Monday, April 9, 2012

Investing is Like Driving on a Punctured Tire

All investment portfolios have leaks. As you drive that metaphorical portfolio, money leaks like air from a punctured tire. You lose money to trading commissions, trading spreads, ETF and mutual fund MERs, income taxes, lack of diversification, and other costs. We can’t eliminate these costs entirely, but we can shrink the size of the hole.

One way to control costs is to trade infrequently. This reduces trading costs and triggers less capital gains tax. For those who embrace the benefits of diversification, Management Expense Ratios (MERs) on exchange-traded funds (ETFs) and mutual funds are a concern. Seemingly low MERs like 2% are actually applied every year, and they add up to big money over many years. To make this clearer, a while back I coined a new 25-year measure called the Management Expense Ratio per Quarter century (MERQ).

To illustrate what the MERQ means, let’s compare the largest Canadian equity fund in Canada to one of the least expensive Canadian equity index ETFs. The RBC Canadian Equity fund controls investor assets of $5.2 billion and charges an MER of 2.05%. This works out to $107 million per year! In contrast, Vanguard’s Canadian Index ETF (VCE) charges an MER of only 0.09% per year.

The corresponding MERQ values work out as follows:

RBC Canadian Equity fund: MERQ 40.1%
Vanguard Canadian Equity Index ETF (VCE): MERQ 2.2%

Suppose that a lump sum investment would have grown to a million dollars in 25 years if the MER charged were zero. After we factor in the MER for these two possible investments, here are their final portfolio values:

RBC Canadian Equity fund: $599,000
Vanguard Canadian Equity Index ETF (VCE): $978,000

It’s hard to believe that a little 2% difference each year could do so much damage, but it does. I’d like to see mutual funds and ETFs start reporting 25-year MERQ figures instead of yearly MERs to make the costs easier for investors to understand. Failing that, reporters who have no interest in hiding these costs from investors can adopt the MERQ as a better measure.


  1. Or you could stop and pump that tire back up every once in a while?

  2. @Big Cajun Man: In this analogy, pumping up the tire means putting more money in your account. I'd rather my investments working for me than have me working for them.

  3. Michael,

    Any idea why the VCE dividend is so low? Vanguard is saying 39 cents per year which is a 1.6% yield. Seems too low; puts the TSX Composite Index dividend yield at 2.94% (April 18).



  4. Anyone know why the VCE dividend is so low - about 1.6%. Current Tsx composite yield is closer to 3%.

  5. @Larry: VCE follows the MSCI Canada index ( which comprises 680 companies and has a dividend yield of 2.2%. The TSX only has 253 constituents. I'm not sure why the gap between VCE's dividend and the MSCI Canada index dividend is so high (0.6%).