Thursday, November 26, 2020

Management Expense Ratio per Quarter Century (MERQ)

Savvy investors know they pay fees to invest in mutual funds and Exchange-Traded Funds (ETFs).  Most of these costs are captured by the Management Expense Ratio (MER).  MERs are calculated by taking the fees charged in a year and dividing by the total fund assets.  By focusing on annual fees, the MER percentage is misleadingly low.  What really matters is how much of your money goes to fees over a lifetime of investing.

For someone who begins investing at age 30 and lives to 85, the total investing period is 55 years.  However, the savings level is low initially and may be low late in life.  When it comes to the cumulative effect of fees over a lifetime, what matters is how long the average saved dollar is in your portfolio from the day you save it until the day you spend that dollar and all the returns it has produced.  For a nice round figure, I use 25 years as the average holding period for saved retirement dollars.

This gives rise to the Management Expense Ratio per Quarter century (MERQ).  This is the percentage of your portfolio consumed by fees over 25 years.  It’s truly shocking how seemingly small MERs accumulate.  A 2% MER corresponds to a 39% MERQ!  This means that over your investing lifetime, a 2% MER reduces the total amount you get to spend from your savings in retirement by 39%.

If this seems impossible, try starting with $10,000 and taking 2% away 25 times.  This gives $9800, $9604, $9411.92, …, $6034.65.  Because of a technicality in the way MERs are calculated, the actual final value is $6065, for a loss of 39%.

Some people mistakenly believe that an MER only applies to returns their funds’ earn, but this isn’t true.  The MER is charged against all of your savings every year.  That’s why the drag on your savings keeps accumulating year after year.

Whenever you see an MER, I recommend translating it into its corresponding MERQ using the table below to better see how it affects your retirement spending.

MER   MERQ         
MER   MERQ         
MER   MERQ
0.1%   2.5%
1.1%   24%
2.1%   41%
0.2%   4.9%
1.2%   26%
2.2%   42%
0.3%   7.2%
1.3%   28%
2.3%   44%
0.4%   9.5%
1.4%   30%
2.4%   45%
0.5%   12%
1.5%   31%
2.5%   46%
0.6%   14%
1.6%   33%
2.6%   48%
0.7%   16%
1.7%   35%
2.7%   49%
0.8%   18%
1.8%   36%
2.8%   50%
0.9%   20%
1.9%   38%
2.9%   52%
1.0%   22%
2.0%   39%
3.0%   53%

For the mathematically inclined, the formula is
MERQ = 1 – e^(–25*MER).

It seems shocking that a 3% MER could consume more than half your savings, but it’s true.  This is why it’s so important to pay attention to fees when investing.

As bad as the MER can be, it doesn’t capture all costs.  There are also trading costs within the mutual fund or ETF.  Confusingly, TER usually refers to the Trading Expense Ratio in Canada, and Total Expense Ratio in the U.S.  If you can get the TER for your Canadian mutual fund or ETF, you can add it to the MER before looking it up in the table above.

There are still more costs:
  • front and back end loads on some mutual funds
  • early redemption fees on some mutual funds
  • trading commissions and bid-ask spreads when trading ETFs
  • currency exchange costs when trading U.S. ETFs
  • unrecoverable foreign withholding taxes on foreign stock dividends
  • income taxes


No doubt there are other costs as well.

Many Canadians are getting a poor deal on either financial advice costs, fund management costs, or both.  Most financial advisors offer little to their clients to justify their fees.  Many of the largest mutual funds are “closet indexers” whose management fees are unreasonably high for what is essentially an index fund.  Fortunately, there are good financial advisors and good mutual funds, but it takes some knowledge to be able to find them.  For those who can manage their own portfolios, there are many great low-fee ETFs.

Don’t let anyone try to tell you not to worry about costs.  Be aware of the effects of seemingly low annual fees on your portfolio over your lifetime by focusing on the MERQ instead of the MER.

8 comments:

  1. Excellent article. I will be sharing it with my son (38) to help me explain to him the long term impact on his savings at 1.8% MER versus available options.

    ReplyDelete
    Replies
    1. Hi Curt,

      I'm glad this article is useful to you and your family.

      Delete
  2. Hi Michael, I've ready some of your previous posts on MERQ as well. Of all of the useful and interesting concepts you've presented, the MERQ has to be one of the most important and accessible concepts IMO. It's relatively easy to understand and should really open people's eyes to how much they are paying. Numbers like 1% or 2% per year just don't sound like much to most people.

    If there could be a single change that I think would really help shape the industry for the better, it would be to require disclosure of MER fees in this sort of context. Unfortunately, the industry has too much power IMO and would never allow that to happen.

    ReplyDelete
    Replies
    1. Hi Returns Reaper,

      Glad you like it. I agree that the industry would fight this kind of disclosure, but the rest of us can translate MERs into MERQs for friends and family.

      Delete
  3. Very good post. More than the % I use the actual $ to scare myself. Even a modest portfolio of $100,000 at 2% you are looking at $2,000 every year. It is more than what most people will pay for drugs or utilities.

    ReplyDelete
    Replies
    1. Anonymous,

      Dollar figures work well too, when people see them. I'm all for making as many tools as possible available for explaining the high cost of mutual funds in Canada.

      Delete
  4. I remember presenting a version of this about 10 years ago (I think it was Preet's version) to our Accountant and MD at work as part of my strategy to get the company I work for to review our Company DC Pension fund fee's. Most of our funds were 1.5 and up, to one fund being 2.8%. Today our highest Pension fund fee is 0.7%. Most just around 50 basis points. Needless to say the former broker of record, was not too pleased with me presenting this information, and subsequently losing an account of about 75 members. I would suggest anyone in this situation (high fees) should attempt to negotiate for lower ones. Or make changes if they are individuals themselves.

    ReplyDelete
    Replies
    1. Hi Paul,

      It's good you had success getting the message across. I tried something similar at my former employer (a somewhat larger company than yours), but all I got back was blank stares from those who set up the new "pension" system. I had better luck explaining it to other employees who understood the need to take advantage of the free once-per-year transfer to a personal RRSP.

      Delete