The cost of investing in funds

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Why it pays to pay attention to MERs

As new fee transparency rules for advisors and money managers start to kick in, more investors have been asking me about difference between the costs of various mutual funds and exchange-traded funds. It’s a valid question, and looking at the management expense ratios (MER) of various funds, you can see the significant difference it can make to your investment returns.

For instance, who on earth would invest in a segregated fund that charges a whopping 3.6% MER, yet returns a dismal annualized -3.1% over the past 10 years? On the other hand, a pure passive broad-market Canadian index exchange-traded fund (ETF) returned an annualized 5.1% in the same 10-year period with a virtually invisible MER of 0.05%. Unless my math is wrong, that works out to an average annual return for the passive index fund that’s 8.2 percentage points better than the seg fund, which charged an MER 72 times more for the privilege of losing money. Investors can be forgiven for wondering about these kinds of head-scratching returns.

The MER is the total of all operating expenses and management fees paid by an investment fund expressed as a percentage of the fund’s assets. Management fees are charged to the fund by the fund’s managers, while the fund pays operating expenses such as legal and accounting costs, custodial fees, and other administrative expenses. The total of all these fees and costs is known as the MER.

MERs vary from fund to fund, ranging from as low as 0.05% for some passive index-tracking funds to over 5% for some types of segregated funds. Generally, funds with more complicated or more active management have higher MERs, because the managers do more research or trade more actively (which raises transaction costs) in search of better performance, and so on. Funds with guarantees (like segregated funds) have higher MERs, because of the cost of the insurance premium involved, which pays for any guarantees offered.

And yes, the price of a capital guarantee built into the MER of a segregated fund is a high price to pay for long-term underperformance. But that has more to do with management style, investment selection, and the fund’s mandate than with a high MER.

Exchange-traded funds tend to have lower MERs than mutual funds. Management fees and operating expenses are kept to a minimum because most ETFs passively track an index of some kind, so there’s no need to pay a fund manager to incur expenses in researching and trading securities. ETFs that track so-called active indexes generally have higher MERs relative to true passive ETFs. owing to higher transaction and other costs incurred when changes are made to the underlying index.

Investors do not pay the MER directly. Rather, it is deducted from the assets of the fund, in effect reducing the fund’s – and ultimately your – return. A high MER is a serious hurdle for both managers and investors, so it’s crucial to look at a fund’s performance data in conjunction with its MER before investing. Is the fund actually delivering long-term performance that warrants a high MER? It’s simple: If it isn’t, don’t invest.

Note, though, that a low MER doesn’t translate automatically into better returns. A fund with an 8% average annual return and a 2% MER still delivers a better return than a fund generating a 4% return with a 1% MER.

© 2016 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

The cost of investing in funds was last modified: April 12th, 2017 by robyn