When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
Total expense ratio (TER): Definition, formula and calculations, TER vs. ongoing charges examples, evaluating total expense ratio
Sail effortlessly through the Total Expense Ratios (TER), knowing that you have one more tool to empower your investment decisions.
In this guide, we will lead you through the intricacies of TER with definitions, formulas and proven techniques.
In this guide, we will lead you through the intricacies of TER with definitions, formulas and proven techniques.
Quote
“Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.”
Big ideas
- There are major differences in Total Expense Ratios, including the management and administrative costs that have a great impact on long-term returns and profoundly vary across fund types like active and index funds.
- In comparing investment alternatives, the variation in TERs across fund types, such as active against index funds, is imperative.
- The investor has to appreciate what is included in the TER calculation because of international disparities in measuring this metric.
Definition of Total Expense Ratio: What is TER?
Definition & Example
TER is a comprehensive measure used to determine the total costs associated with managing and operating an investment fund, such as a mutual fund or an exchange-traded fund (ETF).
These costs typically include management fees, administrative fees, and other operational expenses. TER is expressed as a percentage of the fund's total assets and directly reduces the fund's overall returns.
These costs typically include management fees, administrative fees, and other operational expenses. TER is expressed as a percentage of the fund's total assets and directly reduces the fund's overall returns.
A TER of 1% means that for every £100 invested in the fund, £1 goes towards covering these expenses annually.
Significance of TER for your fund investments
Every investor needs to understand TER as it impacts the worth of their investment. It is possible for an increased TER to eat into returns in the long run, especially during long-term investment scenarios. This is more so for compound interest, where not only returns but also costs compound with time.
Checking the TERs of mutual funds schemes or any other form of investments is vital before making a choice.
Importance of evaluating TER for investors
While analysing funds, there are usually variations in the TERs due to fund management strategies - either it’s an actively managed fund with high TER because of active trading and research or a passively managed index fund with low TER.
The method used to calculate TER is not uniform, leading to different expenses being included or excluded across different regions. This makes it necessary for investors to be cautious. Knowing about the finer details of calculating TER leads to more accurate and unbiased comparisons among different investment opportunities.
Every investor needs to understand TER as it impacts the worth of their investment. It is possible for an increased TER to eat into returns in the long run, especially during long-term investment scenarios. This is more so for compound interest, where not only returns but also costs compound with time.
Checking the TERs of mutual funds schemes or any other form of investments is vital before making a choice.
Importance of evaluating TER for investors
While analysing funds, there are usually variations in the TERs due to fund management strategies - either it’s an actively managed fund with high TER because of active trading and research or a passively managed index fund with low TER.
The method used to calculate TER is not uniform, leading to different expenses being included or excluded across different regions. This makes it necessary for investors to be cautious. Knowing about the finer details of calculating TER leads to more accurate and unbiased comparisons among different investment opportunities.
Total Expense Ratio: Formula and Calculation
The calculation of TER includes management fees, administrative fees, operational costs, and other expenses incurred by the fund. These are aggregated and then divided by the fund's total assets to determine the TER percentage.
Step-by-step calculation process
- Identify all costs associated with the fund, including management, administrative, and operational expenses.
- Aggregate these costs to find the total annual expense.
- Divide the total annual expense by the fund’s average net assets over the year.
- Multiply the result by 100 to get the TER percentage.
Formula
TER = (Total fund assets / Total fund costs) * 100
Examples to illustrate TER formula
Examples
If a fund has total annual expenses of £200,000 and average net assets of £10 million,
the TER is (200,000 / 10,000,000) 100 = 2%
For a fund with £500,000 in total annual expenses and £25 million in assets,
the TER is (500,000 / 25,000,000) 100 = 2%
the TER is (200,000 / 10,000,000) 100 = 2%
For a fund with £500,000 in total annual expenses and £25 million in assets,
the TER is (500,000 / 25,000,000) 100 = 2%
Exploring Total Expense Ratio (TER) in mutual funds
The Total Expense Ratio (TER) is very important in mutual funds. It shows the total cost of running the mutual fund as a percentage of its average net assets.
