Expense Ratios Explained

Expense Ratios Explained

A fund charging 1.5% a year never sends an invoice. The money leaves in daily slices out of the fund's assets, before the price reaches your screen, and the number sits on the ongoing-costs line of a document most investors never open. Spread across a working life, that line stops being small print.

€300 a month for thirty years is €108,000 of your own money. At 7% a year before costs, those contributions end at roughly €352,000 in a fund charging 0.2% a year, and roughly €274,000 in one charging 1.5%. The expensive fund does not take 1.3 percentage points. It takes €78,000.

What the gap looks like while it is still small

After ten years the two pots are close: about €51,000 against €48,000. That is the decade in which people decide fees cannot matter much, and for that decade the arithmetic agrees with them. By year twenty the gap is €22,000. By year thirty it is €78,000, or about 22 per cent of the final pot, and none of it bought a better portfolio.

The rate stays constant. The euro amount does not. In year ten the 1.5% fund charges about €718 on that pot. By year thirty it is taking roughly €4,100 a year, against about €550 for the 0.2% fund. A fee quoted as one small fixed number is, in cash, the fastest-growing line in your portfolio.

"The fee only applies to the gains"

You will hear that sentence from someone selling a product that costs well over 2% a year. It is false, and it is worth knowing why.

A fund deducts its costs from its net asset value, usually as 1/365th of the annual rate each day. On a €50,000 position, 1.5% works out at about €2.05 a day, roughly €750 a year, charged whether the fund rose, fell or went sideways. Suppose the market drops 10% this year: €50,000 becomes €45,000, the fund still takes its cut, and you end at about €44,325. In a year when the index lost 10%, you lost 11.4%. The charge also applies to contributions from the day they arrive, not from the day they turn into a gain.

On a finished pot the two readings are easy to tell apart. A 1.5% charge on €274,000 is about €4,100. On the €166,000 of that pot which is genuine gain, 1.5% would be about €2,490. No fund company charges you the second number and describes it as the first.

What the ongoing charge leaves out

The TER is the one number you can compare across funds, which is exactly why it gets quoted as if it were the whole cost of ownership.

Two funds with the same TER can cost you different amounts. A large tracker earns a little income by lending shares to short sellers, and that income can pull its tracking difference below the published charge; that is why a cheap S&P 500 tracker has in some years lagged its index by less than its own fee. A fund that samples its index, holds thinly traded shares or pays withholding tax on the dividends it receives can lag by more than its TER. The tracking difference is the number that describes what actually happened to your money.

Then there is the question of what the higher fee buys. S&P's SPIVA Europe scorecard has reported that roughly 85% of European equity funds lagged their benchmark over ten years. Anything above 1.5% a year is mostly paying for distribution: branches, advisers, printed brochures. Whatever that is worth to the people selling it, it is not a feature of the fund.