Can you afford to invest in mutual funds?

Many people simply don't realise how much of the returns from their investment portfolios are eroded by mutual fund fees and taxes. They wrongly assume that the only expenses they incur are the funds' published annual Management Expense Ratios (MERs.) This article attempts to describe and estimate all of the expenses that mutual fund owners incur. It then shows how severely these costs impact on the ultimate performance of their portfolio.

Investing's Seven Deadly Sins

The various expenses that mutual fund investors incur have been characterised as the investment industry's Seven Deadly Sins¹. Here's a brief description of each sin:

1. Management Expense Ratio (MER)
The MER is an annual fee that's charged to a mutual fund to pay for such expenses as:

management fees paid to the managers of the fund
adviser sales commissions and ongoing service (trailer) fees
legal and audit fees
custodian and transfer agent fees
fund administration expenses
marketing expenses (guess who pays for all those TV, radio and print ads?)

The MER is calculated as a percentage of a fund's assets. This is the fee that most investors are familiar with. It's usually displayed prominently in the fund prospectus. MERs in Canada generally range from about ˝% to over 3%. The average Canadian equity fund has an MER of 2Ľ%.

2. Front-end (FE) or back-end (DSC) fees
Today, with all the mutual fund sales competition, few Canadian investors still pay front-end "load" fees out-of-pocket when they purchase a mutal fund. Oh yes, they still have to pay these fees. It's just that the're now buried in the annual MER.

Likewise with back-end load fees. These too are built into the fund's MER. Investors only have to repay these fees if they redeem funds before their Deferred Sales Charge (DSC) schedule expires.

3. Trading costs
A mutual fund incurs trading costs when it buys or sells securities. These costs include brokerage commissions, bid/ask spreads and the affect that large transactions can have on the market price of a stock. It's difficult to quantify how much these costs add to a fund's operating expenses because they depend on a variety of factors:

Large mutual fund companies can negotiate lower brokerage fees than their smaller competitors.
Funds with high portfolio turnover incur higher brokerage expenses.
The bid/ask spread on the market price of a stock can vary from as little as a few basis points for a well-known, highly liquid issue to as much as a few percentage points for an obscure small cap stock.
A fund that buys (or sells) a relatively large position in a particular stock can raise (or lower) that stock's market value due to the forces of supply and demand.

It's been estimated that these expenses can add 1% or 2% to the annual costs of managing a mutual fund. They are not included in a fund's MER.

4. Insurance fees
Segregated or "protected" funds offer a guarantee of principle if you hold the fund for (usually) 10 years. The MERs are typically ˝% to 1% higher than for conventional mutual funds in order to pay for this "insurance" coverage. It's worth asking if it makes sense to pay for such insurance when the likelihood of achieving negative returns after 10 years is small, however that's beyond the scope of this article.

5. Wrap fees
These are fees paid to an adviser for selecting, monitoring and adjusting the allocation of funds within an account. They typically run at 1% of assets and are applied on top of MERs. It's worth asking why an investor should pay such fees since the MER should already remunerate the adviser for this service, however that issue is beyond the scope of this article.

6. Taxes on distributions
A mutual fund earns interest, dividends and capital gains from holding and eventually selling the stocks in its portfolio. This income is passed to investors so that they, not the fund company, can pay tax on it. That's what those T-3 and T-5 information slips that you receive at the beginning of each year are all about. (If you hold a fund inside a registered account such as an RRSP these distributions are tax sheltered.)

It's difficult to come up with a single number to account for the affect of these taxes since each type of distribution is taxed at a different rate and the rates themselves vary according to the tax payer's income bracket as well as province of residence. Financial journalist Duff Young calculated² that "the after-tax rate of return on funds has been just two percentage points lower than the pretax returns that are generally quoted in ads and in the newspaper listings." While he concluded that this 2% point penalty was "not bad," as we'll soon see, it's really quite the opposite.

Many investors pay taxes on these distributions outside of their investment accounts. That makes it much more difficult to appreciate the negative effects that these taxes have on portfolio returns.

7. Taxes on redemptions
When you redeem (sell) a mutual fund you'll have to pay capital gains tax on the amount by which it has appreciated. (If you hold a fund inside a registered account such as an RRSP these gains are tax sheltered.)

It's difficult to generalise about the effect of redemption taxes. Realise however that these taxes are incurred only when you sell a fund. Those who buy-and-hold can shelter accrued capital gains taxes for many years.

So what does all this cost me?

We'll try to answer that question by estimating how much these costs subtract from your annual returns. Then we'll show the effect this has on your ultimate portfolio performance over the course of your investment career.

Suppose you own a typical actively managed Canadian equity fund. Your fund charges an MER of 2%, it incurs a further 1% in trading costs, and you pay an average of 2% annually in taxes on distributions. Your returns are eroded at the rate of 5% per year.

To show how the effects of this erosion, Malcolm Hamilton, an actuary and pension consultant with William M. Mercer Ltd. provides this handy "rule-of-40"³:

Take 40. Divide by the [total annual expense rate that your mutual fund incurs.] And presto, you've got the number of years it takes [fund] expenses to consume one-third of your investment.

Using the rule-of-40 it's easy to see that it takes only 8 years for you to lose 1/3 of your portfolio. And remember that when you redeem fund units there are capital gains taxes to pay on top of that!

Here's a chart⁴ that shows how your portfolio erodes over time for a variety of annual percentage costs:

May the Force be With You

The mantra of John Bogle, Senior Chairman of Vanguard, is that mutual fund costs matter. Hopefully this article has helped you to see just how much they matter. Remember that the returns for such indexes as the Toronto Stock Exchange 300, Standard & Poors 500, Dow Jones Industrial Average, etc. that you see in the newspaper or on TV do not include any of investing's seven deadly sins.

Albert Einstein was once asked, "What is the most powerful force in the universe?" He replied, "Compound interest." You benefit from the power of that force when you invest for the long-term. But remember that when it comes to investment costs the force can be equally powerful in the opposite direction.

Footnotes
1. The Seven Deadly Sins analogy was suggested by Fund Library discussion forum's George$.
2. See After-tax returns show that funds offer decent shelter [Globe & Mail, 08May99.]
3. Adapted from the Foreward to Jonathan Chevreau's The Wealthy Boomer. For some earlier thoughts on mutual fund costs, more about the "rule of 40" and a derivation of the rule by Fund Library discussion forum's gummy, see On MERs, Taxes and Partners.
4. Because they are "one-time" costs the following are not included in the chart:

front-end loads on fund purchases
DSC fees on early fund redemptions
capital gains taxes on fund redemptions

To the extent that you incur these costs they will further erode your net investment returns.

Mutual funds offer decent tax shelter?

May99