The fees charged on investments help to pay for professional investment management. Unfortunately, investors often have no idea what they’re paying for investment management and most don’t do the math to convert a percentage fee into real dollars and cents. This article focuses on one particular fee, the management expense ratio (MER). What is an MER? How much is it costing you? What’s considered a “good” MER? And what are 3 strategies to avoid high MER fees? Keep reading to find out.
What is an MER?
The short cuts of fast thinking introduce bias and inaccuracy into our processes and can affect the quality of the decisions we make. In part one, we covered five biases that are probably compromising your investment decisions: availability bias, representativeness bias, affect bias, overconfidence bias and hindsight bias. This time we cover five more biases, plus signs to look out for and steps to take to slow your thinking down.Expenses included in the MER are:
- The fee paid to the portfolio manager and other third parties to oversee the fund, including performance bonuses (if any);
- The fee paid to your financial advisor as long as you remain invested in a fund, which is
- specific to the particular fund series. This fee is usually called a “trailer fee,” and it’s designed as a payment to your advisor for any ongoing services they may provide to you;
- Legal and audit fees;
- Custodian and transfer agent fees;
- Administration expenses of the fund;
- Filings with the provincial securities commissions; and
- Insurance fees, if your fund guarantees to return a portion of your initial investment if you hold the fund for an extended period, as is the case with segregated funds.
Expenses that aren’t included in the MER are brokerage fees, exchange fees, redemption fees, trading costs, switch fees and sales commissions.
The MER is calculated daily as a percentage of a fund’s assets. MERs are charged on mutual funds, segregated funds and exchange traded funds (ETFs).
How much is the MER costing you?
The MER represents the annual rate at which your assets are shrinking, before the fund earns any investment return. You’re charged the MER every year, even when your investment loses money. When your investment has positive returns, the total amount you’ll see in your account has already been reduced by the MER percentage. So, depending on the kind of fund you’re invested in, the MER could be costing you a lot.
Here’s an example to demonstrate how much the MER can cost your investment over time.
Let’s say your financial advisor recommends you invest $250,000 in a particular mutual fund as a way of growing your savings for retirement over the next 10 years. The MER on this mutual fund is 2.50%, but it isn’t a transparent fee on your account statement, so you don’t pay much attention to it. You should, though, because in the first year of the investment that MER has already reduced your initial investment value to 97.5%, before considering any investment return.
Mathematically the formula is:
1 - MER = 1 - 0.025 = 0.975
You’re charged the same 2.50% MER in the second year, this time on the remaining 97.5% of your investment. That leaves you with 95.06% of your original investment.
The calculation is:
(1 - MER) x (1 - MER) = (1 - 0.025) x (1 - 0.025)
This erosion continues, year after year, as long as you hold that mutual fund.
Many investors are told to invest for the long term, but ironically the negative effect of fees on returns becomes more pronounced the longer you hold the investment. If your $250,000 investment produces a pre-tax annual return of 8%, at the end of your 10-year investment horizon it’ll be worth $539,731. If you made the same investment but didn’t pay the 2.5% MER, at the end of the 10 years your investment would be worth $678,520. That’s a difference of $138,789 that was paid in management and operational expenses. This isn’t to suggest that paying no fee is the solution as most investors will benefit from good financial advice and portfolio management, which has a cost. The question is what is a fair price for that management?
What’s a good MER?
In Canada, a good MER for an exchange traded fund (ETF) is usually around 0.25% to 0.75%. A MER above 1.5% is usually considered high, and some MERs are higher than 3%.
How can you avoid high MER fees?
The investment fees you pay will likely have the single greatest impact on the success of your long-term investment performance, so it’s wise to pay attention to fees, including the MER, when investing your savings. Here are three strategies to lower the MER on your investments.
1. Invest your money in exchange-traded funds (ETFs).
Mutual funds are actively managed by their fund managers, who may do considerable research on individual stocks and bonds and regularly increase or decrease exposure to certain sectors or securities. This active management is expensive. Added to this, Canadian investors pay some of the highest mutual fund fees in the world.
Exchange-traded funds (ETFs) tend to have lower MERs because many of them simply aim to replicate the return on a particular index, market, sector or commodity, which requires less active management on the part of the fund’s managers. MERs for ETFs can be as low as 0.03% and go as high as 1%.
2. Buy mutual funds with no trailer fee.
The trailer fee that is buried in the MER of many mutual funds is an ongoing payment to your financial advisor. Front-end load and no-load funds usually pay an annual 1% trailer. Rear-end load funds usually pay an annual 0.5% trailer. Low-load funds have a trailer fee that increases year after year and usually maxes out at 1%. Not only do these trailer fees increase your MER, but they reward your advisor when you continue to hold the same investments, even when this may not be in your best interest.
Fortunately, you can often purchase F-class mutual funds, which have no trailer fee. Advisors who aren’t being paid through trailer fees will usually be paid by their clients directly (see point 3).
3. Pay your advisor yourself.
If you have a larger amount of money to invest—say $500,000 or more—you can work with a private investment management firm. These firms, such as Bellwether Investment Management, offer bespoke, specialized investment services. Instead of being paid by trailer fees or sales commissions, the investment team and advisors at a private investment management firm are paid directly by their clients. The advisory fee is usually between 1% and 1.5% of your portfolio value per year, with larger portfolios being charged even lower fees.
Not only does this compensation approach save you money relative to typical MERs, it offers complete transparency on fee structure and will encourage your financial professional to act in your best interests, since she or he is being paid by you, not the mutual fund manufacturer. The percentage you pay your investment manager may also be negotiable.
In conclusion, the fees you pay for investment products and services will have a significant impact on whether you are successful in achieving your investment goals over the long term. Aim for a “good MER” of 0.25% to 0.75% by investing in ETFs and using a private investment management firm to manage your portfolio.
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