What’s 2.5% Costing You?

Two point five percent. That's about the average hidden Management Expense Ratio (manager fee + fund expenses) of a typical mutual fund in Canada currently being sold to you by the big banks, insurance companies, and investment firms. Of that, the salesperson ("advisor") gets a handy commission of course. But, how much is it costing you?

Mutual funds are the go-to investment products sold by "advisors" because they carry hefty embedded commissions. Basically the "advisor" wants to get paid first.

With some exceptions you generally get suckered in like this. You get referred by someone to go see a certain advisor (he's great, he made me $xxx last year). The "advisor" briefly discusses your financial situation with you and goes over some paperwork. A few weeks later, he calls you in and presents a plan. There's some fancy talk about tax efficiency, out-performance, diversification, professional management, risk mitigation, personalized bla-bla-bla...

Next, he recommends an investment product or two that you should purchase because they're the best for your situation. These products are mutual funds and often the "advisor" all but suggests they cost you nothing. The truth is they don't bill you directly; even the "advisor's" time and services appear free. But even you know the guy's new BMW, shiny suit, and smashing receptionist don't come as a result of "free" services. So how does he make money?

Sales Commissions

There are two ways the "advisor" gets paid and it's all kind of swept away in a smaze of silky words and stacks of paper. First, when he sells you into a mutual fund product, he collects a one-time sales fee on each purchase. Often between 3-5% of your up-front investment. Then he gets a piece of that 2.5% hidden MER each year, usually 0.5-1.0%, called the trailer fee for as long as you're invested in that fund.

A bit of simple math tells us the "advisor" stands to collect as much as $5,000 in year one and $1,000 every year following for every $100,000 you invest with him. He's not paid directly by you, but for every $100,000 you invest you indirectly pay $2,500 in fees from which he receives a healthy kickback from the fund company.

The 2.5% MER embedded into your mutual fund actually comes straight out of your returns every year. Pick just about any mutual fund from a major provider that's been in play for at least 3 years and compare to the true index benchmark (not the company's Frankenbenchmark). Most of the time you will find the mutual fund under-performed the comparable index ETF by a few percent each year. Sometimes it's much more.

Consider a popular blue company's US Large Cap Series A fund which returned 16.68% annually over the last five years; at the same time Horizon's S&P 500 Index ETF returned 20.83%. The blue company's International Equity Series A fund returned a pathetic 2.67% annually over the last three years; iShares Canada's Core MSCI EAFE Index ETF returned 6.39%. These are just examples from one major fund company, but the story plays itself over and over across the industry.

Mutual funds with high fees cannot beat low-fee index ETFs over long time periods—it's mathematically impossible. In fact studies show less than 1% of portfolio managers can outperform their comparable index over a long period of time. They may outperform for a year or two here and there, but that's it. If your "advisor" is promising you high performance to justify the fees he'll hardly mention—run!

The Results

This frequent underperformance isn't necessarily the result of bad stock picking by fund managers, it's mostly due to the fees that drag on portfolio performance during up years and down years. Fees used to pay for your guy's car, suit, glass office, and the receptionist. It costs you a wack of money.

An index ETF charges about 0.20% MER compared to a mutual fund's 2.5% MER. That 2.3% drag difference due to fees can make you seriously poor. In fact, a 2.3% additional fee cuts your total investor return by one-third over 25 years. No wonder millions of Canadians believe the only path to wealth is rental real estate!

Example Comparison

Dave invests in a Balanced Portfolio that returns 8% annually (not adjusting for inflation). He has $100,000 now and will invest $10,000 a year for 25 years. Dave's portfolio will be worth $1.4 million at the end of the 25 years.

Dave's friend Wendy invests the same amount of money with her "advisor" and gets a net return of 6% due to the higher fees. Wendy's portfolio will only be worth $975,000. Over the years the fund company will have quietly siphoned off $425,000 (of which your "advisor" received close to half). Not bad for a bi-annual meeting and some market update emails.

In Retirement

When you're retired the high mutual fund fees really hurt and greatly decrease your chance of success over a long retirement. Remember the 30x, 25x, 20x rule from last week? At a 5% withdrawal rate (20x), you are pulling in $50,000 a year. Add on a 2.5% MER and the true deduction off your portfolio performance is actually 7.5% or $75,000 a year. That silent fee comes off during up years and down years as the fee is charged regardless of the portfolio performance.

On a baseline growth portfolio holding 80% stocks and 20% bonds, your real historical success rate during a 25 year retirement is just 52% when paying a 2.5% MER. Do you want to leave the probability of success on your hard-earned retirement up to a coin toss?

If you want an advisor to help with your portfolio and taxes, hire a pay-for-service advisor. Trust me, you can buy a lot of great advice from accountants and financial planners for way less than $25,000 a year. But it really pays to understand your investments, self-manage your portfolio, and learn the basics of taxes so you can save money on those fees through your whole financial journey.

*"Advisor" intentionally in brackets as many selling these 2.5% funds are really just barely qualified financial product salespeople.

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2 Replies to “What’s 2.5% Costing You?”

  1. You mentioned the benchmark that the company creates. How do they fudge these numbers so that it looks like they are outperforming the benchmark?

    1. Mr. Rich Moose says:

      Many mutual fund companies, especially the more unscrupulous ones, tend to use benchmarks that they created to make their own fund performance look better. I don’t want to name names for legal reasons, but I would really encourage anyone who is interested in this to dig into the fund documents and legal information of some major funds to see for themselves.

      For example, if a mutual fund is simply advertised as a US Equity Fund, their benchmark should be either the Wilshire 5000 Index, the Russell 3000 Index, or the Dow Jones U.S. Total Stock Market Index. However, often the funds will simply use the index that best suits their purposes and will change the benchmark index over the life of the fund to maintain the illusion of outperformance.

      One popular U.S. Equity fund at a major company demonstrates this perfectly. The fund has $1.7 billion invested. Quickly digging through their documents I found they changed their benchmark 3 times in 11 years – from the Russell 3000 Value Index to the Russell 1000 Value Index to the S&P 500 Index. There is no mention of value anywhere in the fund name, so why benchmark to value indices to begin with? Because the Russell 3000 Value Index was underperforming the Russell 3000 Index substantially. Why the recent switch to S&P 500 Index? Because in the past year the Russell 3000 Value Index and Russell 1000 Value Index are nicely outperforming the S&P 500. By switching benchmarks when desired the fund salespersons are able to deceive their clients as to the true performance of their fund relative to a real index strategy.

      Better still, the same fund has also absorbed different underperforming funds from the same company in the past few years. However, the historical performance of those underperforming funds was not transferred. In the end, if someone were to invest in managed U.S. equity funds with this particular fund company they would have been very unlikely to realize the advertised performance because of all the monkeying around the fund managers do.

      Over the last 10 years, the fund I’m referring to posted a 4.9% compounded annual “Frankenreturn”. The most comparable low-fee index fund TD US Index-e posted a 6.7% compounded annual return. So even after all the monkey business the Frankenfund still underperforms a real index fund significantly.

      I just picked out one fund totally random to give an example, but this trend plays itself out over and over and over.

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