Mutual funds and fees
The management fee is the fee charged by the mutual fund company to cover the costs associated with investing the assets of the fund (it typically includes fund manager’s fees and commissions to your financial advisor).
Management Expense Ratio (MER)
This figure is the most relevant as it takes the management fee and adds other costs associated with the operations of the fund like legal, accounting and marketing. The average MER in Canada of all funds is 2.53%. It is important to note that all rates of return are published net of fees. For example, if the fund shows a 10% return in the paper, it actually earned 12.25% but the MER was removed already. You will never see this fee as it is stripped off the fund usually on a monthly basis.
Front end load
In Canada, front end loads are completely negotiable. In many cases you can pay as little as nothing to as high as 5%. This fee comes right off your investment. For example, if you are investing $10,000 and you pay a front-end fee of 2%, you will pay $200 for the purchase and $9800 will get invested. Paying a front-end fee means you have less money at work.
Back end load
A back end load is different in that you do not have to pay anything up front. In the same example, you will have $10,000 invested and put to work. However, the mutual fund company has hooked you into a 6, 7 or 8 year time frame where if you leave their company before a certain time, you will have to pay a penalty for leaving early. The longer you stay with the fund company, the smaller the fee. Typically, you can still move your funds around within the same company without triggering fees. Back end loads promote long-term thinking.
What do higher fees mean to you?
Earlier I mentioned that the average Management Expense Ratio today is 2.53%. Believe it or not, that is up from a year ago when the average MER was 2.406%. Two years ago the average MER was 2.283%. It’s hard to believe that here in Canada; fees are going up while companies are consolidating in hopes of gaining economies of scale.
While I think you need to be aware of the fees you are paying, I do not think the cheapest necessarily means the best. Rather, I choose to believe in a term I call value. Value is the benefit you receive, less the cost. For example, let’s say you have two funds:
Fund A produces a gross return of 10% and has an MER of 3%. The net posted return to the investor is 7%. Fund B on the other hand returns 8% gross with an MER of 2%. This fund gives the investor a net return of 6%. Which would you have rather bought? Without a doubt, given this simplistic fictitious example, you should choose Fund A despite Fund B having a lower cost.
I do not think you can look at a fund based on fees alone, just like you can not look at just performance alone. Given two funds that are the same, you should choose the fund with the lower MER.
Is there a relationship between fees and performance?
I have looked at many studies and even attempted some of our own research. The longer you hold your investment (buy and hold), the more cost conscious you should be. In the shorter term, there is less of a correlation with fees and performance.
Also, if you are buying fixed income funds like money market funds, bond funds, and mortgage funds, you should be more aware of the fees. With fixed income funds, there is a higher correlation that funds with lower MERs will have a better chance of performing better.
My two cents
Fees are important in the sense that any fee you pay takes away from the performance of your investment. It is important that you know how much you are paying in fees. If you are paying more than the average, you should question the value you are getting from higher fees. While there is some correlation that the lower fees you pay the better your long-term returns, don’t get caught up in focussing on fees alone. Evaluating mutual funds goes far deeper than analyzing and comparing MERs.