Do you know what you’re paying for your investments?
When choosing an investment option, it is important to know how much it will cost you. Unfortunately, some investment options have fee structures that make revealing their costs challenging for the average investor.
To add to the confusion, some investment options that seem similar in what they provide can actually cost you a great deal more over the long run.
Here is a summary of the most common fees charged to investors:
1) Mutual fund fees
2) Mutual fund commissions
3) Trading commissions
4) Investment Management fees.
Mutual fund fees:
Management Expense Ratios (MERs)
Mutual funds are one of the most common investment vehicles available to the everyday investor. The cost of mutual funds are expressed as a Management Expense Ratio (MER) and are collected “off the top” of investment returns. This means that if the MER charged to you is 2.75%, and your investment returns (before fees) is 10%, you would realize an after fee return of 7.25%.
Although this fee may seem reasonable, the benefits of lowering your expense ratio can be tremendous, as we will see below.
Time and the Power of Compounding
Few investing concepts are as important as compounding. Compounding reveals that with time, what may initially appear to be a small percentage cost can grow rapidly. The following chart demonstrates the magnitude of a 2.75% MER on $10,000 invested over 20 years.
In a world without fees, the $10,000 investment would grow to $67,275 in 20 years. However, by including the mutual fund fees, the $10,000 investment would only grow to $40,546.
This means that your cost is $26,729 over the investment period. In other words, by paying what appears to be 2.75% fee, you actually end up with almost 40% less at the end of 20 years.
Mutual Fund Commissions
Mutual fund commissions are at times charged along with MERs and come in the following forms:
Front-End Loads (FE) are commissions charged when the fund is first purchased, and typically range from 1% to 5%. In the case of a 5% FE, if you invested $10,000, only $9500 would actually be invested since the remaining $500 would pay the FE commission.
Back-End Loads (BE) are charged when a fund is redeemed, and like FE commissions, generally range from 1% to 5% of the redeemed total.
Deferred-Sales Charges (DSC) are a type of Back- End commission, but with a declining fee schedule. The DSC penalizes you if you sell your investment early, but less so in later years.
The typical rationale Advisors use to justify Back-End loads or DSC charges is that this penalty enforces discipline: it keeps you invested during downturns. We disagree:
“We believe that it is the manager’s responsibility to ensure that it is the investment thesis, not the avoidance of a penalty, that should keep you invested during minor market corrections”.
Trading commissions are paid by investors who use brokers to buy or sell stocks or bonds. Generally, trading commissions are highest with bank-owned brokerages and relatively lower with Independent brokerages or dealers.
Despite seeming relatively expensive, high trading commissions can be fair in times where investments are bought and held over “extended” periods, which we generally consider to be periods greater than one year.
Unfortunately, the revenue from trading commissions provides an incentive for brokers to trade more actively than what might be considered prudent. Thus brokers may be more motivated to sell securities that might otherwise be held long-term.
Investment Management Fees
Investment Management fees are typically paid to Portfolio Managers and are charged as a percentage of the total portfolio value per year.
There are key advantages and disadvantages of investment management fees.
- They are easy to understand and are transparent – you see it on your statement.
- Investment management fees are tax deductible outside of tax-sheltered plans such as an RRSP, RRIF or LIRA.
- This form of fee structure directly incentivizes your manager to grow or preserve your assets.
- Unlike mutual fund fees, investment management fees often proportionally decrease when your investment portfolio grows over certain thresholds.
Fees can be relatively expensive for cash and fixed income investments. Ask how we can address this disadvantage.
Why we use Management Fees
We choose this structure because it aligns us with our clients – our compensation only rises when our clients’ wealth does. Likewise, our compensation will decrease if your wealth decreases.
An additional benefit of this structure comes from our ability to provide favorable rates when managing accounts for multiple family members. We provide this by aggregating the size of your family’s accounts, thus putting you and your family in the lowest fee category.
This report has been prepared by Pacifica Partners Inc. and is intended solely for general educational purposes. This report is not intended to replace consulting by a qualified financial advisor and it is strongly advised to consult a financial advisor as to the personal suitability of the presented information. All information contained in this report is based on facts from sources that we believe to be reasonable as of the date of the report. However, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions reported in this report are also subject to change without notice. No consideration has been made by Pacifica Partners Inc. regarding the specific investment objectives, financial situation, and circumstances of any person who may receive this report.