The relatively poor performance of actively managed funds against benchmarks in recent times is striking with the tenth annual S&P indices versus active funds scorecard finding that of US large cap funds in the US last year, 81.2% did not beat the S&P 500 benchmark and over 5 years only 5% of those who did beat it remain in the top quartile.
With poor performance comes an attendant focus on costs as a contributor to that record. The performance metric and low cost nature of an ETF, coupled with the lack of incentives in commission based sales that RDR and similar EU initiatives will introduce, means the day of reckoning between ETFs and a section of the traditional mutual funds sector is fast approaching. While a balanced portfolio will always have scope for alpha strategies the trend towards beta investment by ETFs can only grow given so many so called alpha funds are not even beating their benchmarks.
Meaningful analysis of funds can only be though a like for like analysis based on cost and performance and it is important that investors – and in particular the retail investor – has sufficient weapons at their disposal to facilitate this.
Within that focus on cost one of the traditional measures has been the funds total expense ratio or TER. The TER is the ratio of the funds total operating costs to its average net assets. The calculation of this ratio will, broadly, include management fees, administration and distribution costs but typically exclude transaction costs, payments through use of derivatives or entry and exit commissions or other fees paid directly by the investor.
The flat fee pricing model of ETFs presents immediate advantages against traditional mutual funds. The majority of ETFs impose a single fee from which all the operating costs are discharged. While the investor in a retail fund may be able to derive useful information through analyzing the TER it is difficult to receive a granular breakdown of the likely costs of investment given the prospectus of that fund will typically suggest a management fee and administration and distribution costs which may vary across a band of maximum limits. The impact of assets under management is also key – while a small traditional fund with low assets under management may see investors suffering a greater impact on value and performance through cost erosion (the custody costs may for example be higher in smaller funds and this cost is borne here by the investor and not the promoter), the promoter of an ETF will generally bear any losses on sub scale funds though he will of course benefit in administrative cost reductions on larger funds. Factory gate pricing with no investor impacts through scale means that smaller and larger ETFs have the “same” TER as compared to traditional mutual funds.
TER is not however the whole picture and we have seen calls from the traditional funds industry for a move to a metric that reflects the complete or total cost of ownership for investors in funds – a metric that would include the transaction, commission and other fees excluded by the definition of TER. This call reflects the growing impact of the ETF model and its attendant transparency on the larger funds universe and perhaps suggests attempts to harmonise the models to some extent – a welcome opportunity to square a circle where promoters offer ex facie rival products in ETFs and traditional funds in the same house.
While moves to a complete cost of ownership calculation within the traditional funds world would be clearly beneficial to the end investor it is not without benefit in the realm of exchange traded exposures.
As we have seen the definition of TER excludes transaction costs. In physically backed funds the impact of rebalancing will not be reflected in the TER and may be a significant cost particularly if the index methodology requires frequent rebalancing and the instrument transaction costs are high – a feature which may be amplified in the case of fixed income funds or where the size of the fund means transaction costs do not benefit from large scale transaction savings.
In synthetic funds the swap transaction costs are similarly not disclosed in the TER and may be significant if not absorbed by the fund promoter. The causes of tracking error in other funds may be smoothed in a synthetic fund but the cost impact of that smoothing may be reflected in the swap spread charged.
In both physical and synthetic funds the secondary market investor needs to consider the market spread charged by their broker which may be significant in less liquid or difficult to hedge markets or where there is only one market maker.
As ever when we consider non fund exchange traded exposures we are in significantly less clear territory and there is no requirement to publish even a TER. While the prospectus of these instruments will require full fee disclosure the experience of the retail investor trying to decipher a prospectus – which may be unseen by the secondary market investor – is not a happy one.
The lessons then are clear. Support for the principle of transparency suggests a move by the entire funds industry towards a complete disclosure on costs of ownership is to be welcomed while again we must draw attention to the unhappy position of unregulated and possibly unsuitable investments being available to the unadvised retail investor.
Total cost of ownership will be a welcome metric for investors assessing their investment through it and supporting measures such as tracking difference and performance.