Portfolio Analysis Basics #1 – Focus on “TER”​ (Total Expense Ratio)

Portfolio Analysis Basics #1 – Focus on “TER”​ (Total Expense Ratio)

A favourite saying of mine (among many!) is that you can “always guarantee charges, but never guarantee returns”, so it clearly makes sense to minimise those charges. Not doing so represents a lost opportunity to avoid paddling upstream in an unnecessarily leaky boat.

In this week’s article I’m going to focus on the Total Expense Ratio of a portfolio, which represents the first significant portfolio attribute I’d like to explore over a short series of articles.

Total Expense ratio – what is it?

The TER is the annual percentage-based charge that the fund manager (e.g. Blackrock, JP Morgan etc) levies to compensate themselves for managing a fund. So, “actively-managed” funds tend to have a higher TER than “passively-managed” index-tracking funds (such as ETFs), reflecting the additional work inherently involved in active management.

An important point to note for active funds is that there are generally two tiers of TER, depending on how much cash you have available to invest (and/or whether you are investing via a platform which provides preferential access due to the mass-purchasing power of the platform provider):

  • “Retail class”: with a TER of e.g. 1.5% e.g. for an investor with e.g. $2000 minimum.
  • “Institutional class”: with a TER generally 0.5% p.a. cheaper than “retail class” (e.g. 1.0% vs. 1.5%) for an investor with e.g. $1,000,000 minimum.

Compared with these, the TER on an ETF (as a passive fund) will generally be distinctly cheaper e.g. 0.25%.

The “portfolio TER” is simply the weighted average of the fund TERs. For example if we have a portfolio with two fund holdings (a 75% holding of fund A with TER of 1.0% and a 25% holding of fund B with TER of 0.8%) the portfolio TER would be (0.75 x 1.0) + (0.25 x 0.8) = 0.95%.

So, if TER is cheaper with ETFs, why not just use ETFs?

A very good question! However, the broader question that needs to be considered is this: “is the active manager earning their higher TER by producing better return vs. simply tracking the index?”.

One area in which I can add specific value as a financial adviser is in finding (and subsequently monitoring) funds with long track records of consistently outperforming their indexes and which are therefore worth investing in, based on net returns (i.e. returns after fund charges have been taken into account).

The following chart, for example, shows 7 years of net performance of a mysterious actively-managed global equity fund “A” (which I’d be happy to reveal over a coffee!) vs. a Vanguard World Equity ETF “B”:

The fund “A” has a TER which is around 0.5% more expensive than the ETF. But the net return, even after paying that additional 0.5% every year over the 7 year period, has clearly been superior to the ETF.

Choosing the “cheaper” ETF in this case would therefore be a very classic example of a “false economy”!

Ah. So if active funds out-perform ETFs, why not just use active funds?

The simple answer to this is that active funds generally do not outperform the indexes they are attempting to outperform. I will therefore use ETFs where such outperforming active funds do not exist and/or as a supplement to an active fund holding, so as to increase diversification (e.g. with an ETF holding 2000 stocks vs. an active fund holding only 100 stocks). The other benefit of using ETFs, returning to the subject of TER, is that this reduces the overall expense of a portfolio.

Conclusion

Are you aware of the TER of your portfolio? I frequently come across portfolios (put together by less cost-conscious financial advisers) which have a TER of 1.8% or more. The TER of one of my own typical lump sum investment portfolios, for comparison, is around 0.7%, representing a 1.1% annual saving to a client just with focus on this one element of portfolio construction.

Written by Michael Davidson
This article aims to provide information, it does not constitute financial advice, nor should it be relied upon as such. You should speak to a financial advisor regarding your circumstances before making a financial commitment. Global Financial Consultants Pte Ltd is a Licensed Financial Advisor and is regulated by the Monetary Authority of Singapore. MAS License number FA100035-3



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