The total expense ratio (TER) is something us ETF nerds like to harp on about, and with good reason. Index-tracking products like exchange-traded funds (ETFs) have two benefits. First of all, they reduce your exposure risk to a single share or sector. Secondly, they allow you to invest cheaply. The combination of the two is what ensures long-term returns for ETF investors.

Your ETF return is whatever the market delivers minus the cost of running the ETF. The TER is the measure we use to determine how much it costs to run an ETF. It is calculated by dividing the cost of running the fund by the amount of assets in the fund. That seems simple enough, but the measure is flawed. We only know the exact TER at the end of a period (usually a year), because even if the issuer can predict its costs exactly, it has no way of knowing how much will be invested in the fund at the outset. The fee is also built into the product. As investors we don’t have eyes on it before we pay it.

The costs of running an ETF

Index fees

ETFs track indices. Mostly, the companies that issue ETFs aren’t the same companies that compile indices. ETF issuers therefore have to pay a licensing fee to companies like S&P and MSCI who compile indices.

Market makers

ETF issuers buy and sell the shares represented in the index using the services of a market maker. While it sounds like an individual, the market maker is usually a group of people responsible for creating ETF units by buying and selling the underlying individual shares in the market. Some issuers have this services in-house while others use an external market maker, which can impact the TER. 

Trading fees

When market makers buy and sell shares to create ETF units, they incur a brokerage fee just like we do when we buy and sell ETFs.

Legal and auditing fees

ETF issuers have to comply with legislation to protect the interest of investors. Ensuring continuous compliance involves legal and auditing costs.

Operational expenses

Like any other business, ETF issuers have employees and offices that need to be paid. The good news is issuers of more than one ETF can add more products without adding too much to this expense, lowering the TER of all products over time.

How TER is paid

The TER can be a silent performance killer, because ETF investors never see this payment. The cost is taken out of your dividends, so you might not realise that you are paying a high TER. This is true for ETFs that pay out dividends, as well as total return ETFs that reinvest dividends on your behalf. Unlike platform and brokerage fees that show up on statements, the TER gets deducted quietly from your dividend. It’s therefore up to you to keep a close eye on minimum disclosure documents to see how much your ETF cost you in the last year.

It is very possible for two ETFs to track the same index, but have different TERs. This is because some issuers are more efficient than others. If, for example, an issuer has an in-house market maker, it can keep tighter control on the costs. In that case, the ETF with the lower TER will always outperform the ETF with a higher TER.

We tend to focus on the costs we can see, like brokerage cost and platform fees. These do impact your investment return in the long run, but it’s important remember that they are not the only fees eating away at your investment.

Historical TERs are disclosed in minimum disclosure documents or fact sheets. Cost-conscious investors will keep an eye on that the historical TER over time.

In the below video, our friend Nerina Visser explains exactly what the TER pays for. As she explains here, a unit trust that tracks the exact same index as an ETF will likely cost more because of fees.

At Just One Lap, we are big fans of passive investment using ETFs. In this weekly blog, we discuss ETFs on the local market and the factors you need to consider when choosing an ETF. If you have wondered how one ETF differs from another, this is where you can find out. We explain which index each ETF tracks, what type of portfolio could benefit from holding each ETF, and how the costs will affect your bottom line.