One of the most important factors in the returns you get from a fund, other than performance, is the level of the fees they charge. Higher fees can substantially eat into the returns of the fund so it is crucial to check what the costs are.
The total expense ratio (TER) is considered to be a better and fuller measure of the expenses incurred than the annual management fees, and useful for comparing similar funds with each other. But the reality is that a TER is far from a total reflection of what a fund costs. "TERs are total nonsense - there is no unique method of calculation and they are not total at all, more partial than total," says Gina Miller, founding partner of wealth manager SCM Private. "They have been designed by the industry to deliberately understate the true costs of investment. We favour TERs being abandoned completely."
Partial expense ratio
The standard way to calculate a TER for unit trusts and open-ended investment companies (Oeics) is to divide its total net expenses by its average total net assets over a given period. However, while these annualised net operating costs include charges such as the annual management fee; operating costs such as administration, custody, audit and legal fees and any performance fee, they do not include the trading costs which can make a huge difference.
If a fund manager frequently trades stocks this will incur more costs than a fund which does not trade frequently, and over many years these costs can stack up to significant amounts. There is no way of exactly knowing what the trading costs are as they are not stated but rather come out of the profit the fund makes, lowering your returns. "This means that comparing TERs between active funds with very different styles and typical levels of turnover will be of limited use in assessing real total costs, and the comparison will be very difficult," says Nick Sketch, senior investment director at Rensburg Sheppards Investment Management.
The nature of the assets the fund invests in is also important as it is more expensive to trade stocks or assets which are harder to buy and sell. Smaller companies, for example could incur greater costs than FTSE 100 stocks, because they do not have many shares traded daily and when the market sees one buyer looking to make a large purchase the price can get bid up.
Investing in foreign shares, meanwhile, can be more expensive as many overseas markets typically have dealing costs materially higher than those in the UK or US, while there are other issues such as tax. This can particularly be an issue in emerging markets.
An indication of the costs the fund is stacking up from trades is indicated by the turnover ratio, which shows the extent to which the fund is buying and selling the contents of its portfolio. However this is not usually put on the fund fact sheet - you tend to have to delve through the fund's annual report to get this information. This will be sent to you if you already own the fund, or if you do not, data provider Morningstar has electronic versions of this in the documents section of its pages dedicated to a fund.
Some argue that by excluding trading costs investors can compare all of the internal charges more easily. "I would not push to include stock market transaction costs, because they constantly change, and investors can see whether the management style involves high turnover or not, though perhaps this itself should be more explicit," says Simon James, founding partner, Gore Browne Investment Management.
Martin Sherwin, senior adviser at the Investment Management Association (IMA), argues that high turnover may not be only due to a fund manager's style, but can occur if there are large inflows of money into a fund in a given year. This means the fund manager has to buy more assets with this money driving up the turnover, even if the holdings are not being frequently changed. "A fund which has expanded massively will have a bigger turnover than one which stayed the same size," he says. "Identifying what the manager did of their own volition is difficult. In addition, what happened in the past year's trading does not necessarily indicate what it will do in future, while the TER is less likely to change dramatically."
It could also be argued, however, that performance figures, which also cover past periods are not a guarantee of what will happen in future. Fund literature has to carry the disclaimer that "past performance is not a guide to the future," which could equally be applied to an expenses or trading figure.
"Trading costs are not the cost of accessing the fund, but rather accessing the market," says Mr Sherwin. "If you access the market directly then you would still have to pay a stock broker. The TER tells you what you incur by going into a fund as opposed to going to the market directly."
Europe revamps fund charges
For this reason under new European regulation on funds known as the Undertakings for Collective Investment in Transferable Securities (UCITS) IV, due to come into force on 1 July, there will be a more detailed breakdown of fund charges, and the term total expense ratio will not be used.
Instead of including any performance fee within the TER as European legislation has required until now, this will be disclosed separately making its impact of this clearer. Fund information will include a breakdown of charges set out along these lines:
| One-off charges taken before or after you invest | |
|---|---|
| Entry charge | % |
| Exit charge | % |
| This is the maximum that might be taken out of your money [before it is invested] [before the proceeds of your investment are paid out]. | |
| Charges taken from the fund over a year | |
| Ongoing charges | % |
| Charges taken from the fund under certain specific conditions | |
| Performance fee | % a year of any returns the fund achieves above the benchmark for these fees, [name of benchmark]. |
The entry and exit charges shown are maximum figures. In some cases you might pay less - you can find this out from your financial adviser.
The ongoing charges figure is based on expenses for the year ending x. This figure may vary from year to year. It excludes:
• Performance fees
• Portfolio transaction costs, except in the case of an entry/exit charge paid by the UCITS when buying or selling units in another collective investment undertaking.
For more information about charges, please see pages x to x of the fund’s prospectus, which is available at www.etc
However the breakdown will still not include trading costs. "This will be cleaner because the performance fee is disclosed separately, making it clearer," says Mr Sherwin. "The trading costs will continue not to be included in these figures but they can always be found in the accounts. The European Union dropped inclusion of the turnover following research they conducted which found that investors really didn't understand what this figure was telling them and that it was confusing."
But others disagree. "Funds should have an all-in cost ratio together with a breakdown of the expenses, in three or four clearly defined categories," argues Christopher Traulsen, director of fund research for Europe and Asia at Morningstar.
Ms Miller suggests that you should ask fund managers to provide a complete analysis and estimate of the total costs of investment to work out the underlying return of the investments a year. The total costs should include:
• Annual management fees
• Any fund expenses
• An estimate of the dealing costs including commissions, spreads and taxes.
• Any underlying other fund costs (eg in fund of funds structures)
• Any performance fees
• Any front end/exit charges
"If the fund manager cannot answer this question do not employ them," she says. "There needs to be an agreed industry wide all encompassing formula set here so that investors can finally compare like with like and make a rational decision."
