The real cost of investing in mutual funds and ETFs
The way the marketing hype has it these days, you’d think investment costs have dropped to zero. What with all the do-it-yourself platforms out there hawking their black boxes and promising, at least implicitly, huge savings on costs, novice investors can be forgiven for thinking that buying mutual funds or setting up an ETF portfolio is somehow cost-free. Just open an online account, press the “trade” button, and it’s done. Unfortunately, it’s not quite that simple. Any economist will tell you that there are costs associated with every good or service. Investments are no exception. Here’s a summary of the costs that you’ll still pay for when buying that mutual fund or ETF.
Many mutual funds still apply a “front-end load” when you buy. This is a commission you pay to whoever is selling you the fund. The load is expressed as a percentage, and is taken off the top of the amount you invest. So if there’s a 3% front-end load on a mutual fund, and you have $10,000 to invest, $300 will be deducted from your investment and given to the fund salesperson as a commission, leaving your total investment in the fund at $9,700. “No load” funds are typically sold by fund companies directly to the investor, without any front-end commission to a salesperson, and are favoured by do-it-yourself investors. But that doesn’t mean you get off scot-free.
This is where the “management expense ratio” (MER) comes in. The MER consists of the fees that the fund pays for various operating costs. The biggest of these is typically the cost of investment management. This compensates managers for researching, trading, and reporting the portfolio. Usually, the more active the fund or the more complex its investment strategy, the higher the MER will be.
Investment funds may also pay commissions, or trailer fees, to financial advisors, brokers, dealers, and fund salespeople for their planning and asset selection services they provide for you, their client. However, given all the bad publicity around trailer fees, these are going the way of the dodo.
In addition to the fee paid to the portfolio manager and investment salesperson, the fund must also pay basic operating expenses, such as legal, administrative, and accounting fees. In addition, Harmonized Sales Tax (HST) must be paid on all of these items, and this also forms a part of the MER for a fund.
The “trading expense ratio” (TER) is a more obscure measure, but is likely to command more attention under the new fee- and expense-reporting rules. The TER is essentially a measure of a fund’s transaction costs expressed as a percentage of the fund’s average asset value over a given reporting period. So, for example, a TER of 0.04% on a fund with average asset value of $500 million over a year, means the fund pays about $200,000 in transaction costs.
The transaction costs include, of course, brokerage commissions that the fund manager pays for trading securities as well as custodian transaction fees. Again, in the case of equity funds, the more active the fund, the higher the TER will be. (Note that in Canada, “TER” refers to “transaction expense ratio,” but in the U.S., it refers to “total expense ratio,” a different measure, and not to be confused with the “TER” used in Canada.)
A growing number of investors like the idea of exchange-traded funds (ETFs) because of their low MERs. ETF MERs are on average around 0.5%, compared with around 1.5% for mutual funds, but many ETFs boast MERs much, much lower than that. The reasons are relatively simple.
First of all, the cost of operating an ETF tends to be lower than operating a mutual fund. The administrative costs of bringing a new investor on board a mutual fund are high because the fund has a direct fiduciary arrangement with the investor – all investor applications, confirmations, deposits, redemptions, and regulatory requirements must be met and paid for directly by the mutual fund. The fund must then invest the new money in the market, incurring trading costs.
ETFs incur no such costs, because investors buy and sell shares of ETFs through a brokerage firm, which places a trade order on the market on which the ETF is listed. In other words, investors trade ETF shares with each other on the open market just like any other stock, and not with the fund company. A mutual fund company, on the other hand, can issue more units at any time (hence the term “open-end” fund).
The majority of ETFs track an index, so there is very little in the way of portfolio management expense, which gobbles up a large portion of a mutual fund’s MER. The ETF’s managers in most cases do not have to do the research, make the macro calls on the market, or trade in and out of specific securities. They simply track their underlying index, rebalancing holdings as the index does. To be sure, that’s changing somewhat with the advent of so-called “actively-managed” ETFs, where MERs tend to creep up along with the costs of managing the portfolio.
Essentially, all funds make their money by charging a fee against assets under management. But because ETF companies charge very low MERs, they basically must make their money on volume. The iShares S&P/TSX 60 Index ETF (TSX: XIU), for example, has some $9.9 billion in assets as of May 2, and doesn’t need more than its low MER of 0.18% to reap massive annual revenues.
But in order to trade ETFs (or any exchange-traded security, including stocks), you have to have an account with a brokerage firm. Most do-it-yourself investors will use one of the many online discount brokerage services. Brokerage commissions are all over the lot, depending on the type of account you have, how big your portfolio is, and how active a trader you are. Generally, you’ll pay a brokerage commission somewhere between $4.95 and $24.95 per trade. With such a wide spread, it pays to really dig into the details of the commission rates before opening a discount brokerage account.
Portfolio management options
To meet the demand for low-cost investments, a number of ultra-low-fee online investment management options have sprung up in recent years. A number of independent firms along with most of the big banks now offer a kind of “black box” approach to portfolio management to those who are looking for extra-low-cost portfolios. Generally, these are pre-packaged portfolios of low-cost ETFs that aim to match an investor’s risk profile and investment objectives. Typically there is no self-directed investing involved, and investors’ assets are placed in a “portfolio” or “pool” that reflects their risk profile – for example, “low volatility,” “balanced,” “growth,” “income,” and so on. Understandably, personal advice tends to be limited with these arrangements, and more sophisticated investors with larger portfolios may feel somewhat restricted.
For investors with investment assets ranging from $250,000 up, who find the process of do-it-yourself management too demanding, and the black-box method too restrictive, a fee-based account with an accredited financial advisor has become the preferred method of money management. For a set annual percentage of assets under management, usually somewhere between 1.5% and 2.0%, the advisor will handle all transactions, trades, commissions, and reporting. This can work out to be very cost-efficient, especially for actively traded accounts and those who desire a higher level of personal attention from their advisor.
© 2018 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.