You very likely comparison shop for new shoes, a bag of oranges, or a new car. So why not take a moment to consider just what you’re paying for asset management?
One area where many believe asset management fees can be too high is with respect to mutual funds. The focus here is on mutual funds because they are probably the most popular vehicle in Canada for investing for retirement.
Mutual funds are big business
According to Statistics Canada, 40% of Canadian families hold mutual funds in their RRSPs. And the Investment Funds Institute of Canada, an industry organization, says that one third of Canadians’ financial wealth is tied up in mutual funds.
Canada’s leading investment fund data-tracking organization, Fundata Canada Inc., says it tracks some 23,000 investment funds in Canada. That astonishing number includes all series and versions of all mutual funds, including segregated funds (which are mutual funds with an insurance guarantee of some sort attached). In total, members of IFIC had $849.7 billion in assets under administration at the end of 2012.
So, yes, mutual funds in Canada are big business. And for those who sponsor and manage funds properly, it can be a lucrative business as well. That’s because the fees charged by a mutual fund in Canada are typically high.
For example, when you buy a mutual fund, here’s a rough idea of what you pay:
1% for an equity fund manager’s compensation
Add another 1% for the built-in compensation to pay an advisor
Add another 0.50% for administration costs
Add them together and you have what is called a Management Expense Ratio (MER) of 2.5%.
The fact is the MER on Canadian mutual funds is the highest in the world - some 0.30 to 0.50 of a percentage point higher on average than comparable funds in the U.S.
The net effect is this: In a strong bull market - where stocks grow 10% to 15% per year - most investors don’t mind the excessive expense; indeed, it can more easily be ignored when returns are high. This was typical of the’90s when the S&P 500 Composite Index averaged over 18% growth annually. Even until the mid 2000s, returns over the previous 10 years averaged more than 12%.
More cost, less benefit
But today, with losses or single-digit returns more the rule than the exception, it’s a different story. The average annual compound return for the average Canadian Equity mutual fund for the previous five years through the end of 2012 was –5%. Take a good, hard look at that number. It’s difficult for people to reconcile paying a 2.5% management expense per year to a mutual fund just to lose 5%!
So the conclusion is this: Select investment instruments that are cost-effective. Make sure you shop around – or make sure your advisor does. Plenty of online resources are available to mutual fund investors, including the massive database at the Fund Library. And this is one thing that is free – really! You can check a fund’s short- and long-term performance and decide whether the MER is worth it. Very often, it may not be.
Less cost, more benefit?
Another solution to the high-cost problem is to use exchange-traded funds (ETFs) instead of mutual funds if you’re looking for broad diversification. ETFs are essentially an investment fund that trades on a stock exchange. Their management expenses are exceptionally low because the funds passively track some underlying market index, say the S&P/TSX Composite Index in Canada or the S&P 500 Composite Index in the U.S. Note that MERs are management costs paid by the fund. You’ll still pay a brokerage fee to buy and sell your ETF, as you would for a common stock.
With ETFs, you can trim the overall costs by up to one percentage point or more. On a $500,000 portfolio over a 20-year period, that works out to a savings of $194,000...not exactly chump change. These are real dollars that you are spending right now if you own high-MER mutual funds.
But a word of warning before you go rushing out to stock up on ETFs for your portfolio: The ETF sector is growing by leaps and bounds, with all types of strange and colorful funds hitting the market. And, as with any type of investment asset, there are risks involved. Before investing, do your research, or better still, talk to a qualified financial advisor.
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