Mutual funds offer a diversified way to invest in stocks, bonds, and other securities. But these funds don’t come for free. Fund managers charge fees to operate the fund, including management fees, which factor into how the management expense ratio (MER) is calculated. If you find these terms confusing, you’re not alone. This article will help you differentiate various fees and expenses so that you can invest with confidence.
What is a fund’s management fee?
The management fee is basically the cost of running the fund. It covers the management of the fund, hiring a portfolio manager to make investment decisions according to the fund’s mandate, and hiring other companies to assist in administering the fund.
Management fees help cover direct expenses related to the mutual fund. Hiring various portfolio managers makes up one of the most significant fees, costing roughly 1% of a mutual fund company’s assets under management (AUM). That means an organization like Sun Life Financial Inc, which has $1.247 trillion in global AUM, spends tens of millions of dollars on hiring and retaining talent alone.
A mutual fund’s fee structure must be listed inside its Fund Facts document. Search the name of the fund, or the mutual fund’s code, to find this information.
What is an MER (Management Expense Ratio)?
MER stands for management expense ratio — which includes both the management fee, plus the trailing commission and operating expenses such as the administration fee, other fund costs and taxes.
It’s an important number to review when you’re considering a mutual fund. The ratio is calculated by adding up the operating costs, trailing commission, management fees, and any taxes and then expressing this number as a percentage of the fund’s average net assets.
The operating costs cover things like administration, bookkeeping, compliance, distribution, marketing, and office supplies. Believe it or not, the cost of buying and selling securities is not included in management fees — instead, a mutual fund company considers this to be trading costs.
The trailing commission (or trailer fee) is a fee for distributing and selling the fund. It’s common to see an equity mutual fund with a trailing commission of 1%, while a bond mutual fund might pay a trailing commission of 0.5%.
Financial management companies don’t use identical language. You may encounter the term trailing commission or trailer fees, depending on where you buy and sell mutual fund shares.
A trailer fee goes from the fund manager to the dealer in exchange for services such as account management, account statements, and investing advice. Remember that investors don’t purchase mutual funds directly. Instead, they buy shares of mutual funds from an advisor who gets them from a mutual fund dealer.
Difference between an MER and a management fee
Simply put, a mutual fund’s management fee is the amount paid to the fund manager for overseeing the fund and making investment decisions.
The MER is the management fee plus operating expenses for legal, auditing, marketing, and other administrative costs.
When a new mutual fund is introduced, the management fee is published (known in advance), but since the fund is brand new the total MER is unknown. It will be published after the fund has been in operation for 12 months.
How MER fees impact your returns
Pay attention to the expense ratio when considering mutual funds and ETF portfolios. (If you want to see the expense data for a fund, check out its Fund Facts document or simple prospectus.) While a few percentage points here and there might not seem like a meaningful difference, they can make a significant impact in the long run. When you’re ready to withdraw your money, a 1% MER instead of a 2% MER might save you many thousands of dollars.
Don’t think of this fee as 2% out of 100%. It’s 2% of the value of your portfolio – every single year. If the expected return on your investments is 6%, then 2% is 1/3 of your overall return. That’s a big deal!
Let’s say you invested $100,000 in a mutual fund that charged a 2% MER. You invested these funds for 25 years and averaged returns of 6% per year. After 25 years you’d end up with $266,584. But you would have also paid an incredible $162,603 in fees.
Now let’s say you invested the same $100,000 in a mutual fund that charged a 1% MER. Your investments earned 6% per year over 25 years. Your portfolio is now worth $338,635 and you only paid $90,552 in fees during that time.
Investing in the lower fee mutual fund gave you a portfolio worth 43.25% more than investing in the higher fee fund. See what a difference 1% can make over a lifetime of investing?
Most companies don’t charge expenses upfront. You won’t receive an annual bill or email notifications. Instead, they will withdraw the fees directly from your account, leading to a reduced portfolio balance.
Canadian law requires mutual fund companies to show their expenses in the prospectus. The transparency makes it easier for investors to understand the costs and fees associated with specific accounts. It can help answer whether an investor should put their money into a fund and what they can expect for long-term gains.
What is a good MER fee?
According to Barron’s, Canadians can expect to pay a median expense ratio of 1.98% for equity funds. Canada has the highest fees for equity funds in the world, except for Italy and Taiwan.
Most banks and retail investment firms sell mutual funds with MERs in the 2%+ range. But every bank also offers lower-fee mutual funds called index funds. These mutual funds passively track popular stock and bond indexes and so they don’t have to pay a fund manager to make active investment decisions. That means index funds charge more reasonable fees in the range of 1% MER or less.
Investors should avoid mutual funds that charge 2% MER or more. A good MER starts around 1.25%, but a great MER is less than 1%. The best example is TD’s e-Series funds where the average MER is around 0.40%.
Looking to save money on your management fees and MER? Use an online brokerage like Questrade or Wealthsimple Trade.
With Wealthsimple Trade, you can trade stocks and ETFs commission-free. Plus, you can take advantage of our exclusive promo offer: open a new Wealthsimple Trade account, and get a $25 cash bonus + $0 commission trades. All you have to do is fund at least $150.
Or for a hands-off approach, use a robo advisor like Wealthsimple. The management fees at Wealthsimple are very competitive: between 0.40% and 0.50%, depending on the size of your portfolio.
How to know the total cost of the investment
The total cost of the investment is made up of two components, namely:
- Management Fee vs. MER (Management Expense Ratio)
- The annual charge for expenses such as trading commissions
The MER is expressed as a percentage of the value of the fund. But percentages can be misleading and so investors should aim to convert that percentage into dollar terms to get a better sense of the overall cost.
For example, an investor with a portfolio worth $500,000 paying an average MER of 2% would be paying $10,000 per year in fees ($500,000 x 0.02).
If that investor could reduce the average MER to 1%, he would be paying $5,000 per year in fees ($500,000 x 0.01).
The final say: How do I find the best investment?
Research, research, research. It’s the single best thing you can do before committing to an investment decision. Understanding the costs and benefits of various mutual funds can save thousands of dollars in the long run, making it easier for you to buy a house or retire early.
Ask yourself some key questions to make your life simpler when choosing a mutual fund or ETF portfolio, such as “What are your goals?” and “How long do you plan on investing your funds?” Your results will vary whether you want a short-term, safe investment versus a long-term one that has more risk.
Remember, fees are the best predictor of future returns. The lower the fee, the better the returns. If you want to cut costs and maximize your returns, invest with an online brokerage or a robo advisor. It’s that simple.
READ MORE: How to Become a Successful Investor