Their View. Know your ETF’s total cost of ownership

I am often part of discussions about selecting between the two variants of passive mutual funds —index funds and exchange-traded funds (ETFs) — and these discussions, in many instances, steer towards the cost of ETFs being very low.

While investing in mutual funds, over the years, we have become familiar with the concept of TER as the total expense ratio which includes management fees, custody fee and other operating costs of a fund. This is a recurring cost of ownership of any mutual fund, including a passively managed index fund, which the investor has to bear. TER is transparently disclosed in the factsheets and on the websites of mutual funds and there are no other expenses involved.

However, when it comes to the total cost of an ETF, the investor should consider the Total Cost of Ownership or TCO. TCO takes into account external costs relating to entering, holding and exiting the investment, which TER does not. TCO can therefore, be seen as a more complete representation of how much an ETF costs. Since all these costs are not directly under the fund’s control, the investor will not be able to find TCO on any factsheet or website.

TCO is calculated by adding all the implicit costs of owning an ETF, to any additional external expenses that are more visible to the investor, such as broking account opening fees, brokerage for trades, the bid-offer spread when the ETF is traded, clearing house fees, and demat charges.

Let us take an example of an ETF which has a TER of 7 bps (or 0.07 per cent). I bought this ETF on the stock exchange through my broker and paid a brokerage of 10 bps and a 1.8 bps GST on the brokerage. There was a bid/offer spread of 5 bps on the stock exchange counter. After buying the ETF, I pay 1 bps on an annual basis for holding it in my demat account . Now, after one year, I sell the ETF and pay an amount equivalent to the brokerage, taxes and the spread. So, my total cost for buying, selling and holding for one year, including the TER of 7 bps, comes up to 41.6 bps (or 0.416 per cent).

For a mutual fund or index fund, the TER is the same as TCO, i.e., there are no other costs. Hence, in case there is a comparison between ETFs and index funds, one should use TCO for the ETF, as opposed to TER. By using this, the costs of the two types of fund options — ETFs and index funds — become more comparable.

However, both have their own benefits. The selection therefore, comes down to the individual needs of the investor. ETFs are better- suited for an investor looking for intra-day pricing, holding only in a demat format, and wants to invest and redeem via a broking platform. On the other hand, if one is looking for long-term portfolio allocation, day-end NAV- based pricing, and wants to invest without opening a demat account and a broking account, index funds would be a better choice.

The writer is Head of Passive Investments and Products, DSP Investment Managers

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