ETFs & Funds · Intermediate · 4 min

Costs: TER and tracking difference

You can read a fund's TER, explain why tracking difference is the better measure of real cost, and estimate what fees do over decades.

Small leak, big loss

Fund fees are written as tiny percentages: 0.2%, 0.5%, 1.5%. They look like rounding errors next to the swings of the stock market.

But fees are taken every single year, from everything in the fund, whether the markets rise or fall. Over decades, small differences compound into very large amounts. This lesson shows how to read a fund's costs, and which number tells you what you really lose.

TER vs. the real gap

The total expense ratio, or TER, is the yearly percentage of the fund's assets used to pay for running it: management, administration, the depositary, index licences. It is not billed to you separately. It is taken out of the fund, so it shows up as a slightly lower return. In EU fund documents, you will find it as ongoing charges or ongoing costs.

The TER does not include everything. Trading costs inside the fund are extra. On the other hand, some funds earn income, for example by lending securities, and tax treatment can help or hurt.

That is why two other measures matter for index funds:

The tracking difference is the gap between the fund's return and the index's return over a period. ESMA's guidelines define the annual version as the difference between the fund's and the index's annual return, and require funds to disclose and explain it in their annual report.
The tracking error measures how much that gap fluctuates over time.

A fund can have a tiny tracking error and still trail its index by a steady 0.5% a year. For a long-term investor, the tracking difference is usually the more useful number. A tracking difference close to the TER, or even better, is a good sign.

54,300 vs. 37,500

Two fictional funds on the same index. Before costs, both earn 6% a year. One has total yearly costs of 0.2%, the other 1.5%.

0.2% costs: 10,000 × 1.058³⁰ ≈ 54,300.
1.5% costs: 10,000 × 1.045³⁰ ≈ 37,500.

The difference is about 16,800, almost a third of the cheaper result, for the same index and the same market. The investor never saw an invoice. It simply never arrived in the account.

Common mistakes

Comparing TER only. The tracking difference shows what you actually received.
Looking at one year. Compare several years, because single years can be distorted.
Ignoring costs because they are small. They compound like returns, in the other direction.
Forgetting trading costs on your side. Spreads and broker fees come on top of fund costs.

The takeaway

The TER is the yearly fee, but the tracking difference shows what you really lose against the index. Small yearly gaps compound into big ones.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the fund that ends up with more money.

Tap the chart.

A difference of 1.3 percentage points a year grows to almost 17,000 over 30 years.
2What is the tracking difference?

ESMA defines the annual tracking difference as the difference between the fund's and the index's annual return.
3An ETF has a TER of 0.20%, but its tracking difference is −0.05%. How is that possible?

The TER is only one part of the picture. Other effects can push the real result above or below index minus TER.
4What does tracking error measure?

Tracking error is the volatility of the difference. A fund can have a small tracking error but still trail the index steadily.

of 4 correct.