Getting to grips with the Total Expense Ratio
For many years South African investors poured billions of rand into the collective investments industry. Unit trusts made sense because they offered targeted exposure to a range of economic sectors without requiring massive capital commitments. If you wanted exposure to the banking and financial sectors you would simply select an appropriate unit trust and invest a once-off lump sum; or set up a debit order to make small monthly purchases.
This investment product was successful for a number of reasons. Unit trusts offered easy access, affordable monthly instalments, were viewed as a ‘forced savings’ opportunity and were relatively transparent when compared with other investment products. This popularity helped the industry to grow exponentially. At 31 March 2008 the total assets managed by funds under the Association of Collective Investments (ACI) umbrella reached R776.445m. There were a total of 844 local funds and 369 foreign funds for investors to choose from. But for many years investors paid little attention to the costs associated with these products.
It’s only two or three years since investors became more aware of the costs associated with their investment decisions. To the industry’s credit the ACI has been instrumental in unveiling a local system to compare costs across the industry. Known as the Total Expense Ratio (TER) investors have been able to compare lists of collective investment opportunities and assess the overall cost of each fund since April 2007.
Understanding the Total Expense Ratio
The TER will express the percentage of a fund’s assets required to cover the operating expenses and investment management fees in that particular portfolio over a specific period. Unit trusts will calculate this ratio over a period of 12-months and will mostly update it quarterly. The TER will be published with unit trust fact sheets and must accompany any published performance claims too. A basic computation looks as follows: TER = (Investment management fees plus operating costs) / Net asset value.
Investors can use the TER to compare how costs affect various unit trusts funds. Fees included in the TER calculation are: the fund’s bank charges, the fund’s audit fees, taxes, custodian and trustee fees, income retained from scrip lending and the annual service fee (including performance fees).
The damage to your long-term investment return
Definitions are useful; but what’s the actual damage done to my investment over time. To answer this question let’s take a quick look at an imaginary general equity unit trust with a TER of 1.5%. We’ll consider the five year period from January 2002 to December 2007 and assume an initial investment (after once-off fees) of R100 000. We’ll also assume that the performance on our unit trust exactly mirrors that of the JSE All Share Index. Annual returns for the All Share Index over this period were 3.95% (2003), 16.61%, 42.98%, 37.67% and 16.23% (2007). After five years an investor in this ‘dummy’ unit trust would have experienced net growth of x% to R30 447.03. And had the TER been 0% the investment would have been R32 860.99. The impact of the annual fee in the short-term is rather insignificant… Where it really hits home is over the 30-year period of saving that precedes retirement.
Changing the parameters slightly we can compute the impact of TER over a longer period. Let’s assume an initial lump-sum after once-off charges of R10 000, an annual average return of 15% and a period of 30-years. We’ll then play around with the TER ratio to see what kind of an impact investment costs have on long-term investment returns... At a TER of 1.5% the initial investment grows to R564 298.04… Had there been no fees over this period the investor would have been sitting on R886 352.58.
What this shows is that an investor stands to ‘lose’ as much as 25.9% of his ‘feeless’ portfolio return for each additional percentage of TER incurred! Of course these calculations have been completed at a rather basic level – the percentage ‘lost’ to fees reduces as the average annual return reduces and if monthly investments are made – but they illustrate the significant damage that can be caused by annual management fees levied as a percentage of fund value.
Beware – not all costs are included
Not all fees associated with unit trusts are included in the TER. “How is this possible?” we hear many of our readers ask. If the TER is so transparent, then surely all possible fees will be included in the calculation. Although it would be nice to have everything lumped together there is a reason for some fees not being included. It goes to the separation of fees borne by the portfolio (included in the TER) and those borne by the investor directly (not included).
Initial charges (including commission), annual adviser fees agreed between client and adviser, stockbroker fees and expenses relating to the settling of transactions and taxes associated with share trading are thus not included. Fortunately the once-off initial charges have been declining steadily in recent years and now average in the region of 1% to 1.5%. But investors should note that some unit trusts still levy an initial charge of up to 7%!
Editor’s thoughts:
Investing can be a costly exercise. Before you know it you could be dumping 10% of your first year’s investment in fees – 1.5% management fee to your adviser, 7.5% to initial costs in the unit trust and 1.5% TER. Is the industry doing enough to provide cost effective savings products to assist in retirement planning? Add your comments below, or send them to [email protected]
Comments