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Primer on Mutual Fund Fees – Ownership Fees

This is a post by our regular columnist Clark.

Part I of the primer looked at the types of mutual fund sales loads charged by the typical mutual fund. This post will touch upon more ways that mutual funds use to take their share of one’s investment.

Management Expense Ratio (MER)

The Management Expense Ratio encompasses the several types of ongoing fees associated with owning mutual fund units and provides a single number to determine the cut that the fund takes, irrespective of its performance (whether it beats the corresponding market index on a consistent basis is immaterial to the fee structure and collection).

a) Management Fees

These fees are paid to the mutual fund’s investment manager for managing the fund. The fees are taken from the fund’s assets, thereby lowering the fund’s portfolio value.

b) Administrative Fees

These are charged for the necessities of record keeping, postage, client service, etc. It is possible for the fund company to showcase its efficiency by keeping these costs low (not just this one!) but it does not always happen.

c) 12b-1 Fees

This fee is charged by some mutual funds to support their operational expenses, i.e., to fund their marketing (advertising) and distribution costs on behalf of the fund broker. The Securities & Exchange Commission (SEC) has recently proposed to cap the fee, require disclosure, call for inclusion of the fees on confirmation statements and allow brokers to set their own fees, if they are happy with a lesser percentage. You can read more about how these fees impact fund performance at The Motley Fool.

Certain mutual funds may also collect “shareholder service fees”. As might be evident, these fees are paid to representatives who service potential investors by providing responses to their inquiries and supply details about investments to existing unit holders. It is possible for a fund to charge shareholder service fees without having a 12b-1 plan in place.

Purchase Fees

As evident from the name, a purchase fee is collected by some companies when an investor buys their mutual fund units. The charge is meant for the fund company and not the broker as is the case with the 12b-1 fee. Typically, this charge helps the fund company pay some of the costs related to the investor’s purchase.

Redemption Fees

A redemption fee is collected by some funds when the investor sells (redeems) his fund units. As with the purchase fee, the redemption fee is meant for the fund company and not the broker. It is deducted from the sales proceeds and aids in alleviating the cost of the investor’s sale.

Transfer (Exchange) Fees

This fee is charged when an investor transfers (exchanges) from one fund to another, sometimes even when within the company’s same fund group.

Account Fees

This fee is typically used to pay the costs associated with the maintenance of the investor’s account. This charge may be a blanket one or restricted to those with account values less than a specified amount.

Other Expenses

This category helps mutual funds claim other charges that were not included in any of the above-mentioned types. Examples include custodial, accounting or legal expenses.

Mutual Funds and Exchange-Traded Funds

There are several differences between a mutual fund and an exchange-traded fund (ETF), the important one being the cost of owning each. Mutual funds can be bought free of cost, while ETFs involve trading commissions. However, the low expense ratios that ETFs offer while following a benchmark index help to achieve close-to-market return (minus tracking error) for that index. Canadian equity mutual funds have MERs ranging from 2% to 3% meaning that the fund would need to beat the benchmark index by that 2% – 3% to match a corresponding ETF investor’s (close-to-market) return.

Paying a premium for stellar service, product or item is understandable and the same goes for mutual funds. Purchasing funds that have beaten their respective indices over several years may have a tale of success to narrate but jumping into funds that were the top performers the previous year is irrational. It could have been the fund manager’s skill or luck and one may already be late to the party. ETFs have also started narrowing their focus to niche markets (in addition to broad market indices) and there are many actively-managed ETFs but that topic is better saved for another day. As always, do your due diligence and read the prospectus before purchasing any investment. Some links are provided below to get you started.

1. (Canadian) Get Smarter About Money Calculator

2. FINRA Fund Analyzer

3. SEC Mutual Fund Cost Calculator

4. Dinkytown Mutual Fund Expense Calculator

5. Effect of Expenses on a Portfolio (spreadsheet)

6. ETF Connect

Are you strictly in mutual funds or ETFs or do you have both in your portfolio? Have you converted from mutual funds to ETFs? If so, why?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.

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About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 11 comments… add one }
  • Sustainable PF March 16, 2011, 11:15 am

    Fees, fees everywhere the fees … taking my money, bringin’ me to my knees .. know thy know fees oh wontcha pleeaase?

    Kidding/singing aside this is a good primer.

    I am now a 100% ETF investor and switched all of my MFs last year and opened my own questrade account so I could implement the couch potato strategy. So far so good.

  • alexander45 March 16, 2011, 3:47 pm

    I stick with Index Mutual Funds, which typically have low MERs (~1%, rather than the 2-3% you quote above).

