passive vs active
One of the great advantages of ETFs is that they are a cheap way to invest; cost is a crucial factor in determining your long-term success, so consider the Total Cost of Ownership (TCO) as well as the Total Expense Ratio (TER)

 

 

 

The total cost of owning an ETF isn’t completely captured by the TER or its near identical twin, the Ongoing Charge Figure (OCF).

These are the charges that you will see quoted on a product’s website or in the Key Investor Information Document (KIID) and are deducted pro rata from your holdings on a daily basis; but it isn’t the full price you’ll pay – for that we need to consider the Total Cost of Ownership.

The TCO isn’t generally found on a website or factsheet because, whilst the TER and OCF have been agreed between the investment industry and the European Union, there is no standard definition of the TCO.   Nevertheless, investors should consider the TCO when selecting ETFs because the product with the cheapest TER isn’t necessarily the cheapest product you can buy.

The TER and OCF include the ETF’s annual management charge plus various other expenses including index licensing fees, legal fees, administration, marketing, regulation and auditing. The TCO captures extra internal costs that are missed by the TER including dealing fees, spreads and taxes or swap fees in case of synthetic replication that are incurred on the ETF’s underlying holdings; gains from security lending are also attributed to it. On top of that come external costs that are more visible to the investor which include platform charges, dealing fees and the bid-offer spread you pay when you trade the ETF.

 

 

Total Cost of Ownership for an ETF investment

 

Costs of ETF

 

 

Tracking difference is the discrepancy between an ETF’s returns and the returns of the index it aims to replicate and it helps to uncover any hidden internal costs. For example, if an index returns 10% and the ETF returns 9% then the tracking difference is 1%; the difference is effectively the TCO plus the costs discussed above. Tracking difference can actually be positive if an ETF earns extra revenue from activities such as securities lending or benefits from a more favourable tax regime than is included in the calculation of the index return. It may even be because the ETF’s composition differs slightly from the index and this plays out to its advantage. If you compare the returns of several ETFs replicating the same index, usually the one with the highest returns – within several time periods – shows the lowest TCO.





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