Know your investment fees before they start to pile up

A mutual fund has a portfolio manager who actively manages the investments.   The manager is making decisions with respect to the fund and is being paid to do so.  The prospectus outlines what restrictions (if any) the manager has with respect to the types of investments the fund may invest in.  Within this same document you will be able to see the types of expenses associated with operating the fund, commonly referred to as the Management Expense Ratio  or MER.

Most investors would be more than happy to pay fees provided there was value in the form of performance.  In the absence of this value, Exchange Traded Funds (ETFs) were created providing a lower cost option with a passive strategy.    People may purchase ETFs to obtain broad coverage to an entire Index (Canada, US, International) or Sector.  No manager is choosing to remove some positions and overweight others.  ETFs are often associated with low fees as there is no portfolio manager making active decisions.

There has been so much debate between mutual funds and ETFs.  Financial commentary often overlooks another alternative – purchasing direct holdings within a fee based account.  Before we go much further, mutual funds or ETFs may be the best option for investors with less than $150,000 who seek adequate diversification.  In our opinion though, if an investor has $250,000 or more they should explore the option of opening a fee-based account and holding direct investments.

Recently we wrote an article about fee based accounts for an investor with $500,000 in mutual funds paying a Management Expense Ratio (MER) of 2.30 per cent.  This may not seem like much when quoted in percentage terms but when we translate this into a dollar amount, the annual cost is $11,500.  With the HST now in effect the MER on mutual funds has increased a further 7 per cent (previously only subject to the 5 per cent GST).  The fund above that had an embedded MER of 2.30 per cent is now 2.45 per cent (or $12,250) with the HST.  This represents an annual increase of $750.

We compare this to the fee based account option at 1.0 per cent.  Before the HST, the fees for a $500,000 account were $5,000 plus $250 GST, equalling $5,250.  This represented a savings of $6,250 a year.   The savings are even greater if the fee-based account is non-registered and you are able to deduct the investment council fees.  With the HST the fees are now $5,000 plus $600 HST equalling $5,600.  This represents an increase of $350 (considerably better than the increase of $750 above).  The key point to take away from the above is that the lower your fees are, the less of an impact the new HST will have on your portfolio’s overall return.

Let’s spend a moment to compare ETFs with direct holdings in a fee-based account.  In our opinion there is nothing wrong with a combination of both of these two types of investment options.  ETFs are useful to obtain coverage to areas where you may not have direct holdings.  Two examples may be to obtain broad exposure to a geographical area or to focus on a specific sector ETF.

ETFs can typically be purchased within a fee-based account with no transactional costs.  The low annual costs associated with ETFs are very complimentary within a low annual fee type account.

The following represents some key points to consider:

  • Investors wishing to have geographic coverage in higher growth areas such as China, Brazil, and India may find an ETF a good option.   It is more difficult to purchase individual equities in these geographical areas.
  • It is possible to set limit and stop-loss orders on ETFs and individual stocks.   It is not possible to set these types of orders on mutual funds.
  • Both ETFs and mutual funds provide investors with the ability to increase or decrease market exposure quickly.
  • Investors with a large cash component can plan to ease into the market by purchasing equity investments over time – this is often referred to as dollar cost averaging.  Both mutual funds and ETFs work well for dollar cost averaging.

Many of the newer ETFs are deviating away from their traditionally “passive” index approach by adopting a more active style.  We caution most investors to stick to the plain-vanilla ETFs.  Some of the structured ETFs have very complicated features and fees that are higher than the vanilla style ETFs.  Some structured ETFs utilized leverage and derivative products not suitable for most investors.