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4. A fund's TER, and compounding against you

Costs 1: What you pay and can see

The three previous modules dealt with costs charged for doing something: buying, holding, converting. This one deals with the quietest cost of them all and, over the long run, far and away the dearest. You will not see it on any statement, you will receive no charge, and there will be no date on which money is taken out of your account. And even so, over an investing lifetime, it can carry off a third of everything you would have accumulated.

What the TER is and why it is invisible

The TER (total expense ratio), which European documentation calls ongoing charges, is the annual percentage of a fund's assets deducted to pay for running it. Inside it sit the management fee, the depositary fee, the audit, the regulator's levies and administration.

The key lies in how it is charged: it is deducted from the net asset value, apportioned daily. A TER of 1.5% means subtracting around 0.004% every business day. You will never see that entry. The fund is simply worth a shade less each day than it would otherwise be, and since you have no cost-free version in front of you, there is nothing to compare it with. That is an enormous psychological difference from the dealing commission: that one you see and it annoys you, this one bleeds you without your ever noticing.

Today's ranges are very wide. Index funds and ETFs on the big indices usually run between 0.03% and 0.25%. Actively managed equity funds sold to retail investors in Europe frequently sit between 1.2% and 2%. It is worth holding on to one more thing: the TER is not the vehicle's total cost. The fund's own transaction expenses and any performance fees fall outside it. That belongs to another level; here we work with the TER as a figure and with what it does to time.

The full sum: two identical portfolios, thirty years

This is the heart of the module, and it has to be done with numbers, not with adjectives. Take two investors who do exactly the same thing: 100,000 euros invested in the same market, which returns 7% gross a year for 30 years. Their portfolios are identical in everything but the TER.

First, the cost-free benchmark. 7% over 30 years multiplies the capital by 7.61: 761,226 euros. That is the wealth the market generates.

Investor A, an index fund with a TER of 0.15%. That leaves a net return of 6.85% a year.

Investor B, an active fund with a TER of 1.50%. That leaves a net return of 5.50% a year.

Difference between the two investors: some 231,300 euros. More than twice the capital they put up at the start, for a difference in tariff of 1.35% a year, in two portfolios that bought exactly the same thing.

Why the result is so wildly out of proportion

The natural reaction on seeing these numbers is to suspect the arithmetic. There is no trick; there are two effects multiplying each other.

That is the argument John Bogle repeated for decades, and it is worth putting in its most uncomfortable form: the investor puts up 100% of the capital and bears 100% of the risk, and in the scenario above keeps 65% of the result. The split is not decided by merit; it is decided by a figure written in the prospectus.

The arithmetic that admits no argument

One might object that an expensive fund can be worth it if its manager is good. The objection has a problem that is not empirical but arithmetical, and William Sharpe put it with a cleanness that is hard to improve on: active managers, taken together, own the market between them. Therefore before costs, the average return on actively managed money is the market's, and after costs it is necessarily lower. This is not a claim about anybody's talent, nor a result that better data could refute: it follows from everyone's holdings adding up to the whole.

That does not mean no manager can beat the market; it means the group cannot, and that the share the fees carry off comes out of the unit holders' pockets. Burton Malkiel and Charles Ellis take the idea into practical territory and reach the same conclusion: since the future return is uncertain and the cost is certain, the rational course is to optimize the one variable you control.

What to do with this

Three operating consequences that follow directly from the sum above:

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