How are the "total expense ratios", or TERs, quoted on unit trusts and exchange traded funds calculated? - CI

Mike Brown, managing director of etfSA.co.za, responds:

THE way to measure the expenses paid to manage a portfolio is set out by the standard on the calculation and publication of total expense ratios released by the Association of Savings and Investment in SA (Asisa).

These measured expenses include asset management and administration fees, custody costs, trustee fees, audit fees, bank charges, taxes, interest-rate charges, the costs of buying and selling units from investors and scrip-lending costs. Collective investment schemes also have a management charge which goes to the fund manager to cover the costs of marketing, advertising, staff overheads and so on. These are included in the total expense ratios.

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

The following costs are not included in the total expense ratios:

Brokerage costs

The Asisa standard allows collective investment schemes 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 manager actively "churns" the assets in a portfolio in an attempt to outperform a benchmark, these brokerage charges can be substantial. Most index- tracking products in collective investment schemes, 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. Therefore they 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 investment scheme products (both unit trusts and ETFs); or through stockbrokers (in the case of ETFs). Also, many investors make use of financial advisers, whose services are paid for by the fees up front or through trailing commissions - and sometimes both. These distribution costs can vary considerably, depending on the client size and distribution channels, so cannot be aggregated for the purpose of total expense ratios.

In general, most funds in South Africa disclose their expense ratios in quarterly fact sheets. Investment platforms, such as etfSA Investor Scheme, disclose the total expense ratios 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 expense ratio has already been paid in the price of the product and they do not have to pay the expense directly.

Of course, as explained already, the expense ratio only covers certain costs in a collective investment scheme portfolio. Distribution and brokerage charges, as well as any commission, to financial advisers (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 expense ratios on investment performance and ignore the other costs. As a rule of thumb, for unit trusts between 2% and 5% a year (the upper figure can be applicable if financial advisers are used) must be added to the expense ratio figure to get an indication of true total costs. The equivalent number for ETFs is between 0.5% and 1.8% annually. Of course these numbers detract from the performance of the applicable unit trusts and ETFs.