All You Ever Wanted To Know About The TER But Were Afraid To Ask

Ken Kivenko A lot has been written about mutual fund Management Expense Ratios (MERs) and the impact on returns, but the Trading Expense Ratio (TER) tends to be ignored. It shouldn’t be, as it adds to fund costs and can provide valuable clues as to fund management.

The TER is calculated by taking the sum of all the fund’s transaction costs, (including brokerage commissions the fund manager incurs when buying and selling securities (including derivatives), custodian transaction fees, which are charged when a portfolio manager (PM) buys or sells a security) and dividing it by the average value of fund assets for the annual reporting period. For example, if a $100 million fund incurs a total of $1 million in trading commissions (expenses) for the year, the TER is 1%.

The infamous MER doesn’t include portfolio trading costs, which are reported in the Regulatory “Fund Facts” document of a mutual fund or in its annual and semi-annual Management Report of Fund Performance (in the “ratios and supplemental data” section). The TER is usually in the range of 5-20 bps but sometimes it can be much larger depending on the fund’s strategy. For example, the Caldwell Canadian Value Momentum Fund – Series F aims to generate capital growth by investing in a concentrated basket of Canadian equities which show the highest potential for capital gains over a moderate holding period. Its TER is 0.61% and its MER is 1.29% for total fund expenses of 1.90%. Fund Facts at https://caldwellinvestment.com/wp-content/uploads/2019/07/CCVMF-Series-F-FF-July-2019-English.pdf

In any case, the regulatory disclosure documents provide information on this and other fund statistics. Generally the higher a fund’s TER, the more actively the fund manager has traded in a given year. Fund performance is reported after all trading related expenses have been deducted.

Why break out the TER? Regulators argue that the TER can vary significantly from year to year and for disclosure reasons it is required to be reported separately from the MER. It is listed within Fund Facts documents and added to the MER to provide the total fund expenses.

Investor advocates had asked that the Portfolio Turnover Rate (PTR) be included in Fund Facts but regulators decided otherwise. While regulators decided to present the TER as an isolable, visible cost to be split from the MER, they chose, unlike U.S. regulators, to keep the trailing commission embedded in the management fee and disclosed via defined separate language in Fund Facts.

There are five key drivers of trading expenses:

Portfolio turnover rate.
The fund’s category and investment strategy.
Flows in and out of a fund (investor purchases and redemptions).
Negotiating power on commission rates.
Events (e.g. reinvestment of distributions).

A fund’s PTR indicates how actively the fund’s PM manages its portfolio investments. A portfolio turnover rate of 100% is equivalent to the fund buying and selling all the securities in its portfolio once in the course of the period. The higher a fund’s portfolio turnover rate in a period, the greater the trading costs payable by the fund in the period, and the greater the chance of an investor receiving taxable capital gains in the year. The increased trading costs show up in the TER statistic.

Investing in global markets is much more expensive than North American markets. Emerging market funds tend to have the highest trading expenses. Similarly, one would anticipate a higher TER for a small or micro-cap fund with a mandate for higher portfolio turnover rate within the fund.

The TERs of bond and equity funds can’t be compared because of the different ways these securities are traded. Commissions are embedded in a bond’s price spread, so unlike equity trading commissions, they don’t factor into the TER calculation. See for example the Fidelity Canadian Bond Fund “Fund Facts” https://www.fidelity.ca/cs/Satellite/doc/FF_CC_A_en.pdf where the TER is shown as 0.00%.

For funds that hold both stocks and bonds, it’s important to compare funds with similar asset allocations. For example, a growth fund with 75% equity and 25% fixed income will have a higher TER than a balanced fund with a 60% equity and 40% fixed income mix, simply by virtue of the asset allocation. (Cash falls in the fixed- income category.) When comparing two balanced funds that are more closely aligned in terms of asset mix, any differences would be explained by the Portfolio Manager’s (PM) investment style.

A manager with a buy-and-hold investment strategy incurs fewer transactions and fewer trading commissions, and therefore the TER will be lower. Similarly, an index fund would be expected to have a lower TER.

The number of securities the fund holds can also impact the TER. Some equity funds have 25 stocks, others 200 or more. The fund with more securities may result in more trading simply because there are more holdings that don’t meet defined criteria, and the PM makes adjustments as appropriate.

Although unlikely, it is possible the manager is making consistently exceptional choices that quickly achieve his/her price targets, triggering sales. If so, these capital gains will be reflected in his/her fund’s performance. But if a high-turnover fund is underperforming, there may be a disconnect between the manager’s buy-and-hold moniker and how the fund is actually being managed.

