Total Expense Ratio (TER) does not show all costsHowever, the total cost of owning an ETF (or any other investing vehicle) isn’t completely captured by Total Expense Ratio (TER). The TER or its near identical twin the Ongoing Charge Figure (OCF) is the estimated annual cost of owning an ETF. These are the charges that you will see quoted on a product’s website or in the Key Investor Information Document (KIID).
This cost will be deducted pro rata from your holdings on adaily basis but it isn’t the full price you’ll pay. For that, we need to turn to the Total Cost of Ownership (TCO).
Total Cost of Ownership (TCO): All costs at a glanceYou won’t generally find the TCO on any website or factsheet. That’s because the TER and OCF have been agreed between the investment industry and the European Union while there is no standard definition of the TCO.
Nevertheless, investors should consider the TCO when selecting ETFs because the product with the cheapest TER isn’t necessarily the cheapest product you can buy. We’ll tell you how to work out the TCO below.
A look behind the scenes of cost figuresThe TER and OCF includes the ETF’s annual management charge plus various other expenses including index licensing fees, legal fees, administration, marketing, regulation, auditing and so on.
The TCO, meanwhile, captures extra internal costs that are missed by the TER including dealing fees, spreads and taxes or swap fees in case of synthetic replication, respectively, that are incurred on the ETF’s underlying holdings. Gains from security lending are also attributed to it. These costs are an inevitable part of running any type of investment fund.
On top of that come various external costs that are more visible to the investor: these include platform charges, dealing fees and the bid-offer spread you pay when you trade the ETF.
Those external costs are relatively transparent because your platform must disclose its platform charges and dealing fees to you while you can check the bid-offer spread (the difference you sell and buy for - think buying foreign currency when you go on holiday) by looking up the prices of your ETF.
Total Cost of Ownership for an ETF investment
Tracking difference as cost figureBut how can you uncover the hidden internal costs of the ETF if they’re not included in the TER? The answer is to look at the ETF’s tracking difference.
Tracking difference is the discrepancy between an ETF’s returns and the returns of the index it aims to replicate.
For example, if an index returns 10% and the ETF returns 9% then the tracking difference is -1%.
And that 1% difference is effectively your TCO plus the external investor costs discussed above.
Strangely, tracking difference can be positive on occasion. This is because an ETF can earn extra revenue from activities such as securities lending or it can benefit from a more favourable tax regime than is taken into account by the calculation of the index return. It may even be because the ETF’s composition differs slightly from the index and this plays out to the advantage of the ETF for a period.
The best way to see tracking difference is to chart your shortlist of ETFs against the index they follow over a longer time period. You may ignore any comparison below one year.
However, it is difficult to find appropriate index data for a significant comparison like outlined above. Alternatively, you can compare the returns of several ETFs replicating the same index. Just choose the appropriate ETFs and chart them against each other. Usually, the one ETF with the highest returns - within several time periods - shows the lowest TCO.
FTSE 100 ETFs in comparison
Source: justETF.com; FTSE 100 ETFs older than 3 years, accumulating;
Period: 3 years (31/07/2012 - 31/07/2015); All calculations in GBP