Estimated reading time: 8 minutes
I’ve invited my friend Gary, a fellow Canadian blogger and investment advisor, to explain mutual fund fees, penalties, and how advisors are paid.
Question: Can you explain Mutual Fund Fees and Penalties regarding investments?
What Does MER Stand For?
MER means Management Expense Ratio.
There are a variety of expenses that make up MER.
Some examples would be:
- The fee paid to the fund managers for managing and investing your money
- Legal and audit fees of the fund
- Advisor sales compensation and trailer fees (ongoing service fees)
- Advertising expenses that promote the fund
- The cost of buying and selling the stocks the fund holds
How does this impact my investing return?
All published returns for a fund are net returns after the MER has been deducted.
In simple terms, Fund A has a return of 10%. Its MER is 2.5%.
The net return to the investor is 7.5%. Fund B has the same 10% return but has an MER of 2%. The net is now 8%.
The lesson we can learn from this is that lower MERs usually mean more money for the investor, all other things being equal.
Some investors have focused exclusively on buying investments with the lowest cost.
Some investments like ETFs (exchange-traded funds) have very low-cost factors—some range from 0.15% to 1.40%.
I will comment more on this later.
Sales Commissions, Fees, and You
There are three main ways advisors are compensated.
- Commission based
Sales commissions are embedded in the MER to compensate advisors.
This can take one of three forms, each impacting the investor.
The three commission-based options are:
- Front End Load
- Deferred Sales Charge (DSC)
- Low Load Sales Charge (LL)
In the Front-End Load option, the client and the advisor negotiate a percentage of the deposits as a sale commission, usually from 0% to 5%.
This percentage is deducted from the investment right up front.
In the long run, this is not good for the investor.
In addition, the advisor would receive a portion of an ongoing trailer fee of 1%.
The other portion belongs to the dealer where the advisor does business.
The client, however, can move his/her funds to another fund company at any time without any sales penalties or charges.
Nothing is deducted from the investment in the Deferred Sales Charge (DSC) option.
The Mutual fund company pays the dealer/advisor an upfront commission.
Because they advance the commission, they are penalized if the client leaves the funds from the current company to another company.
This is based upon a percentage of the original deposit, not the current fair Market Value.
The percentage is declining and lasts 6 or 7 years, depending on the fund company.
After this period, the investor is free to do what he/she wants without penalty.
Deferred Sales Charge
Here is a sample of the Deferred Sales Charge:
Deferred Sales Charge
An advisor will receive an ongoing trailer commission of 0.5% under this fee option.
Again this is shared with the advisor’s dealer.
An investor purchasing funds under this option has 2 relief options.
One is he/she can withdraw 10% of the fund’s value in a given year.
The 10% is non-cumulative.
If you didn’t use it in years 1 and 2, you can’t withdraw 30% in year 3, just 10%.
Some clients annually move the 10% fee-free amount to the same mutual fund but on a zero-commission basis.
In this way, you can indeed accumulate the 10% over time.
The sales charge only applies if you sell some or all of your funds and purchase other funds with another mutual fund company.
The second relief option to the DSC charge is that many fund companies have many fund options, and a move or switch from one fund to another within the same fund family does not incur the DSC penalty.
The low-load sales charge (LLSC) works similarly to the DSC option.
However, the restriction is limited to 3 years versus the 6 or 7 on the DSC option, and the penalty percentages for withdrawals are roughly half of the DSC option.
Traditionally the commission option has been the main way advisors have been paid for their efforts.
Many argue that the advisor’s compensation should be upfront, known, and factored out of the MER. It should be transparent versus embedded.
This has led to some advisors charging a fixed percentage of your assets, like 1.5% to 2% for smaller amounts of money and a lower percentage for bigger amounts (usually over $250,000).
These advisors are known as Fee-Based Advisors.
The cost of advisor compensation is stripped out of the MER, and the investor will have MERs about 1% less than before.
