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Fees Suck. Amirite?
I know, such a bold statement to make. Fees are bad. From parking tickets to gym memberships to whatever the Bloody Hell Ticketmaster’s “convenience fee” is for, whenever I see the word “fee” written on something, a tiny piece of my soul (and wallet) dies a little.
But out of all the fees we have to put up with, one stands out as simultaneously the most damaging and the most misunderstood: Investment fees.
Quick, how much are you paying to invest? If you have no idea, you’re not alone. Investment fees usually don’t appear in your statement, and are instead embedded inside your mutual fund and taken silently out of the fund’s performance. Why would they do this? Simple! If you saw a line item that said $-500 fee, you’d call someone up and scream at them. But if your mutual fund just goes up slower than it should, you don’t notice. It’s brilliant!
And lucky you, we here in Canada have among the highest Investment Fees in the world!
All mutual funds and ETFs have an embedded fee called a Management Expense Ratio, or MER. This pays for the cost of running the fund, paying all those analysts and salespeople, as well as the cost of marketing and advertising and is usually given as a percentage of the fund’s total value.
Finding a fund’s MER may be as straightforward as just looking at the fund’s webpage, but if it’s not there it’s required to be shown in the fund’s prospectus. As an example, I went to a certain bank’s site and picked its “Canadian Equity Fund.” At the bottom there was a (tiny!) link named “Fund Financial Reports and Prospectuses” and that led me to the fund’s prospectus. When I clicked on that link, I saw a description of what the fund invests in, their top 10 holdings, and the MER. Which is a whopping 2.39%.
And don’t think I’m picking on that particular bank for sucking here. All the banks do this. In fact, the average MER of equity funds in Canada is 2.42%, so technically this fund is slightly…better, I guess?
Sorry, it’s just so hard to contain my excitement.
Meanwhile, an ETF tracking the TSX, which by the way, holds many of the same companies that Canadian Equity Fund up there is holding, has an MER of…0.06%.
That’s right. 0.06%. Almost 40x lower than a bank-run mutual fund.
Why is this important? Because any ongoing percentage fee eats into your fund’s performance, and just like gains can compound over time, fees compound also. Over sufficiently large periods of time, a couple percentage points paid to your fund can results in massive differences. Lets pretend, for example’s sake, that we went back 25 years and wanted to invest $100,000 in the TSX. So January 1, 1990, we buy $100,000 worth of either that mutual fund with a 2.42% MER, or the ETF with a 0.06% MER. On January 1, 2016, what does our investment look like?
The red line is the low-cost ETF and the blue line is the higher-cost mutual fund. Both are generally investing in the same stocks, but you will notice that while the lines start off at the same point, the difference between them grows and grows as the fees eat into our fund’s compounded growth, and at the end we are left with a huge gaping chasm. That gap is worth $100,000, JUST in fees!
And here’s the wild part. For most things, paying more money equals better quality, right? An expensive car is better than a cheap car, an expensive laptop is better than a cheap laptop, etc. This is NOT one of those times. Paying more does NOT mean a better product.
In fact, when it comes to Investing, the opposite is true. The more you pay, the worse the performance, because that fee just eats into your returns.
So what should you do?
First of all, if you’re looking at a fund and you can’t figure out it’s MER, DO NOT BUY IT.
Secondly, if a fund discloses its MER and it’s above 1%, DO NOT BUY IT. No mutual fund (or ETF) has a chance of giving you the performance you need with a handicap that big.
Mutual Funds vs ETFs
Generally, ETFs have a much lower fee than mutual funds, so a good rule of thumb is to always use ETFs over mutual funds. There is one caveat, though, and it’s to do with trading commissions.
Mutual funds generally cost nothing to buy/sell. This is because the cost of trading is built into the (higher) MER. ETF’s, however, are trade on the stock exchange, so there’s generally a per-transaction cost to buy/sell.
For TD Waterhouse, the cost to trade is $9.99 per transaction. They also offer low-cost mutual funds called “E-Series” funds, designed for Index Investing and with considerably lower fees than other bank-run funds. The Canadian Index e-Series fund, for example, has an MER of only 0.33%. While we were working and self-directing our investments, we would dump money into our investment accounts with each paycheck and buy more units of each mutual fund in our portfolio. We were using 4 funds at the time (Bonds, TSX, S&P500, International) Had we done this using ETFs, we would have racked up $10 x 4 trades per paycheque x 2 paycheques a month x 12 months = $960 a year in transaction costs alone.
In that scenario, it made more sense to use the e-Series mutual funds to dump our paycheques into it, and then when that total balance got big enough that the higher MER started to become expensive (we used $100,000 as our cut-off point), we sold the mutual funds and rolled it into ETFs that track the same indexes to take advantage of the lower MER.
But that was then. There are many more options for low cost brokerages now. Recently, our readers have alerted us to a whole slew of them…like Questrade and Qtrade. And for Questrade, you don’t even need to pay to buy ETFs, only to sell. And since it’s gotten so many good reviews, we’re going to try it ourselves and report back the results.
So there you have it. Fees suck, avoid at all costs by using ETFs. The only time you should ever use mutual funds is if the transaction costs are greater than the difference in the MER.