Paying Fees On Your Investments
Most recently, I wrote an article highlighting some of my research showing that mutual fund fees do matter in investing. Mutual fund fees are only one type of fee that impact investors’ returns. In this article, I would like to highlight some of the different types of fees that every investor should be aware of.
Mutual Fund Fees
When buying mutual funds, there are three key types of fees to be aware of:
1. Management Expense Ratios (MER)
Lot has been written on management expense ratios. They are one of the primary fees to be aware of when investing in a mutual fund. The Management Expense Ratio measures all of the fees and expenses associated with the fund. One of the expenses wrapped into the MER is the ‘trailer fee’ that goes to the financial advisor or broker as part of their ongoing compensation.
2. Front End Load
In Canada, front-end loads are completely negotiable. In many cases, you can pay as little as nothing to as high as 5%. This fee comes right off your investment. For example, if you are investing $10,000 and you pay a front-end fee of 2%, you will pay $200 for the purchase and $9800 will get invested. Paying a front-end fee means you have less money at work.
3. Back End Load or Deferred Sales Charge
A back-end load is different in that you do not have to pay anything upfront. In the same example, you will have $10,000 invested and put to work. However, the mutual fund company has hooked you into a 6, 7 or 8 year time frame where if you leave their company before a certain time, you will have to pay a penalty for leaving early. The longer you stay with the fund company, the smaller the fee. Typically, you can still move your funds around within the same company without triggering fees. The theory is that back-end loads promote long-term thinking.
A significant part of the front and/or back-end loads go to the financial advisor or broker for compensation. Do-it-yourself investors also need to be careful. I’ve seen some investors who have bought mutual funds in their discount brokerage accounts choose the wrong versions of a mutual fund, where they buy a back-end load fund instead of choosing the no load option or the front-end load option.
Other Fees
Discretionary Fees
On some larger investment portfolios, financial advisors or brokers will promote the merits of a discretionary account. This annual fee is similar to an MER but it is negotiable depending on account size. This fee can also be potentially tax-deductible on non-RRSP accounts. The investment industry is a scalable industry which means the more money you have to invest, the more you can negotiate the fees. Discretionary fees typically range between 1% and 1.5%. The big thing to be careful of is to watch the fees on the investments in the account. If you hold a mutual fund inside a discretionary account, you will be paying 2 sets of fees. Especially watch for double-dipping where the broker is making money from the discretionary fee as well as the fees off the underlying investments inside the portfolio.
Self-Directed Fee
This fee only applies to RRSPs and is typically charged by the administrating financial institution. Self-Directed RRSPs allow investors to invest in a myriad of investments not restricted by the investments offered by one single company.
Trading Fees
Trading fees refer to the cost to buy and sell specific investments and/or securities within an investment account. Typically full service brokers will charge higher trading fees than discount brokers. If you are paying discretionary fees, you should not be paying trading costs. Watch how your trading fees affect smaller purchases. For example, paying a $50 fee to buy a $1000 worth of stock is really a 5% fee. It might be more economical to buy no-load mutual funds on smaller purchases.
There can be other fees like account closing fees, administrative fees, withdrawal fees, etc. Fees will differ from institution to institution so it is important that investors be aware! Know how much you are paying in fees. Never be afraid to ask what the fees are and how institutions and advisors get paid.
Comments
i would recommend to avoid any type of load fees front in or back end. most of the time you will have some sort of fee associated with the purchase and sale of the investment and to pay on top of that in my mind is silly.
It is as bad as the phone company with all their nickel and dime tactics. Sad thing is, I would be probably see more value and be willing to pay more if they would make it easier and more transparent.
I do think we can get too overfocused on fees instead of returns. I would be happy to pay 2% fees if I got a 12% return. That does make more sense than only paying .05% and getting a 8% return. There is something to be said for focusing on returns not just fees.
Craig,
I tend to look at it the other way… using your example, paying 2% is a handicap of 1.5% without any guarantee of getting a better return. Unfortunately high fees do not equal high returns.
Exactly Tom, especially over longer (15-25 years) terms. Over short periods, you can always find funds that dramatically outperform…or should I say, HAVE dramatically outperformed in the last 1, 3, 5, etc. years. Did you (or your adviser, know to put you in that particular fund 1, 3, 5, etc. years ago? If not, that superior performance means very little. If it luck…it won’t last. If it’s truly superior skill, the fund manager will be offered more money by another investment firm and you’d be hard pressed to know that they have left. These are the two main reasons why, over long periods of time, the pre-fee performance of all funds in a given category tend to revert to the mean average, and the only differentiator remaining is the MER.
…Bruce Thompson
Thanks for the comment:
Fees are an economic reality and cannot be completely avoided. In my travels too many people have no clue what they are paying in fees and that is scary because no one cares about your money more than you.
@Craig, I agree with your point. I’ve always said seek value which is your benefit less cost. The point I make is know your cost so you can relate it back to value.
Lastly, as in my article Mutual Fund Fees do Matter (http://tinyurl.com/24bns3p) fees do have an impact on returns which is why people need to be aware of fees.
@Jim
an even better study was just published recently http://advisor.morningstar.com/articles/article.asp?docId=20016
although I’m sure you are aware.
I’d also though that for some types of investments it may be worth accepting a high fees if you’ve done your research and those are justified. It’s just way too often people don’t spend even 10 minutes looking at a mutual fund, making their judgment based on assumptions and how popular the fund is. A bit of a vicious cycle.
I like the idea of a back end load for both parties. Investing really is a long term activity and thinking too short term usually leads to problems for the typical investor. Though something does bother me when banks and investment firms rake in billions in profits and then charge their customers who really need the money.
@Craig Ford The problems with paying fees upfront is that there is no return guarantees. While anyone would be happy to pay 2% to get 12%, you don’t know what you will be getting. I think a sliding performance based payment would be a happy medium. May be you pay 10% of your earning and nothing if you loose money?
I don’t mind paying a broker fee or advisement fee as long as the investment pays a handsome dividend. If I’m working with a broker that produces 10%-12% returns, I’m more than happy to pay the fee on the front or backside of the transaction. I do like the idea of a sliding scale. Perhaps pay a small fee upfront and if the investment pays, pay a fee on the back end.
@Seth I agree with your assessment. If both parties are in it for the long term investment fees are less and both parties win at the end.
@Lawleaf I think anyone would be happy with a broker providing dividends in the 10-12% range.
Speaking of investment management fees, there has been much buzz lately about the so-called “robo-adviser” services that have been launched in Canada. (I’m pretty sure that term was coined by the full-service brokerage industry in the U.S., in an attempt to paint a picture of faceless machines using claws to move people money between asset classes, with zero regard to human existence!)
I recently analysed a portfolio that is invested in a well-known “professionally managed money program” offered by a Canadian investment firm.
My clients were told that they were paying 1.35% management fee (plus tax) “plus a little for MERs on the mutual funds and ETFs” Strictly speaking, this is not incorrect,…BUT…I did the math:
2.06% combined weighted average across all of their accounts!!!
which, in their case = $30,000 per year as it’s $1.5 Million!!!
AND they are looking elsewhere for retirement etc. planning???
ARE YOU KIDDING ME???!!!
It’s all good though: “Blessed are the greedy, as they provide the motivation for revolutionary change in the investment industry.” …Bruce Q. Thompson…just now.