This is a post by our regular columnist Clark.
Part I of the primer looked at the types of mutual fund sales loads charged by the typical mutual fund. This post will touch upon more ways that mutual funds use to take their share of one’s investment.
Management Expense Ratio (MER)
The Management Expense Ratio encompasses the several types of ongoing fees associated with owning mutual fund units and provides a single number to determine the cut that the fund takes, irrespective of its performance (whether it beats the corresponding market index on a consistent basis is immaterial to the fee structure and collection).
a) Management Fees
These fees are paid to the mutual fund’s investment manager for managing the fund. The fees are taken from the fund’s assets, thereby lowering the fund’s portfolio value.
b) Administrative Fees
These are charged for the necessities of record keeping, postage, client service, etc. It is possible for the fund company to showcase its efficiency by keeping these costs low (not just this one!) but it does not always happen.
c) 12b-1 Fees
This fee is charged by some mutual funds to support their operational expenses, i.e., to fund their marketing (advertising) and distribution costs on behalf of the fund broker. The Securities & Exchange Commission (SEC) has recently proposed to cap the fee, require disclosure, call for inclusion of the fees on confirmation statements and allow brokers to set their own fees, if they are happy with a lesser percentage. You can read more about how these fees impact fund performance at The Motley Fool.
Certain mutual funds may also collect “shareholder service fees”. As might be evident, these fees are paid to representatives who service potential investors by providing responses to their inquiries and supply details about investments to existing unit holders. It is possible for a fund to charge shareholder service fees without having a 12b-1 plan in place.
As evident from the name, a purchase fee is collected by some companies when an investor buys their mutual fund units. The charge is meant for the fund company and not the broker as is the case with the 12b-1 fee. Typically, this charge helps the fund company pay some of the costs related to the investor’s purchase.
A redemption fee is collected by some funds when the investor sells (redeems) his fund units. As with the purchase fee, the redemption fee is meant for the fund company and not the broker. It is deducted from the sales proceeds and aids in alleviating the cost of the investor’s sale.
Transfer (Exchange) Fees
This fee is charged when an investor transfers (exchanges) from one fund to another, sometimes even when within the company’s same fund group.
This fee is typically used to pay the costs associated with the maintenance of the investor’s account. This charge may be a blanket one or restricted to those with account values less than a specified amount.
This category helps mutual funds claim other charges that were not included in any of the above-mentioned types. Examples include custodial, accounting or legal expenses.
Mutual Funds and Exchange-Traded Funds
There are several differences between a mutual fund and an exchange-traded fund (ETF), the important one being the cost of owning each. Mutual funds can be bought free of cost, while ETFs involve trading commissions. However, the low expense ratios that ETFs offer while following a benchmark index help to achieve close-to-market return (minus tracking error) for that index. Canadian equity mutual funds have MERs ranging from 2% to 3% meaning that the fund would need to beat the benchmark index by that 2% – 3% to match a corresponding ETF investor’s (close-to-market) return.
Paying a premium for stellar service, product or item is understandable and the same goes for mutual funds. Purchasing funds that have beaten their respective indices over several years may have a tale of success to narrate but jumping into funds that were the top performers the previous year is irrational. It could have been the fund manager’s skill or luck and one may already be late to the party. ETFs have also started narrowing their focus to niche markets (in addition to broad market indices) and there are many actively-managed ETFs but that topic is better saved for another day. As always, do your due diligence and read the prospectus before purchasing any investment. Some links are provided below to get you started.
2. FINRA Fund Analyzer
5. Effect of Expenses on a Portfolio (spreadsheet)
6. ETF Connect
Are you strictly in mutual funds or ETFs or do you have both in your portfolio? Have you converted from mutual funds to ETFs? If so, why?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.