Costs matter l Take the time to understand them
In 2016 the Association for Savings & Investment South Africa (ASISA) introduced standards relating to the disclosure of total expense ratios and transaction costs [1] for financial products such as collective investment schemes.
The total expense ratio (TER) indicates what portion of a financial product’s underlying assets are relinquished as payment for the administration of the financial product. It’s calculated on an annualised basis over a three-year period and is expressed as a percentage of the daily net asset value (NAV). This is where fund management fees, administration fees, audit fees, bank fees, custody charges and scrip lending fees, amongst others, are reflected as a percentage of a fund’s NAV.
Transaction cost (TC) indicates the costs incurred in buying and selling the underlying assets of a financial product. It’s also calculated on an annualised basis over a three-year period and is expressed as a percentage of the daily NAV. This is where brokerage commission [2] , VAT, securities transfer tax (STT), Strate and other transaction-related fees are expressed as a percentage of a fund’s NAV.
By adding these two measures together, a total investment charge (TIC) can be calculated for a unit trust or exchange traded fund (ETF).
Various factors contribute to the resultant TIC, which are summarised in Table 1.
“IT IS IMPORTANT TO HIGHLIGHT THAT THE NAV FOR A FUND IS NET OF ALL EXPENSES AND TRANSACTION COSTS, THEREFORE NAV PERFORMANCE OVER A PARTICULAR PERIOD ALREADY CAPTURES THE REDUCTION IN PERFORMANCE ARISING FROM THE TER AND TC MEASURES.”
Table 1: Factors influencing TER and TC
What becomes clear from the table above is that these factors are interrelated. A high turnover investment strategy in low-cost assets may have a lower transaction cost figure than a low turnover investment strategy in high-cost assets. Furthermore, TER and TC are not completely independent, with smaller funds likely to suffer from higher TER and higher TC than larger funds.
What may be overlooked is that a unit trust fund takes part in the transaction costs associated with client subscriptions and redemptions. This means, despite a relatively low inherent turnover on the fund arising from rebalancing by the investment manager, the fund may incur high transaction costs due to large flows relative to the size of the fund over a sustained period of time. To make matters worse, these flows may net each other off over time, thereby not resulting in an increased fund size, yet adding to the fund’s TC figure.
Finally, some costs are incurred to generate additional returns, such a scrip lending. Only the cost leg is reported in the TER, while any additional returns arising from scrip lending are reflected in the NAV performance. Similarly, some investment strategies require a higher turnover, thereby incurring higher transaction costs in order to generate their returns, such as the top performing Satrix Momentum Index Fund [3]. Focussing only on the TC without considering the resultant NAV returns already inclusive of the impact of TER and TC measures would be a classic case of not seeing the wood for the trees.
In the context of index funds, does this matter?
In short, it depends…
For two index funds tracking the same single asset class benchmark, you would be hard pressed to choose the fund with the higher TIC, as it is likely to have a lower NAV return. However, only after evaluating the factors in Table 1 and which factors contributed to a high or low TIC, would you be better equipped to evaluate what is likely to occur in future. For example, a fund that has recently lowered its fees and has attracted significant assets as a result, would still show a time-weighted TER that reflects the old and higher fee structure. It would also have a higher TC due to the costs arising from the increased client contributions to the fund over the three-year period. The competing fund with a lower TIC may be smaller and therefore more at risk of a high TC impact with an associated negative impact on NAV performance, should it experience large client flows in future.
Where a unique index is being tracked, the more important issues are likely to be whether the investment strategy is suited to the client’s objectives and evaluating the performance of the index fund relative to any other fund with similar investment objectives or across the category as a whole [4]. Focussing exclusively on the tracking error or performance differential of a unique index fund relative to its benchmark, may be a case of placing the cart before the horse. This is certainly the case for some of our factor-based index funds, as well as our multi-asset class index funds, such as the Satrix Balanced Index Fund.
As index funds gain in popularity, they become victims of their own success from a TC perspective, as they will experience higher turnover due to ongoing client demand arising from the shift to greater adoption of index funds. However, the magnitude of flows should reduce as a percentage of a larger fund size, and the TC figure should settle to a more normalised level based on the inherent turnover of the investment strategy.
Final thoughts
We analysed client flows and transaction costs within the Satrix Low Equity Balanced Index Fund over the last three years. The gross monthly flows [5] have a 0.90 correlation to the monthly TC, while on an annual basis the correlation increases to 0.96. Flows are therefore the primary driver of the resultant TC, particularly for an inherently low turnover index fund.
The similarity in shape of the annual gross flows and annual TC [6] lines illustrates this, while the magnitude of inflows the fund attracted at the beginning of 2018 resulted in the increased annual TC thereafter. The return to more regular flows, coupled with an increased fund size, resulted in the fund’s lowest annual TC over the period under review. The official TC for the Satrix Low Equity Balanced Index Fund is 0.05% as at 31 March 2019, and includes additional transaction costs arising from underlying funds, which were excluded from our analysis.
Figure 1:
Satrix Low Equity Balanced Index Fund – Fund size & flows vs. annual gross flows
Figure 2:
Satrix Low Equity Balanced Index Fund – Fund size & flows vs. annual TC
Another option for clients investing in collective investment schemes, but who want to be protected from the impact of other clients’ flows, is to consider investing in an ETF. By design, the subscription and redemption process protects existing investors in the fund. Because of this feature, the size of an ETF is less of a consideration than would be the case for an equivalent unit trust.
Satrix Managers (RF) (Pty) Ltd (Satrix) a registered and approved Manager in Collective Investment Schemes in Securities and an authorised financial services provider in terms of the FAIS. Collective investment schemes are generally medium- to long-term investments. Unit Trusts and ETFs the investor essentially owns a “proportionate share” (in proportion to the participatory interest held in the fund) of the underlying investments held by the fund. With Unit Trusts, the investor holds participatory units issued by the fund while in the case of an ETF, the participatory interest, while issued by the fund, comprises a listed security traded on the stock exchange. ETFs are index tracking funds, registered as a Collective Investment and can be traded by any stockbroker on the stock exchange or via Investment Plans and online trading platforms. ETFs may incur additional costs due to it being listed on the JSE. Past performance is not necessarily a guide to future performance and the value of investments / units may go up or down. A schedule of fees and charges, and maximum commissions are available on the Minimum Disclosure Document or upon request from the Manager. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Should the respective portfolio engage in scrip lending, the utility percentage and related counterparties can be viewed on the ETF Minimum Disclosure Document. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The index, the applicable tracking error and the portfolio performance relative to the index can be viewed on the ETF Minimum Disclosure Document and/or on the Satrix website. Performance is based on NAV to NAV calculations of the portfolio. Individual performance may differ to that of the portfolio as a result of initial fees, actual investment date, dividend withholding tax and income reinvestment date. The reinvestment of income is calculated based on actual distributed amount and factors such as payment date and reinvestment date must be considered. If the fund holds assets in foreign countries it could be exposed to the following risks regarding potential constraints on liquidity and the repatriation of funds: macro-economic, political, foreign exchange, tax, settlement and potential limitations on the availability of market information.
