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Beyond The Expense Ratio

Written by Paul Amery

 –  February 02, 2011

“I worry,” said the CEO of one of Europe’s index providers recently, “that indices and ETFs are becoming too complex.  Many involve extra layers of costs – in one recently launched ETF’s prospectus I counted five levels of index-related charges faced by an investor, all over and above the fund’s total expense ratio.”

Confusingly for someone who’s approaching the subject of fund management costs for the first time, the total expense ratio (TER) is a misnomer. The TER – a standardised measure of fund expenses, typically including the management fee as well as certain administrative charges – remains frustratingly incomplete.

This is particularly true for actively managed funds, where it has been estimated that trading activity by equity fund managers can easily double a fund’s effective expense rate.  According to Ed Moisson, head of research at Lipper, academic studies based on the activity of UK equity funds suggest that a turnover rate of 100% a year adds around 1% to the ultimate costs faced by an investor.  These costs result from the bid-offer spreads incurred in equity transactions, as well as from brokerage commissions.

As active fund managers are supposed to have their performance measured net of fees and trading costs, everything should be factored into the ultimate return received by an investor.  If the manager outperforms, high fees and turnover may not be a concern, but if a fund underperforms its benchmark, excess trading activity can easily be seen as a major contributor to any return deficit.

For passive funds, things are rather different.  Index funds and ETFs aim to replicate the performance of their benchmark (before fees).  Any excess costs will inevitably detract from a fund’s return and lead to greater tracking error.

One well-known cost faced by passive funds – the index licensing fee – is typically included in the TER. Although index providers keep their licence agreements with ETF issuers a closely guarded secret, in certain cases it is possible to see this charge as a discrete expense.  For the world’s largest ETF, the US-listed SPDR S&P 500 (NYSE Arca: SPY), for example, the fund’s report and accounts list the index licensing fee as 3 basis points per annum.

For funds where the fee is not disclosed separately, a typical ETF tracking a capitalisation-weighted equity benchmark might pay a licensing charge of around 5-7 basis points a year to the index compiler, according to one ETF provider.  If the index’s construction methodology involves more intellectual capital, such licensing fees can easily reach double digits in annual basis point terms, he added.

There’s no getting away from some frictional costs, even for passive funds.  All indices have inherent costs that result from internal turnover and rebalancing; these costs then impact investors in any index-following strategy.  For a capitalisation-weighted benchmark, turnover levels may be very low, often a few percentage points a year.  At the other end of the scale, certain indices representing an active underlying management strategy can easily generate turnover levels of hundreds of percent a year or more.

For example, the new Man GLG Europe Plus Source ETF, launched this week, follows a computer algorithm to select from amongst the stock trading ideas generated by the European brokerage community.  According to Sandy Rattray, head of Man Systematic Strategies, the index’s implied internal turnover levels are likely to exceed 1000% per annum.

Is this a concern? Whether high turnover levels imply a significant return drag to the end-investor depends partly on the nature of the underlying market and the relevant costs of trading.  Turnover of several thousand percent a year in a government bond fund or currency tracker might not worry investors too much since the relevant markets are so liquid; if applied to high yield corporate debt or emerging market equities, however, such turnover levels would have a major cost impact.

In the case of the Man GLG Europe Plus Source ETF, high turnover levels go hand in hand with the fund’s underlying strategy.  The brokers whose trade ideas feed Man’s computer programmes are remunerated by commission for doing so – each buy and sell trade by the fund incurs a 6 basis points levy, which is then paid into a commission pool that ultimately rewards the generators of the best ideas.  Presumably, if you didn’t accept that this was a sensible way of constructing a fund, you’d be unlikely to buy the ETF in the first place.



 



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