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
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.
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.
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.
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.
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.