The TER can also be impacted by investor behaviour that affects fund flows. If a fund experiences net redemptions, it will be forced to sell securities if the cash cushion is inadequate to match the amount of redemptions. Conversely, a new fund is going to have a higher ratio of inflows to the fund versus total assets and the manager is required to invest the cash received. The resulting trading commissions typically show up in the form of a higher TER. Fund age can have an effect on the TER statistic that’s not immediately obvious.

The TER is affected not only by the volume but also by the unit costs of transactions. If a fund manufacturer has sufficient market power, it may be able to negotiate lower commission rates for executing trades. Vertically integrated firms may be able to strike attractive pricing arrangements via a related affiliate, thereby reducing fund trading commission expenses and the TER (alternatively, they could just be steering business to a related party to maximize corporate profit.)

In July, 2019, an Ontario Securities Commission hearing panel approved a settlement with Caldwell Investment Management Ltd. (CIM) that requires the firm to pay a $1.8-million penalty and $250,000 in costs to settle allegations that it violated securities rules by directing client trades through an affiliated dealer (Caldwell Securities Ltd.) when it often could have received better terms at an independent dealer. CIM also admitted that it had inadequate policies and procedures relating to best execution, made misleading statements in the Annual Information Forms for two of its mutual funds, and provided insufficient and inaccurate information to the Independent Review Committee for the two mutual funds. The higher trading costs adversely impact fund returns.

There is another way in which trading commissions can be misused. In July 2019, the British Columbia Securities Commission (BCSC) sanctioned Genus Capital Management Inc. for misusing client brokerage commissions. As part of the settlement, Genus agreed to repay $1.67 million to current and former clients for excessive transaction expenses. The firm also will pay $350,000 to the BCSC. The misuse of commissions involved “soft dollars”—credits provided by a broker to an investment manager in return for executing trades on behalf of the manager’s clients. The credits are part of the brokerage commission paid by the investment manager’s clients. If appropriately disclosed, the investment manager may use the credits for eligible expenses, such as research services that benefit clients. Genus admitted that between 2009 and 2016 it used $1.67 million in soft dollars to inappropriately pay for the development of in-house software, and then transferred the software to a company in exchange for part-ownership of that company and a permanent license to use it.

Fund Facts describes a short-term trading fee (2%) if a mutual fund is sold within a certain period, typically 7-90 days. Short-term trading fees are meant to discourage investors from using mutual funds to make a quick profit by “timing” the market. Market timing involves short-term trading of mutual fund securities to take advantage of short-term discrepancies between the price of a mutual fund’s securities and the stale values of the securities within the fund’s portfolio. International funds are most vulnerable to this type of trading abuse, as traders can exploit differences between time zones. Short-term trading adversely affects long term investors because it increases the fund’s transaction expenses and administrative costs. Indeed, investor advocates examining fund PTR and trading statistics contributed to the detection of anomalous trading that led to the discovery of the 2004-5 mutual fund market timing scandal.

Finally, certain events, like reinvesting distributions or a change in mandate can cause a fund to incur transaction costs that will impact the TER.

Today, investors must remain content with the TER despite its limitations. However, until 2006, mutual funds in Canada were providing valuable Statements of Portfolio Transactions (SPT) upon request. Unlike the TER, this statement provided detailed disclosure of the PM’s trading. When National Instrument 81-106 (Continuous Disclosure) came into force, the SPT vanished without discussion or consultation. Canadian regulators knowingly removed the availability of a vital source of investor information regarding a fund manager’s trading practices. The trend of decreased transparency is a loss for investors as well as analysts, academia and media.

The TER, along with PTR, can help investors judge whether a manager’s published disclosure materials are congruent. Buy-and-hold managers with consistently high PTRs and TERs indicate incongruence. A high TER and a high PTR suggest that tax issues should be considered in non-registered accounts. This may assist in determining an optimum location for the fund (e.g. in a registered account).

When investors examine TER’s and PTRs, they must look at more than one year to capture what the experience might be with that fund. Certain years with certain market conditions can cause more turnover than would otherwise be expected e.g. with sinking natural gas prices, managers may dispose of positions they might have otherwise retained. As the TER will vary by fund, it is important to evaluate this cost in conjunction with a PM’s investment style, track record, skill and strategy over time.

One thing is for sure, the TER adds to fund expenses. Make sure you’re getting value for money.

Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com