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Trying to decipher the different levels of costs in the fund management industry is a bewildering task. But with the rise of ETFs, making a like-for-like cost comparison between different types of funds is perhaps the first thing an investor should try to do after deciding which market to invest in. IndexUniverse.eu has put together a 10-point checklist to help investors make such an assessment, which we will cover in two features. Today, we cover costs 1-5.
While not all the costs we describe arise from within fund structures, they are all relevant to the overall decision-making process that an investor faces. We’ve approached the subject from the perspective of a UK investor, although many of the costs we look at are equally applicable in other markets.
1. Annual Management Charge
This is the “headline” charge levied by the fund manager or provider for the cost of providing fund management services. However, while the AMC usually forms the major part of fund fees, it can significantly understate total fund operating costs (see “Total Expense Ratio”).
Annual management charges for actively managed funds are higher than those for passively managed funds such as ETFs or index funds, often by many multiples. This is the cost investors pay for hiring a fund manager to look after their assets for them and it may also include a commission element, payable to intermediaries involved in the sale of the fund. Is it worth paying? Well, that’s a multi-billion dollar question.
2. Total Expense Ratio
The total expense ratio (TER) includes the AMC and certain additional costs such as administration, accountancy, custodial and legal fees. It also covers performance fees where applicable. However, the TER does not include fund turnover or borrowing costs.
In the ETF universe most fund providers operate using the TER measure, giving a reasonable – but by no means perfect – way of comparing exchange-traded funds on a like-for-like basis.
Strictly speaking, the TER is a backward-looking measure, meaning that to work it out you have to wait until a reporting period is over and look at the fund’s annual accounts to find out what the total expenses were. ETF providers usually deal with this potentially awkward uncertainty by making a commitment to cap the TER on a forward-looking basis at a given percentage of a fund’s size.
It should be noted that not all ETF providers call the TER the same thing. For example, db x-trackers uses a measure for its ETFs called the “all-in fee”, though it’s essentially the same as a TER.
While the UCITS III directive requires that compliant European funds list their TERs in their “simplified prospectus” (a key legal document), confusingly, there’s apparently no requirement for funds to do the same in their regular marketing literature, where many actively managed funds still use the AMC as the stated measure of charges, potentially understating investors’ costs by a wide margin. The difference between the two measures can be substantial, as Chris Traulsen, director of funds research at Morningstar UK, highlighted in an article on the subject in 2007. In a telephone interview with IndexUniverse.eu, Traulsen said that not much has changed in the two years since he wrote his article, though regulatory changes may be on the way.
The Committee of European Securities Regulators has recently proposed that all UCITS funds should produce a short description, called the "key information document", which should enable investors to distinguish easily between an actively-managed fund and one that tracks an index. The section on charges would require a figure for "ongoing charges" taken periodically from the fund to be shown, similar to the "total expense ratio" currently disclosed in the simplified prospectus.
From the index fund sector, a recent example demonstrates how the AMC and TER measures are used slightly differently by different providers.
In its UK launch earlier in 2009, Vanguard equated the two measures, giving the “AMC/TER” for all its index funds. The manager says that it covers all of its own expenses out of this single fee (although Vanguard also levies a “purchase fee” on certain index funds to cover the cost of transactions in the underlying markets – see “entry and exit costs” in the next part of this article, to be published in a few days’ time).
However, HSBC’s index fund repricing, announced in August this year, lists both an AMC and a “predicted TER”, with the TER exceeding the AMC by a total of 2-12 basis points per annum, depending on the underlying market being tracked.
A last word on total expense ratios: recent research by Ed Moisson, head of consulting at Lipper FMI, shows that the average TER of UK-based actively managed equity funds has actually increased over the last 10 years (a period of relatively poor performance), rising from 1.52% in 1998 to 1.65% last year. That leaves quite a gap for active managers to bridge when compared to cheaper tracker funds. In Europe, for example, the average equity ETF has a TER of 37 basis points and the average fixed income ETF has a TER of 16 basis points. Is it any wonder that the ETF market is booming in Europe?
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