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Thursday 21 September 2017

Why TER Trumps Brokerage

Did someone say Trump? 
If, like me, you subscribe to the "buy low cost index trackers and wait" investment school of thought, you will already be well drilled in the importance of keeping fees low. In short, lower fees mean better returns.

So when I heard some market commentators becoming very vocal about the lower upfront costs of investing in an index tracking Unit Trust compared to an index tracking ETF, it definitely got my attention.

So I got out my spade, and started digging.

Maybe a little background first, to help understand the arguments being made for an Index Tracking Unit Trust and against an Index Tracking ETF.

Some Differences Between A Unit Trust And An ETF

An ETF (or Exchange Traded Fund) is a Fund that is Traded on the Exchange (bet you never saw that one coming!). So what does this mean? Well, because it trades on the exchange, it means you have to buy it through a stockbroker. So when you buy an ETF, you will pay stockbroking fees, STRATE, IPL etc. Basically, there are a number of upfront transaction costs involved in buying an ETF.

In addition, because an ETF trades on the exchange, there are buyers and sellers, which means there is a spread. At a basic level, the spread is the difference between what the buyers are willing to buy at and what the sellers are willing to sell at. For example, an ETF that has a value of R100 may see buyers willing to pay R99.50 for ETF units and sellers wanting to get R100.50 for their units. This means if you went in and bought, you would have to meet the sellers asking price of R100.50 (for something that is worth R100 - i.e. you are already 50c per unit down on your investment just due to the spread. And technically you would be R1 per unit down if you wanted to exit again immediately).

Compare this this to a Unit Trust which does not trade on the exchange. If someone wants to buy into a unit trust, the unit trust company takes their money, and then at the end of the day they will calculate the value of a Unit in the Unit Trust, and buy your units according to that value. For example if you gave an instruction to buy R2000 worth of a Unit Trust, and the value of a Unit in that Unit Trust is R100, you would get 20 Units (no deductions for spreads, and no brokerage or exchange fees).

In short, there are definite upfront costs involved in buying an ETF which you do not incur when you buy into a Unit Trust.

(For more information on the differences and similarities of index tracking ETF's and Unit Trusts, you can check this write up by Satrix)

So, with all things being equal, when you have a UT and an ETF that track the same index, the UT should perform better due to the difference in upfront costs. The problem is though, not all things are equal...


The Total Expense Ratio (TER) is the annual cost that an investor pays per year to the management company for the running of the ETF or Unit Trust. Now important to note, this is a per year charge (unlike the one off transaction costs and spread of an ETF).

Quick side tangent - it seems legislation is now forcing ETF and Unit Trust providers to disclose their Transaction Costs (TC) and TIC (Total Investment Cost = TER + TC) in their Fact Sheets/MDD's. So I should theoretically be talking about TIC and not TER here, but TER made for a far more catchy headline :) But in effect we are talking about ongoing costs here, so wherever you see TER, you can replace it with TIC, or even better "total ongoing annual charges" (which may include things like platform fees, admin fees etc.)

Now keep in mind that an investment into an index tracking product should be a long term investment. This has two important consequences with regards to TER (and any other ongoing charges).
  1. The TER will be charged for each year that the investment is held. Over many years that is many TER's (cool rhyme!)
  2. Over a long period of time, an index tracking investment should grow in value, and because the TER is a percentage based fee, it will become a larger and larger Rand amount as time moves on.
And for this reason, I think a lower TER is far more important than lower brokerage and spread. But this is probably best illustrated by way of an example.

Low TER Versus Low Upfront Costs

Let's look at a R2000 monthly investment over 10 years. Let's assume the index tracking product is expected to return 15% a year. You have found two providers who offer the same index tracking product - one via a Unit Trust, and one via an ETF.
  1. Unit Trust option - Pay 0 upfront fees, TER 0.43%
  2. ETF option - Pay stock-brokerage of 0.25%, spread 0.25%, TER 0.1%
(The above two options may or may not be a look at Sygnia's Top 40 Index Tracking Unit Trust versus Satrix's Top 40 ETF (with newly announced TER or 0.1%))

The results are as follows (click for larger image):

Numbers and lines
For the first two years, while the investment is relatively small, you will notice that the upfront costs of the ETF option eat away at your investment faster than the higher TER of the Unit Trust option. But as mentioned, index tracking investments are best held for the (very) long term, so what we really care about are the 10 year plus numbers. By this point the investment is all grown up, and the higher TER of the Unit Trust option starts making a bigger and bigger dent than the upfront costs. In year 10 you are 1.5% better off, and by year 15 you will be 2.72% better off. This difference will grow ever larger as the investment continues.

Now I concede that a couple of percentage points over a long period of time is maybe not worth the admin of switching over from one option to another if you are already invested in the more costly option.

But this is definitely something to think about if there are both UT and ETF options for the index tracking option you have chosen to invest in. And of course there may be situations where the UT option is better (for example Bond ETF's which you may want to invest in due to a shorter term view) or if the upfront costs are really high (i.e. traditional stockbrokers).

Don't get me wrong, the lower the upfront cost the better - no doubt about that! But when the lower upfront cost comes at the expense of a higher ongoing cost, then I am not so keen - especially over the longer term. I think it is safe to say for the average investor, a lower ongoing annual fee, is far more important than low once off fees.

Which Way To Go?

I think it is best to evaluate ETF versus Unit Trust options on a per investment basis - and for this reason I have sent the spreadsheet I used for the example comparison to the blogs subscribers (if you are not a subscriber but would like a copy, get in touch and I will send it to you).

*Update - this spreadsheet is available for download on the Spreadsheets page

It is best to check the numbers on a case by case basis, and factor in all the costs (e.g. some products are available on platforms which charge a platform fee, there may be advice fees etc, etc). Use the spreadsheet to plug in your own parameters (grey blocks are for editing) and see what comes out the other side.

One final thing which shouldn't be forgotten - at selling time you will also pay brokerage and spread on an ETF which you will not pay on a Unit Trust option.

Happy tinkering!

Personally, for the long term view I have and for the index trackers I have chosen, I am happy to go through a low cost stockbroker and pay the upfront fees to enjoy the benefits of lower ongoing costs.

Till next time, Stay Stealthy!
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