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

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.