It encompasses such expenses as:
It encompasses such expenses as:
- Portfolio management charges
- Administrative charges
- Operational expenditure
The importance of TER lies in its direct effect on an investor’s earnings. Basically, the higher TER, the lower the investor will receive because it means that these costs are deducted from a fund’s overall returns.
Fund expenses go directly into reducing the return on investment (ROI) of the funds and become a major part in appraising the effectiveness of mutual funds.
Fund expenses go directly into reducing the return on investment (ROI) of the funds and become a major part in appraising the effectiveness of mutual funds.
The best way to describe the effect is that if there are two mutual funds with similar gross returns, the one with a lower TER will present higher net returns to its investors.
This is especially important for long-term investors since even a small difference in TER can become quite significant when it is compounded over many years.
Actively managed funds. which entail more intensive research as well as active trading strategies, usually have higher TERs than passively managed funds, such as index funds that replicate a market index and involve fewer trades.
Actively managed funds. which entail more intensive research as well as active trading strategies, usually have higher TERs than passively managed funds, such as index funds that replicate a market index and involve fewer trades.
Example #1
To illustrate, let's consider two hypothetical mutual funds: Fund A and Fund B.
Fund A is an actively managed fund with a TER of 1.5%
Fund B is a passively managed index fund with a TER of 0.5%
Assuming both funds have a gross return of 8% per year, the net return after accounting for TER would be 6.5% for Fund A and 7.5% for Fund B.
Fund A is an actively managed fund with a TER of 1.5%
Fund B is a passively managed index fund with a TER of 0.5%
Assuming both funds have a gross return of 8% per year, the net return after accounting for TER would be 6.5% for Fund A and 7.5% for Fund B.
Conclusion
Over a prolonged period, this difference in TER and, consequently, in net returns can lead to significant disparities in investment growth.
Example #2
Another example could be a mutual fund that primarily invests in stocks (equity fund). Suppose this fund has a TER of 1.2%.
This TER would include costs like management fees, legal expenses, and administrative charges.
This TER would include costs like management fees, legal expenses, and administrative charges.
Conclusion
If the fund's assets grow significantly, the TER can decrease due to economies of scale, potentially making the fund more attractive to investors.
Investors should diligently consider TER, alongside other factors, to choose the funds that align with their investment goals and risk tolerance.
Total Expense Ratio components
Within the total expense ratio of any mutual fund, there are several factors that are instrumental in the overall operation of the fund. In totality, these components determine the aggregate burden on investors. The understanding of these components helps to evaluate more thoroughly the effectiveness and suitability of a fund.
Component | Description |
Management | Charges by fund managers for their expertise in selection and management of investments. A significant part of TER ensuring competent management of the fund's assets. |
Marketing | Expenses incurred in advertising and promoting the fund to potential investors. Crucial for attracting investment, impacting the performance and growth of the fund. |
Distribution | Costs linked to making a fund accessible to investors, including payments to brokers and agents. Often associated with marketing. |
Administrative | Day-to-day expenditures related to running the fund, such as record keeping, customer service, and general administrative work. |
Compliance | Costs ensuring the fund complies with legal and regulatory requirements. Includes legal fees, auditing expenses, and regulatory filings, due to heavy financial market regulation. |
Other Necessary Fees | Miscellaneous costs like custodial services fees, accounting fees, transfer agent service fees, etc., essential for the fund's operation. |
Role played by 12b-1 fees in mutual funds
One particular component of Total Expense Ratio often discussed is called 12b-1 fee. These fees which were named after an SEC rule that allows them are meant for covering distribution and shareholder services charges. Payments for selling and marketing shares of a given mutual fund can be classified under 12b-1 fees thus enhancing activities aimed at retaining investors.
Distribution and Shareholder Service Fees form part of 12b-1 charges specifically meant for distributing securities (like broker compensation) and also for providing shareholder services (like answering questions and maintaining accounts).
Distribution and Shareholder Service Fees form part of 12b-1 charges specifically meant for distributing securities (like broker compensation) and also for providing shareholder services (like answering questions and maintaining accounts).
Comparison of TER in ETFs vs mutual funds
Expense ratios will differ across all ETFs. ETFs tend to display lower TERs than equivalent mutual funds, but this is not always the case. The reason is that ETFs normally employ a passive management approach that usually involves tracking indices rather than choosing stocks actively.
