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 A||Fund B|
|Holding period||25 years||25 years|
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.
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,
- TER = Total Operating Costs / Average Net Assets [↩]
I have a question which I think will sound very naive. If I look at the performance chart of a fund does that “allow” for the TER or AMC or any of the charges or is it simply comparing the unit price? For example if I look back over 10 years at a fund’s chart and compare it to say a FTSE 100 tracker it may seem to have outperformed it by 5% over those 10 years. However, if this isn’t factoring in anuual charges of say 1.5% for the fund and 0.25% for the tracker it will have actually underperformed. Hope this makes sense?
Worth making the point that costs hit the all-important “real” returns harder than the “nominal” usually quoted.
If nominal return is 7% and inflation is running 3% then real return is 4%. 1% in costs knocks 14% off the nominal return (1/7) but 25% off the real returns (1/4).
If nominal returns are 10% then the ratios are 10% reduction on nominal vs 14% on real.
Put that over 25yr and you really see the impact.
Nice web-site…a lot of sense.
Excellent points on the TER issue.
During the recession the portfolio turnover rates for some funds were above 90%. Of course, this buying and selling won’t show up in the TER and it’s a good way of earning some extra cash – if done in the right way.
From memory, I’m not sure it’s a regulatory requirement to put the TER in the fund fact sheet, although, some do. As you say, the prospectus is another area to look at.
IMPORTANT NOTE Re. Personal Pensions and Stakeholders
There are funds referred to as “external” funds and they’re meant to mirror some of the non-insurance company funds out there. The idea is, you gain access to some of the better known fund managers and their expertise.
They’re rarely a perfect mirror and even those that invest directly in the fund they are supposed to mirror it isn’t done that often e.g. querterly. I wonder where the money goes inbetween???
Only use the fact sheet from the pension company, not the actual fund they are mirroring.
@ branoc – the fund performance chart should factor in TER as TER is deducted from return.
@ Thomas Jones – UCITS funds do have to put the TER in the factsheet.
This is a very good article on Total Expense Ratio. Guess what. Three years on, nothing changes, as you can see from an article on FT.com in the same vein – http://www.ft.com/cms/s/0/faf614da-170f-11e3-9ec2-00144feabdc0.html