Monday, May 12, 2008

MER: the Gift that Keeps on Giving

Mutual fund fees are very different from many of the other types of fees that we encounter in our financial lives. It’s important to understand the difference.

Mutual funds charge investors yearly fees that are disclosed to the public as a percentage called the Management Expense Ratio (MER). To see the difference between MERs and, say, real estate fees, imagine the following exchange after the doorbell gets you out of bed on a Saturday morning:

Agent: “I’m here to collect my $30,000.”
You: “What!?”
Agent: “My $30,000. The fee for selling your old house.”
You: “But, that was last year. I already paid you.”
Agent: “Right, but we’re into a new year. Your old house is worth $600,000. At 5%, that’s $30,000 this year. My fees are yearly. How do you intend to pay?”

Of course, real estate fees don’t work this way, but MERs do because they are charged every year. In the case of income taxes, you only pay tax on new money you earn during the year. Your savings aren’t taxed. But MERs get charged on the same money year after year taking bite after bite out of the same pot of money.

MER percentages seem harmlessly small, but they add up. For example, if the MER is 2.5% per year, this leaves 97.5% of your money in your account after the first year. In the second year, the MER is 2.5% of your remaining money. Now you’re left with about 95.1% of your money.

The following chart illustrates how much of your money gets consumed by the MER over the years. We assume a starting value of $100,000 and that the investments held by the fund return 4% per year above inflation, which leaves about 1.5% after the MER is charged.

After 25 years, the MER has consumed 47% of your money. This shows why it is important to pay attention to the MER when investing in mutual funds. There are index funds that charge less than 0.5% per year. These funds tend to outperform high-MER funds mainly because of the lower fees.

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