There are two issues to consider when assessing the total costs of ETFs.
1. The ETF’s total costs which consist of the following:-
Management Expense Costs plus Other Costs = Total Expense Ratio (but still excludes transaction and some other costs)
2. Other specific investor costs (refer article Investors Total Portfolio ETF Cost).
These are the type of costs that will be different for each individual investor. For example transaction costs, tax issues etc vary depending on the individual investors choices and situation.
Typically funds disclose two expense ratios:
1. The management expense ratio (MER) which provides a measure of ongoing costs and expenses, it is the fee that the fund company charges annually to manage the fund. The truth is that the MER is selective in the expenses included and will always underestimate the amount actually paid by an investor.
2. The total expense ratio (TER) is not widely adopted in Australia and can be calculated as an amount which includes ‘other’ charges incurred with running the fund. These other charges can consist of expense recovery amounts, share registration fees, legal fees, auditor and custodian fees.
The Total Expense Ratio is calculated by dividing the total annual cost of the fund by the funds average total assets.
However not included in either the MER or the TER is transaction costs as a result of trading of the fund’s assets and also any performance fees if applicable.
Transaction costs include brokerage on equity and exchange traded derivatives transactions, transactional custodian, ASX and registry fees, others transactional service fees and other transaction fees associated with buying and selling the funds assets or other costs an investor would ordinarily incur when investing in the underlying assets.
Transaction costs can be far from insignificant a new study has found, in the study published in the Financial Analysts Journal, Roger Edelen, Richard Evans, and Gregory Kadlec—of the University of California, the University of Virginia, and Virginia Tech looked at 1,758 domestic equity funds and analyzed available information to estimate trading costs, which can come in the form of everything from brokerage fees to bid-ask spreads.
They found investors pay around 1.4% in trading costs. In many cases, that’s more than they pay in management and operational fees. Investors in small-cap growth funds payed an average of 3.2% percent per year in trading costs and large-cap value funds, investors paid around 0.84% percent.
As noted above TER ‘all in fee’ does not include transaction costs but there are sometimes some other add ons to watch out for in the prospectus which include:
1. Custodian, index and account service fees
2. Swap spreads
3. Securities lending charges
4.Withholding tax cushioning
Custodian, index and account service fees
Funds have to pay to track indexes and this comes out of the funds returns
Funds that track indexes using derivative contracts pay a spread which is not disclosed
Securities lending charges
Some funds lend out their securities to earn additional income, although this is/should be a net revenue income to the fund, investors are often charged an additional amount for the service (whilst investors carry the risk).
Withholding Tax Cushioning
Some funds which invest in overseas securities are liable to pay withholding tax.
Many ETF’s actually track their performance against the NET total return version of the index, but the net return is after withholding tax. And this net total return often deducts a larger amount of withholding tax than ETF’s actually pay. For example the S&P500 Net Total Return Index includes a deduction for an assumed 30% withholding tax but ETF’s generally use double taxation agreements and only actually pay 15%. Or sometimes they actually avoid paying any withholding tax at all through their stock lending arrangements (just the when the dividend is due the stock is lent to a 3rd party where no withholding tax is payable).