Weighing Up Fees

There are now so many different ways of quantifying fees that it's hard to know which one to use. Nic Oldert tries to untangle the web.

First there was TER. Then there was TC, followed immediately by TIC. But there was also RiY, and now we also have EAC and RSC. Did somebody mention TCO? And what's OCF again?

Pity the retail investor. Even for those of us who work in the industry the various measures of fund costs can be confusing. How do the various numbers differ from one another? Are they comparable? If more than one number is available for a fund, which is the best one to use?

Total Expense Ratio (TER)

Let's start with TER, which was implemented specifically for collective investment schemes. The TER includes everything that is charged to the fund except transaction costs, which are quantified separately. The manager's annual fee, administrative costs, and a performance fee if there is one, are the main components of the TER, but it includes other things like annual trustee fees.

if you hold the product for ten years the cost will be 1.7% per year, but if you only hold it for three years the cost will be 2.6% per year

Like most cost measures, TER is expressed as a percentage of asset value. A TER of 1.5% means that costs of R15 per year are removed from portfolio assets or portfolio income for every R1,000 in the fund. If you invest R20,000 and TER is running at around 1% you give up about R200 a year of your potential return to pay for administration and asset management services.

TER is reported historically, quarterly in arrears, so it does not tell you what you will pay in the future. For most established funds, however, the TER does not fluctuate too much, so it provides a good indication of what to expect.

Importantly, TER is calculated and reported at fund level. It relates to a fund and only includes the fund's costs.

TIC TOC

As mentioned above, the TER does not include transaction costs. These are reported separately as a "TC" percentage. Most fund fact sheets add TER and TC together and call it TIC (Total Investment Cost).

How "total" is the Total Investment Cost figure? Well... TIC includes everything except platform fees, initial charges and commissions payable to financial advisors.

Hold the phone, I hear you say, so it's not everything?

Well, yes, there may be other costs.

TIC is an accurate measure of all-in costs if you invest directly with a fund manager without the help of an advisor. The reason that platform fees, initial charges and broker comm are excluded is because they vary and may or may not be applicable. Many investors deal directly with the manager, circumventing platform costs. Not everyone uses a financial advisor and advisor fees are negotiable. So as a reporting standard for funds themselves, it makes sense that these are excluded from TER.

Effective Annual Costs (EAC)

As we said above, TER and TIC are expressed as annual percentages of asset value. Why, then, is there another cost measure called "effective annual cost"?

The problem with the TER is that it doesn't work well for products with defined life spans, like investment endowment policies. It also excludes upfront charges which are compulsory in some other products.

Unlike unit trusts, which are created under the collective investments legislation, endowment policies are insurance products. In the insurance industry, certain costs, like broker comms, are built in and paid out immediately. The "effective annual cost" of these fees reduces (on a per annum basis) the longer you stick with the product. EAC therefore reports costs based on certain defined periods.

In the example below, the effective annual costs are for the life of the product. In other words, if you hold the product for ten years the cost will be 1.7% per year, but if you only hold it for three years the cost will be 2.6% per year .

Charges	1 Year	3 Years	5 Years	10 Years
Investment Management	1.0%	1.0%	1.0%	1.0%
Advice	1.0%	1.0%	0.5%	0.5%
Administration	0.5%	0.3%	0.3%	0.2%
Other	0.3%	0.3%	0.3%	0.0%
Effective Annual Cost	2.8%	2.6%	2.1%	1.7%

EAC is an attempt to make different kinds of products comparable. In theory, EAC allows you to compare, for example, the costs of a unit trust and an endowment – but there are a few complications.

The EAC for a unit trust is generally reported as if you are buying directly from the manager – it doesn't automatically include broker comm.

Most fact sheets actually refer you to online calculators for EAC, and the calculators usually allow to enter percentages for initial comm, trailer comm, and so on. By using these fields it's possible to ensure you're comparing apples with apples. Of course you may not want to compare like with like – for professionals it is interesting to see what an endowment costs compared to a unit trust bought directly (not via a platform) with no commissions payable.

Ongoing Charges Figure (OCF)

With the increasing popularity of offshore investing, you may come across OCF on fact sheets. OCF is the UK version of the TER (and conforms to the principles of the European Ongoing Charges metric).

Like TER, OCF excludes transaction costs. Unlike TER, OCF does not include performance fees.

Retirement Savings Cost (RSC)

RSC is a new metric designed to assist potential and existing participating employers and/or boards of trustees (referred to as "clients") when comparing quotations from different ASISA members of product solutions to retirement funds.

The RSC differs from the EAC because the latter is aimed at individuals.

The RSC Disclosure Standard is for use by employers and trustees, it is not a member level cost disclosure standard – it is not designed for disclosure to individual fund members.

In short, unless you're an employer or a trustee, you can scratch RSC off your list.

Reduction in Yield (RiY)

RiY is a method used by the life assurance industry to illustrate the possible effect of costs on an investment. It is an estimate of the decrease in total annual returns attributable to costs.

The total annual return is the percentage gain per year as a result of capital appreciation, interest and dividends (assuming these are reinvested).

An RiY of 3% means that the product provider expects that 3% of the annual return – over the life of the product – will be absorbed by costs. For example, assuming total growth of 10% per annum, an RiY of 3% means a net return of 7% per annum. To put it differently, if a fund suffered zero growth, a 3% RiY would mean a 3% per annum reduction in capital, which equates to 14% total loss over five years.

RiY, as a future estimate rather than an historical calculation, can be misleading. Firstly, the projected annual return, which is an unknown, impacts the RiY inversely (ie, RiY rises with returns where annual fees are a percentage of investment value). So conservative projections actually understate RiY. Secondly, because it includes upfront costs (like commissions), it is sensitive to the time period – the RiY on a product held for 10 years will be lower than the RiY over five years, all other things being equal. Hence assurers can play down RiY by using long time-period projections. Thirdly, RiY does not take into account penalties that may be levied if contractual contributions are reduced or stopped (and, historically, a minority of policies go the distance). These and other factors mean that RiY often understates future costs to the investor.

Conclusion

Right, did we miss anything? Oh yes, TCO. Total Cost of Ownership, or TCO, stems from a call by the FSCA for a single measure of fees that can be applied to all types of financial products. The EAC goes some way to meeting this call. At this stage TCO is just a concept.

If you're confronted with a range of cost measures, some of the main points worth remembering are:

TER and TIC are backward looking, EAC and RiY are forward looking;
EAC and RiY include various costs excluded from TER and TIC, such as initial charges / broker comm, contract penalties and exit charges;
OCF is similar to TER but excludes performance fees.

If RiY is all you've got, assume costs will be higher than estimated, especially for shorter periods.

And finally, TOC stands for Total Ownership Cost, which is a metric used in project commissioning. If people are talking about TOC they probably mean TCO. Unless you're all in uniform carrying firearms, in which case they might mean Tactical Operations Centre.