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Smart Beta: why the TER is not enough when measuring performance

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Smart Beta: why the TER is not enough when measuring performance

Alan Miller, partner at SCM Private, compares the performance and costs of ETFs versus index trackers

In an exclusive article for Wealth Manager he writes:

As investors become more familiar with exchange traded funds (ETFs), it is important that they do not assume you simply select the fund with the lowest total expense ratio (TER) and this will perform the best.

Most people in the industry know the so-called TER or ‘ongoing charges’ can be thoroughly misleading, particularly when a fund trades actively or charges performance fees. It is equally misleading for trackers.

Measuring performance

We analysed 33 FTSE 100 and FTSE All Share ETF or mutual fund trackers over the past three years. The total sum invested in the funds is £22.8 billion. Key findings include:

The performance of index trackers varied significantly – the worst tracker underperformed its index by 2% a year.

The average ETF underperformed by less – the ETFs underperformed by 0.4% per annum, compared with 1% per annum for an equivalent mutual fund tracker.

The average ETF charged less – the reported TER for a FTSE 100 ETF was less than half its mutual fund equivalent (0.37% versus 0.88% a year). The average FTSE All-Share ETF charged 0.4% a year versus 0.67% for the average mutual tracker. 

‘Hidden’ costs or performance drag can be significant in mutual fund trackers – the extent to which they underperformed beyond their stated TERs represented an extra 54% of an average mutual fund tracker’s costs, but just 10% of an average ETF tracker.

Three popular mutual fund trackers, managing a combined £2.2 billion, managed to underperform their benchmark by three times or more than their stated TERs.

Careful selection was much more critical in mutual funds. The difference between selecting the worst against best ETF in terms of performance was 0.2% per annum for the ETFs but it was 1.9% annualised for the mutual funds analysed.

So why is the reported TER such a bad guide, particularly for mutual fund trackers?

First, some of the mutual fund trackers are run by traditional active management companies that probably do not have the same level of experience and expertise found in many pure index-tracking companies.

One big mutual fund tracker, from a group known principally for its active funds, has managed to underperform its benchmark by 0.9% a year over the past three years when its reported TER is just 0.3%. It recently had 12.7% invested in FTSE 100 futures and another 8.1% via a money market fund. 

When tracking a diverse index, such as the FTSE All-Share, there may be many smaller stocks that some funds choose not to fully replicate to save direct costs. Second, the way the mutual fund structure works can often mean that when there are big inflows or outflows into a fund, the associated dealing costs are often effectively being borne by all unitholders, both old and new.

Fund managers often charge a dilution levy on new, large single inflows to offset this but the system is by no means perfect. Interestingly, one mutual fund company avoids this by operating a pre-set dilution levy on all purchases and sales.

Diligence is due

This issue does not arise in ETFs as each unit is essentially created at its direct cost, and most people are effectively buying it secondhand and therefore much more cost effectively.

For example, while buying shares directly costs 0.5% stamp duty and spreads of often around 0.3%, commissions may add up to 1%. The spread of some FTSE 100 ETFs is just 0.1% a year if you buy them through the market with no stamp duty. 

The lessons are that due diligence needs to be performed almost as much in index funds as conventional active funds, be it in a mutual fund or an ETF structure. 

Key questions must be asked:

What is the expertise in index tracking by the provider? 

How do the funds replicate the index?

How are dilution levies charged?

What is the spread of the ETF?

The difference between a good or bad ETF tracker is relatively small but for mutual fund trackers the differences can be significant. Until there is a proper system of displaying costs, extensive due diligence is required whether analysing active or index funds.

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