It’s time to bring out the heavy artillery (by which I mean pictures) to explain the effects of the Management Expense Ratio (MER) charged by mutual funds. Fees charged to manage your money are a good example of a death by a thousand cuts. They are barely noticeable over short periods, but are devastating over long periods.
For the charts we’ll use a MER of 2% per year. This figure is on the low side for actively-managed funds in Canada, and on the high side for funds in the US. I collected some data from 1950 to the present on the S&P 500 index, the 500 biggest businesses in the US. Any other index, including Canadian stocks, would have worked equally well and would give similar results.
Our hypothetical investor, Harry, has $100,000 in a tax-sheltered account. He puts it all in stock funds that we’ll assume perform as well as the S&P 500 (including reinvested dividends) less the 2% MER each year. All returns in the examples below will be real returns, meaning that we account for inflation.
Harry likes to check his returns each day; so let’s see what a typical day looks like. The S&P 500 data from 1950 to the present show that 90% of the time, daily returns are between $1400 down and $1408 up. Let’s call these a bad day and a good day. The 2% MER on $100,000 is $2000 per year, which works out to a little less than $8 per trading day. The following chart sums this up:
The MER in red is barely noticeable. Why should Harry care about eight bucks when his portfolio is swinging up and down by hundreds or thousands of dollars each day? It turns out that the daily ups and downs partially cancel out, but the daily MER costs all point in the same direction: down.
Suppose that Harry takes a month-long vacation without checking on his portfolio. What kind of change can he expect when he gets back? To answer this, I found all the one-month returns of the S&P 500 since 1950 including reinvested dividends and removing inflation. Finding the return values that bracket 90% of the cases gives us a “good month” and a “bad month” for the following chart:
The MER is still quite small compared to the possible swings in return over a month. However, the MER is growing. Now let’s see how the MER compares to the possible returns over a year:
Over a year, the MER is noticeable, even on a bad year. This is like watching the height of Harry’s daughter Hanna. Her growth isn’t noticeable to people who see her every day or month, but her grandparents who only see her once a year sure notice the difference.
Let’s see what happens over 25 years:
Now the MER really begins to dominate, consuming 44% of the returns in the good scenario and 73% of the returns in the bad scenario. This should make it clear how much damage a “little” 2% MER can do.