Through the power of compounding, one million dollars invested at an annualized rate of 6.5% over 30 years can turn into nearly $5 million ($4,983,951) . . . that is, if you are paying only 1% in fees and other costs. Unfortunately, if you are like most Canadian investors, you probably pay one or two percentage points more than that, putting that same compounding power to work in reverse to diminish your returns over the long term. Paying 2% in fees over the same time period will reduce your returns to $3.7million, and 3% to $2.8 million (see graph).
To reach your long term financial goals, it is very important to pay attention to both sides of the investing equation: not only the expected returns on your investment over time, but also what the costs of making your investment are going to be. It is not always readily apparent what these costs are: some you have to consider are management fees, fund expenses and taxes.
Canadian investors are particularly vulnerable to erosion of their returns by costs: Morningstar’s Investor Experience Study (2011) of 22 countries found that Canada has the highest annual expense ratios for equity funds (median is 2.31%), the third highest for bond funds, and tied for the highest for money-market funds. Typically, several fees and costs are bundled together, making it difficult for investors to understand which costs are associated with managing the fund itself and which are fees being paid to an advisor or broker (even if little or no advice is received).
The fee structure largely accounts for the negative press mutual funds have received over the years. There are a variety of costs, with the management expense ratio (MER) being the most inclusive way to identify the hard costs of owning your mutual fund. There may be additional costs, such as back end loads (should you wish to sell prior to a specified time period) or taxes incurred because of turnover of individual securities inside the fund. The ‘trailer fee’ paid to advisors has often been singled out for criticism because it could lead an advisor to select a fund that pays the best trailer rather than the one that is best for his or her client.
The mutual fund itself, however, is a valuable structure. It provides broad diversification, lower trading costs, stronger purchasing power, access to a variety of global markets and a methodology for very efficient investment portfolio structuring. Savvy investors (and their advisors) can find options in the mutual fund market that charge low fees: for example, see Rob Carrick’s August 31, 2012 article in the Globe and Mail on Dimensional Fund Advisors (DFA): ‘A little-known company that keeps fees low.’ DFA (based in Austin, Texas) runs global assets of $239 billion and has an MER of 0.4 per cent on its core Canadian equity fund. Their funds are available only through advisors which they have put through a selection and educational process (dfaca.com/find_advisor/).
Why invest in funds at all if the fee structures are so opaque that you can’t understand what you are paying for? When you hire a stockbroker to buy individual securities on your behalf, you feel that you are getting value for your money because you see activity—buying and selling—in your account. However, research has shown that picking individual stocks is a less efficient strategy over the long term than buying the market (through a fund that tracks the market or mirrors the holdings of major stock and bond indexes). Also, investors who buy individual securities tend to limit themselves to a familiar geographic area, with the result that Canadians own mostly Canadian stocks and a few US stocks. As the Canadian stock market is only about 4% of global capitalization, this leads them to invest the lion’s share of their wealth in a very small pool of the global market.
That being so, how can you manage investment costs while taking advantage of all the benefits offered by funds? Insist on transparency in fee structure and terms that will allow you to understand exactly what you are paying for and to make meaningful comparisons between the costs of investing in one vehicle versus another. Those advisors who choose to unbundle their fees and charge them directly to the client clearly differentiate between the management costs to run the mutual fund itself and the advisory costs to build, research and manage your portfolio. In other words, you are able to weigh the value of the advice you are being given against the cost of this advice.
As with running any business, there are costs that are critical to a successful outcome. Good advisors welcome questions about their fees because they hold themselves to a standard of delivering advice and services that prove valuable enough to receive the fee they charge. In addition to building a portfolio that will achieve your financial goals, the value of good advice on financial planning, tax planning, estate planning and business planning as you build your financial future is invaluable.
Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. Rates are not guaranteed and are subject to change at any time without notice.