TER at all times in printed or internet based material. The CIS Manager is also required to disclose to every new investor the most recent TER.

In general, most CIS funds in South Africa disclose their TERs in quarterly fact sheets and other transaction material. Investment Platforms, such as etfSA Investor Scheme^TM, disclose the TERs for each product plus any annual management fees charged by the platform provider for their services on their websites and in application forms.

Investors should always bear in mind that the TER has already been paid, as detailed above, in the price of the product and they do not have to pay the TER expense directly.

Unit Trust and ETF Total Expense Ratios

As shown above, ETFs generally speaking, have significantly lower TERs than the average for unit trusts. Of course, as explained in this article, the TERs only cover certain of the costs in a CIS portfolio. Distribution and brokerage charges, as well as any commission, to financial advisors (if applicable), also need to be taken into account.

Unfortunately, the performance figures for unit trusts and ETFs only take into account the impact of TERs on investment performance and ignore the other costs, over and above the TERs. As a rule of thumb, for unit trusts, between 2% to 5% per year (the upper figure can be applicable if financial advisors are used) have to be added to the TER figure, to get an indication of true overall costs. The equivalent number for ETFs is between 0,5% to 1,8% per annum. These, of course, detract from the performance numbers of the applicable unit trusts and ETFs.