    ETFs really only make sense if you have a very large portfolio, because the transaction costs make it prohibitive to to make small, regular purchases to take advantage of dollar cost averaging or to rebalance often.

  • My University Money March 16, 2011, 5:21 pm

    Great summary on Mutual Fund Fees. Why do we have such astronomical fees here in Canada versus other countries?

    Also, what is your general view if someone has a 1.5%+ MER, but the mutual fund manager (who cares about the fund, it’s only a name) has posted 2%+ gains over their index over 5-10+ years? Is it worth investing in, or do you play the odds game and just fully minize fees and do ‘couch potato’ investing?

  • Clark March 16, 2011, 9:30 pm

    @Sustainable PF: Good one!

    @alexander45: True (about the ETFs); I hold some TD e-Series funds (combined MER works out to ~0.45%), which was my entry into the world of investing.

    @My University Money: Canadian Capitalist published a relevant post about mutual funds today….
    http://preview.tinyurl.com/48p7rne

    Regarding your question… you may have heard about Bill Miller; go through his Wikipedia entry (http://en.wikipedia.org/wiki/Bill_Miller_%28finance%29) and there should be an answer.

  • My University Money March 16, 2011, 10:32 pm

    @ Clark: Thanks for the link, I have heard of Bill Miller. He is constantly used as the counter example to the whole “All-Star Manager” argument. I take it you don’t believe that any manager can beat the market over an extended time frame then (or at least if they do it’s luck, and consequently no one can predict who they will be)?

  • Clark March 16, 2011, 11:18 pm

    @My University Money: There may be a few managers that possess a lot of skill and only need a bit of luck. But, there are probably more in the opposite camp. I don’t know how to turn hindsight into insight; of course, I can learn from experience and avoid mistakes but how can I believe that the star manager of the last 5 years (hindsight) will continue his streak for the 6th year (insight) when I buy his funds? I’ll be trying to predict then and if I did possess such (foretelling) skills, I’ll be putting it to better use by picking the next Microsoft or Google directly. :)

    You could argue that I’m virtually doing the same thing (predicting) by buying individual stocks using my limited knowledge and trying to compete with experts that earn their livelihood doing it. But, I’d like to try and fail while keeping my costs low; discipline, modest return expectations, time (to research and hold), knowledge, and motivation go a long way.

  • Sean March 17, 2011, 3:04 pm

    My contention is that many of these managers would out-perform if they were not constrained to the degree that they are running a mutual fund. The funds are often so huge, and there are so many restrictions, that it becomes extremely difficult to out perform net of fees. When you can’t put a decent % of a fund in a few stocks you think will out-perform, you can be right but still not gain much. Add to that the rules that prevent most funds from using instruments like options to reduce risk and increase returns.

    Luckily, as individual investors we are not saddled with these restrictions, and with much lower commissions available today, the economies of scale the pro fund managers have are far less important.

    You have to be crazy to pay the egg management fees!

  • My University Money March 17, 2011, 6:56 pm

    Sean, love the ‘egg management fees!’

    I definitely agree with your sentiments, that’s why I kind of asked Clark about it in a round-about way. Ed Rempel has some great guest posts on this site about this very topic.

    If mutual fund managers have too large a fund, are only supposed to invest in large cap Canadian stocks, or are ‘closet indexers’ (see his definiton for this) then they can’t help but underperform in the long run when the fees are added in.

  • Bob March 18, 2011, 12:05 am

    Like Sustainable PF, I have started the process of converting all my MF into ETF’s. Sadly I am discovering that my largest holding has a deferred sales charge :-( and I am not very happy about that. Fortunately the penalty is not too large, but I will likely liquidate the rest in the very near future and wait another year on the remainder.

    I have recently become a convert to the whole idea of passive investing. I do not have the time or inclination to track markets, research, etc. but I am very good at putting money aside every month and leaving it alone.

    I started with Questrade and they are OK, but I also have an account at QTrade. About $50 more per year and the customer service is beyond compare to Questrade.

  • Jason March 19, 2011, 9:25 pm

    I tell all of my clients to not buy mutual fund shares with any sales loads. Before I make any transaction for them, I do my thorough research and always pick out the fund that has the lowest expenses and the highest return depending on the suitability of the client.

  • Brian Poncelet,CFP March 20, 2011, 9:26 pm

    Unless I missed it there is no talk about taxes, how to pay less how to avoid capital gains when moving from one fund to another. How to pay less taxes for open funds in retirement… distribution problems for RRSPs,etc.

    Taxes, in many ways is a big problem not discussed.

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