Don’t be misled: think TER not AMC

The Annual Management Charge (AMC) is one of the most useless terms bandied around the world of investing. It’s trumpeted time and again in the media, in errant fund screeners, and by online forum dwellers as evidence of low cost funds that are worth investing in.

But the AMC is as misleading as a price that doesn’t include VAT. The sting is in the final bill.

What is TER?

The Total Expense Ratio (TER) is the cost to look out for when comparing funds. It’s a FSA-approved measure1 that offers a more accurate picture of the annual operating expenses that drag down the performance of your investment.

These operating expenses include:

• Annual management charge
• Legal fees
• Administrative fees
• Audit fees
• Marketing fees
• Directors’ fees
• Regulatory fees
• The mysterious ‘other’ expenses (biscuits, perhaps?)

Unlike reading that list, the TER will never make you yelp with pain. It’s not deducted directly from your bank account. It’s a stealth cost: a percentage silently shaved off your fund’s investment return over the course of a year.

The lower the TER the better, although you’ll struggle to beat a TER of 0.27% on a UK equity tracker fund. A TER of 1% on a similar fund would be like daylight robbery with extra kickings.

What difference does the TER make?

As fund firm Vanguard put it in their own prospectus:

Even seemingly small differences in expenses can, over time, have a dramatic effect on the Fund’s performance

We can witness that drama like an episode of 24 by comparing the TER cost of two otherwise identical funds:

Fund B has been whacked for over £8,000 more in charges over the period. That cuts your return by a painful 15.77%.

This sort of needless loss can be avoided by choosing funds with the most competitive TER wherever possible. You can compare TER damage yourself using a fund cost comparison calculator.

The illustration above also shows why it’s important to deal in TERs not AMCs. For example, Fidelity’s MoneyBuilder UK Index Fund declares an AMC of 0.1%, which is nearly three times smaller than its TER of 0.27%. A difference guaranteed to knock your calculations out of whack if you listen to lazy journalists.

TER twists

Beware that TERs are not fixed. You can find the TER in the fund fact sheet or prospectus, but you’ll also find small print explaining the fund manager reserves the right to charge extra for any unexpected operating costs.

That’s because the TER is a calculation based on the previous year’s events. Published TERs therefore represent an expectation of costs rather than a guarantee.

Don’t expect listed TERs to be accurate when you’re screening for funds, either. I’ve yet to find a fund screener that’s 100% up-to-date, or above occasionally quoting the AMC. The only way to be sure of an accurate TER is by checking the latest fund literature.

Hidden costs not in the TER

Sadly for the weary investor, the TER is not the one-stop cost-shop it’s often thought to be.

Though it’s the most practical tool we’ve got for instantly comparing funds, TER doesn’t tell you anything about:

• Initial charges and exit fees
• Brokerage fees
• Bid-offer spreads
• Market impact costs
• Taxes (e.g. stamp duty)
• Interest on borrowing
• Soft commissions

You’d need to subject most funds to a forensic examination to suss the impact of that lot upon your costs. Happily though, there are some useful rules of thumb that help show the way. I’ll return to that in a future post.

Suffice to say, the passive investment strategies adopted by index trackers make them far less prone to these costs than active funds.

Take it steady,

The Accumulator

1. TER = Total Operating Costs / Average Net Assets [↩]