Understanding financial statements: TERs

With all the talk in the media about mutual fund fees, you may have seen references to TERs. What are those?

Trading Expense Ratio (TER) is a metric that figures into the price of mutual fund investing. The TER’s calculated by taking the sum of all the fund’s transaction costs and dividing it by the average value of fund assets for the annual reporting period.

So, if a fund has a TER of 0.27%, it means 0.27% of the fund’s average yearly assets went to trading expenses.

Those expenses include brokerage commissions the fund manager incurs when buying and selling securities, notes Terry Rountes, CFO of Funds at Mackenzie Investments in Toronto.

They also include custodian transaction fees, which are charged each time a portfolio manager buys or sell a security. It’s similar to paying bank fees for certain transactions, such as ABM withdrawals.

Investing in global markets is much more expensive, notes Dennis Tew, head of sales compliance and business operations at Franklin Templeton Investments in Toronto, and that will be reflected in higher TERs.

Emerging and frontier market funds tend to have the highest expenses. These markets aren’t as efficient and lack the liquidity of developed market exchanges, so it costs more for managers to get trades done.

Tew adds some companies have better access to volume pricing on trades, which trims trading costs — like buying food in bulk.

Comparing TERs of bond and equity funds doesn’t work because of the different ways these securities are traded. Commissions are embedded in a bond’s spread, so unlike equity trading commissions, they don’t factor into the TER calculation.

Funds that hold both stocks and bonds should have similar allocations for it to make sense to compare TERs. For instance, a growth fund with 80% equity and 20% fixed income will have a considerably higher TER than a balanced fund with a 50% equity, 50% fixed income mix, simply by virtue of the asset allocation. (If there’s cash in the fund, it’s likely going to be used for buying. And, as far as fees are concerned, cash falls in the fixed-income bucket.)

“But let’s say you compared two balanced funds that are more closely aligned in terms of asset mix,” says Rountes. “Any differences would be dictated by the manager’s investment style.”

A manager with a buy-and-hold strategy “doesn’t go in and out of the market a great deal. So, the expectation is he or she can incur fewer transaction costs and fewer commissions, and therefore the TER will be lower,” adds Rountes

The TER, along with Portfolio Turnover Rate (PTR), can help you judge whether a manager’s marketing fits the facts.

Say you want buy-and-hold managers who hand-pick stocks through bottom-up analysis. Consistently high PTRs and TERs could be a red flag, notes Tew.

“If [he’s] getting into more rapid turnover every year or two years, and [is] being held out as a buy-and-hold, bottom-up stock picker, the question would be, ‘Why are you finding better opportunities so quickly after making these picks?’ ”

He notes it’s possible the manager’s making consistently exceptional choices that quickly hit her growth targets, triggering sales. When that’s the case, gains will be reflected in her fund’s performance. But if a high-turnover fund isn’t doing so well, there may be a disconnect between the manager’s buy-and-hold billing and how she actually runs the fund.