The investor, in turn, pays the advisor the fee, which in the past has been paid by the mutual fund company.
Using this type of advisor allows clients to freely move monies from one company to another as they are sold on a 0% front-end load.
(Note of caution, this freedom to move anytime isn’t always good).
The only compensation besides the upfront fee they charge is the ongoing trailer fee paid by the fund company.
There are no penalties or charges if a client moves their money to another fund company other than a fairly nominal account closeout fee, usually less than $125.
If they are licensed for other products, such as life insurance, fee-based advisors can still earn commissions from selling those products.
The fee-based refers to the investment component.
Another variation is that some advisors charge a fee for planning and advising on investments and perhaps life insurance, estate planning, etc.
This fee can be based on the nature of the work being performed.
Some charge hourly, work on an annual retainer, or again as a percentage of your account size.
They receive no compensation for the products being purchased.
These advisors are known as fee-only.
The investor pays the fee, and the client has no penalties if they move their funds to another institution, except for the closeout fee.
Which Option Is Right For You?
I am sure by now you all have an opinion. Let me say there is no perfect answer.
If you have less than $100,000, many advisors will not work with you on a fee-only or fee-based option, as the earnings don’t adequately compensate them for their time and effort.
That is why many advisors have an advertised account minimum.
Many investors don’t like the thought of writing a cheque for the fee. If they have $200,000 and the fee is 2%, then the cost is $4,000.
They could buy under the LLSC and the advisor is properly compensated and the client pays no fee.
All advisors worth their salt will explain in simple English the various compensation options a client has.
Then the advisor and client can settle on a mutually acceptable basis of dealing.
Failing To Plan
What Is More Important Than Costs and Commissions?
MER is important!
Understanding how an advisor is paid and impacts your investment is important!
However, in my 37 years of advising Canadians, I think there are two more critical factors.
- The absence of a financial plan
- The biggest determinant of financial failure is behaviour, specifically bad behaviour.
- It is not the cost of an investment, the commission or fee option being chosen, or the products selected.
Products like Mutual Funds, ETFs, etc., are tools to accomplish a goal.
In 37 years, people don’t plan to fail; they fail to plan.
What product solutions you buy should be in the context of an overall plan.
However, I have too often seen Canadians buying the product of the month or the one with the latest high returns published in the newspaper.
The axiom we have all heard is buy low, sell high, but because of our behaviour we buy high and sell low.
Our behaviour looks like this:
Dalbar every year does a survey on Investor Behaviour.
They discuss many factors in their Quantitative Assessment of Investor Behaviour (QAIB).
The results consistently show that the average investor earns less – in many cases, much less – than mutual fund performance reports would suggest.
- Fact: From 1991 to the end of 2010, the S&P 500 index had increased by 9.14% annually.
- Fact: The average investor only made 3.83% ignoring taxes and inflation in the same period.
One point that caught my attention was the average time an investor held an investment fund. (This is a 20-year study)
- For equity funds, it was 3.27 years.
- For fixed-income, it was 3.17 years.
- For asset allocation funds, it was 4.29 years.
Implicit in these numbers is the investor chasing the next new big thing.
I point out these factors to show that yes, costs matter, but what matters more is managing your bad behaviour.
My one true value as an advisor to my clients is to prevent them from making emotional decisions that are very costly.
Sober Second Opinions
I have lived and advised through a long arc of history and witnessed many clients make emotionally based investment decisions to their financial detriment.
My job is to act as a sober second opinion and help them take a more reasoned approach to what they do, remind them of history and that this, too, shall pass.
Clients pay me for this to help prevent them from making costly emotional mistakes.
So now you know about MERs, costs, and how advisors are paid.
I hope you focus on the more critical factor in your financial success, managing your behaviour.
Guest Writer: Gary’s $$$ and Sense.
I am an investment advisor employing behavioural finance principles in my advice-giving and a licensed life insurance broker with 36 years of experience helping Canadians achieve financial security.