Thursday, March 17, 2011

A Message for Mutual Fund Investors Who Pay No Fees

Based on an informal poll over the years of family and friends who invest in mutual funds, about half believe they don’t pay any fees to buy and own mutual funds. I have a message for them: you’re mistaken. There is no such thing as mutual funds without fees. The fees you pay have been hidden from you.

There are rules about disclosing mutual fund fees, but financial advisors can follow the letter of the law without their clients actually understanding what fees they pay. The fees are explained in a document called a prospectus that is supposed to be given to clients, but even a simplified prospectus is long enough and complex enough that few clients read it.

All mutual funds have expenses. Most of the ongoing expenses to run a fund are components of the Management Expense Ratio (MER). This is expressed as a percentage, such as 2%. This means that 2% of your money comes out of the fund every year to pay costs including salaries of the fund managers, payments to your financial advisor, and other costs.

A cost of 2% each year may not seem like much, but another 2% of the same money will be taken out again next year and the year after that. The math says that it will take about 35 years for half of your money to disappear.

You’d think that your mutual fund statements would have a line showing the amount of the MER being deducted from your money, but this is usually not the case. The money evaporates silently in most cases.

Another category of fees are loads. Depending on the type of mutual fund, you may pay some type of load:

Front-end load: This is where a percentage of your money is removed before the money goes into the mutual fund.

Back-end load (Also called a deferred sales charge (DSC)): This is where a percentage of your money is deducted before you get your withdrawal from a fund. This type of load is popular among advisors and many of their clients don’t understand how it works until it comes time to make a withdrawal.

There are some good financial advisors out there who properly explain these fees to their clients. It’s unrealistic to expect people to work for you for nothing. But you should understand what you are paying. If you own mutual funds and thought there were no fees, maybe your advisor isn’t the great person you thought he or she was. You thought the two of you were a professional and a client, but maybe you’re a salesperson and a mark.

14 comments:

  1. @Mark: I'm actually hoping to reach a few people who have never heard this message before. I worry about people who hear something about mutual fund costs and think "I don't have to worry about that because I don't pay any fees for my funds."

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  2. I remember talking to my brother-in-law a few years ago about his mortgage rates, and he said "oh well, what's 1% over 30 years?". It was as though the 1% were spread over 30 years or something. I didn't have a snappy response at the time, but now I'd say that 1% times 30 years amounts to (very roughly) 30% of your house's value.

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  3. @Patrick: That's a good example of why it's so easy to mislead people with math. Sales tax of 13% only adds a buck or two to the cost of a package of batteries, so why should we worry about only 1% on a mortgage interest rate? People make crazy comparisons between things that sound similar. The 1% difference over 30 years will cost less than 30% of the house value because of the mortgage's declining balance, but the cost is likely to be close to 20%. The answer to "what's 1% over 30 years" is "a couple of cars."

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  4. "A couple of cars" is a great way to illustrate the point Michael. I also find this tool from Vanguard helpful: https://personal.vanguard.com/us/insights/investingtruths/investing-truth-about-cost

    In over 8 years of personal experience working with investors if somebody thinks they are paying "no fees", we usually find out they are actually paying egregious fees.

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  5. @Chris: That's a good tool at the Vanguard site. We need a version with Canadian level of expense ratios. My limited experience with people who think they pay no fess is consistent with your observation that they are really paying very high fees.

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  6. Very good point, Michael - I'm sure this opinion (free investments) is very common.

    Maybe one of the investment companies should sponsor a "survey" to find out the exact numbers for this problem? ;)

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  7. @Mike: It would be easy to change the survey question slightly to serve the industry. Instead of "do you pay fees" to reveal ignorance, ask "are your fees too high". Those who think they pay no fees will say no and the industry could use the results as "evidence" that there is no problem.

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  8. I have always thought that some smarter fund providing company would make a "performance based" group of funds. I would not mind paying a variable fee based on the funds performance. If it returnd you 15% over one year they can have 3% from me that period. But if it fares poorly the next, the fund MER should go down to a minimum of for example 0.3% (like an ETF) in the lean years. So it gives the fund managers incentive to perform, they should get a bonus out of the 3% years....

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  9. @Paul: You have to be careful about incentive structures. With the incentive plan you mention, the fund manager has an incentive to take wild chances.

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  10. Incentives like that, particularly in an actively managed fund, would require frequent trading. Transaction fees can significantly impact returns--in the industry it's called the transaction expense ratio, explained nicely here https://secure.globeadvisor.com/servlet/ArticleNews/story/gam/20070414/STMAIN14

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  11. @Anonymous: Yes, the transaction expense ratio isn't included in the MER. It's sometimes abbreviated TER which nicely conflicts with the use of TER for total expense ratio. All this is wonderfully confusing for those who make their money from investor ignorance.

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  12. Since the very first client I have sat down with a pen and paper and described "how I get paid" with real numbers. Never a fan of the DSC, I used Low-load or FE. Now I offer an "assets under management' option starting at 0.75% using F Class so clients can save money on fees.

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  13. @Anonymous: You take a very honest approach. I respect that.

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