On the other hand, mutual funds tend to have higher management and operational costs, which are incurred by actively managed funds. This distinction in style of management is crucial to understanding why TER between these two forms of investment vehicles differ.
The total expense ratio (TER) has the same effect on ETF performance as it does on mutual
funds.
On the other hand, mutual funds tend to have higher management and operational costs, which are incurred by actively managed funds. This distinction in style of management is crucial to understanding why TER between these two forms of investment vehicles differ.
The total expense ratio (TER) has the same effect on ETF performance as it does on mutual
funds.
Total expense ratio vs ongoing charges: Key differences
Unlike the TER, the ongoing charges figure typically does not include transaction costs incurred from buying and selling securities within the fund, except in certain cases where these costs are included in the ongoing charges figure for funds marketed in the European Union under regulations like UCITS (Undertakings for Collective Investment in Transferable Securities).
Formula
OCF (Ongoing Charges Figure) = (Average NAV of the Fund / Total Recurring Costs) * 100
The ongoing charges are expressed as a percentage of the fund's average net asset value over the year. They provide investors with a clearer picture of what it will cost them annually to hold the investment, helping them compare the costs of different funds more effectively.
Evaluating Total Expense Ratio: Best practices for investors when evaluating TER
Evaluating the Total Expense Ratio (TER) is a must when putting money into mutual funds or exchange-traded funds (ETFs). Here are some best practices for investors:
- Understand what TER includes: TER covers all of the costs that come with running the fund in a year. This includes management fees, administrative expenses, and other operational fees. You want to know about this so you can see how efficiently the fund is being managed.
- Compare TERs across similar funds: Comparing TERs is important because it will show if you’re paying too much for similar investment strategies. If two funds are practically equal, but one has a lower TER, it’s probably better to go with that one.
- Balance TER with fund performance: Having a low TER is great, but it shouldn’t be the only thing you look at when choosing which fund to invest in. You also need to take note of its historical performance and risk management strategies. Sometimes it might be worth going with a slightly higher TER if you think it’ll give you better returns.
- Consider the impact on long-term investments: Even if it’s small, a difference in TER can have big effects on compounded returns over time. Use expense ratio calculators to get an idea of how much long-term impact your chosen fund will have on your total investment.
- Evaluate the services offered: Higher TERs aren't usually bad as long as they provide you with more benefits than lower ones would have. That could mean additional services or expertise provided by the fund manager.
Recap
Total Expense Ratio (TER) is an important factor when evaluating the potential costs of mutual funds and ETFs. It combines the associated fees into one total amount. These fees include management, administrative, and operational expenses.
Investors need to understand what TER is because it directly affects the performance of these investment vehicles by reducing their net returns. With a strong understanding of TER and how it impacts your investment strategy, you’ll be able to easily decide between different funds from a cost perspective leaving the other main consideration as the expected future returns of the fund.
Investors need to understand what TER is because it directly affects the performance of these investment vehicles by reducing their net returns. With a strong understanding of TER and how it impacts your investment strategy, you’ll be able to easily decide between different funds from a cost perspective leaving the other main consideration as the expected future returns of the fund.
FAQ
Q: What is Total Expense Ratio (TER) and why is it important?
The Total Expense Ratio (TER) shows the cost of managing a mutual fund or an exchange-traded fund (ETF), expressed as a percentage of the total assets of the fund.
Why is it crucial? It decreases the overall returns from investments, i.e. a higher TER implies more costs to run the fund, which leaves less profit to distribute to shareholders.
Why is it crucial? It decreases the overall returns from investments, i.e. a higher TER implies more costs to run the fund, which leaves less profit to distribute to shareholders.
Q: Does TER include all costs associated with a mutual fund?
While TER consists of mostly annual operating expenses such as management fees, administrative expenses, and other operational charges, the transaction expenses incurred in trading securities within the portfolio are typically not included, nor do they include performance payments in some cases.
Q: How does TER impact my investment returns?
As your return on investment is decreased by this cost, which is subtracted from a fund’s assets, TER directly affects your investment returns. More costly funds – with higher TERs – can significantly affect your investment growth over time, especially where compounding investment strategies are used.
