Annual fund charges and Total Expense Ratios (Fitzrovia TERs)
Investment in collective or mutual funds worldwide, including unit trusts, investment trusts, OEICs and ISAs in the UK, are becoming increasingly popular. But investors rarely know how much it really costs to invest in their chosen funds, or why such charges are important.
Fitzrovia International, the specialist fund research company who provide data and analysis to fund managers, funds associations and regulators around the world, believes that knowledge of true annual costs is essential information for investors. The following notes are offered as a guide to annual charges and their importance.
1. What is a Total Expense Ratio (TER)?
Total annual fund charges are expressed as the Fitzrovia Total Expense Ratio (TER).
The TER represents the drag on fund performance caused by all annual operating costs (including administration, trustee and audit fees), not just the basic annual management charge.
All funds incur other charges not usually included in the annual management charge that do not contribute to a fund's investment management, but impact on an investor's returns.
So the Fitzrovia TER is the annual percentage reduction in investor returns that would result from largely fixed operating costs if markets were to remain flat and the fund's portfolio were to be held and not traded during a period.
The formula used to calculate the TER highlights that it is calculated as a proportion of the same exact average net assets as the annual management charge. Thus the TER is sound regardless of the length of the accounting period.
Below is an actual example of a fund's annual charges:
| Fund Expenses | GBP | ||
| Management Fees | 316,000 | = 1.30% | "Annual Management Charge" |
| Registrar's fees | 30,000 | ||
| Marketing fees | 41,000 | ||
| Secretarial fees | 58,000 | ||
| Custodian's fees | 28,000 | ||
| Audit Fee | 7,000 | ||
| Professional fees | 15,000 | ||
| Director's fees | 31,000 | ||
| Other expenses | 27,000 | ||
| |
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| Total Annual Expenses | 553,000 | = 2.27% | Total Expense Ratio (Fitzrovia TER) |
| Average net assets over 365 days | 24,336,692 | ||
Explaining annual charges: Questions and Answers
Q: What charges do I pay each year?
A: A range of annual expenses are charged to the fund every year for the ongoing management and operating costs of running your investment.
Q: How are these paid?
A: While you do not write a cheque to cover annual charges, these are all indirectly borne by investors each year, through a reduced return on your investment. You can expect to pay 1% to 2% a year for these (in some instances less, but in the worst cases, considerably more).
Q: That seems quite small, so why should I worry?
A: Because you pay year in, year out, for as long as you hold your investment, all of these annual charges will mount up and act as a drag on the fund performance, irrespective of market conditions.
Q: Can you provide an example of this "drag" effect?
A: A £5,000 investment growing by 7% a year should grow to be worth £19,348 after 20 years (with no annual expenses). But if the total annual expenses charged to the fund (the Total Expense Ratio, or TER) are just 1% these will drag down the performance to £16,036. An extreme example of a TER of 2.5% drags it down even further to only £12,059 - over £7,000 has been taken in charges.
Q: So should I choose a fund that has the lowest charges?
A: Not necessarily. Charges are just one of the factors to take into account when choosing or assessing a fund's prospects. Some of the best performing funds have higher charges - but they are not a guarantee of superior performance.
Q: So how do I find out about the total annual charges?
A: All the information is not always easily available to investors. When a figure is quoted as "the annual management charge" or even "the annual charge", it is almost invariably the annual investment management charge and does not include other costs such as audit fees, administration and trustee charges.
In the UK, there is guidance about charges in the document you receive with an application form called the Key Features. This includes projections of the impact charges (initial and annual) are likely to have over a period of a hypothetical investment, assuming a hypothetical growth rate. However, this is only provided at the outset: consumers do not have to be updated on changes to non-management charges, even though these charges may change over the course of an investment.
This is why Interactive Investor shows Fitzrovia International's Total Expense Ratios (TERs) on their web site. This is simply a single percentage figure showing the proportion of a fund's assets consumed by all annual charges.
Fitzrovia is the only research company to provide comprehensive total annual fund cost figures outside the USA. Their TERs have been calculated for 8 years, with greater consistency over a greater number of funds than anyone else.
Put simply, when comparing collective investments, TERs are a fairer and far more accurate indicator of total annual charges and the true drag on fund performance than the openly quoted annual management charge.
Notes on Funds of Funds and Performance Fees
a) Funds of Funds
In the case of funds of funds, Fitzrovia's TER currently reflects the total operating costs only of the scheme itself, and one should appreciate that investors will, in addition, be incurring the average annualised TER of the underlying investments as well.
Investors should note that where a fund of funds invests in funds managed by the same company, steps will usually be taken to avoid double charging of annual management charges at both fund of funds and underlying fund level. In other words, because the fund promoter is receiving management fee revenue from the underlying funds, they will not charge this at the 'top tier' fund of funds level as well.
Where investment is made in the funds of other management companies, the fund of funds' management company will charge an annual management charge at the 'top tier'.
For both of these types of funds of funds, non-management annual charges will be incurred at both 'top tier' and underlying levels.
b) Performance Fees
Performance-related annual fees are not only excluded from Fitzrovia's TER calculations, but the regulators ban them for UK-based Unit Trusts and OEICs.
It is worth noting that the Edinburgh Portfolio Performance Fund and Gartmore's Focus funds charge a management fee that changes with the fund's performance.
This tiny minority of funds gets around the performance fee ban by rebating annual management charges if they fail to reach a certain level of performance, rather than charging a proportion of the fund's out-performance of a pre-determined level. (The latter being the more conventional method used for performance fees internationally).
All of Fitzrovia's Total Expense Ratio calculations are based on published fund accounts and show all annual operating costs that have been charged to the fund over a one year period. This applies for the funds referred to above, as with all other funds.
Investment trusts and funds based 'offshore', or elsewhere outside the UK, can charge a conventional performance-related fee and some are sold into the UK. Again, while this is something to be aware of, the performance fee is excluded from the TER calculation.
© Fitzrovia International plc