Are you invested in Mutual funds? Congratulations, you’ll now be working an additional 3 years.

by Avrex on November 15, 2012

[November is “Financial Literacy month”. Bloggers are participating in the “Blog for Financial Literacy” campaign by sharing their ‘best financial tip’ with their readers.]

Many investors don’t realize it, but the high Management Expense Ratios (MER) of Mutual Funds are slowly eroding their personal life savings.

Let’s compare the characteristics of the two main investment vehicles that most investors utilize. Exchange-traded Funds (ETF) versus Mutual Funds.

Exchange-traded Funds (ETF) Mutual Funds
MER fees low cost high cost
Investing style passive index based active stock selection
Assets under Management* $49 billion $773 billion (94%)

* according to the Canadian ETF Association

1. ETFs are low-cost. Mutual Funds are high-cost.

Of course there are exceptions to this. For example, we are now seeing specialized ETFs. These niche ETFs with their higher associated costs are really not suitable for most investors. Investors should stick with core ETF holdings. In the mutual fund world, there are some low-fee exceptions. I’m thinking here of TD Waterhouse’s excellent TD e-Series Funds. These low cost index funds are great for investors, with smaller portfolios, who are just starting out.

But, those are the exceptions. In general, mutual fund fees are too high.
In fact, a Morningstar report shows the following average costs for Mutual Funds.

  Canadian Equity 2.3% MER
  Canadian Fixed Income 1.3% MER

2. Investment style

Typically, mutual funds are run by a management team that makes active stock selections, in an attempt to beat the returns of an index. Several studies have shown that over the long-term, active management returns will not beat the returns of the benchmark index. The MERs are a constant drag on the manager’s performance.

As an investor, you would be considered lucky if you selected an equity fund manager who consistently exceeded the index by 2.3% (the MER fee) year after year. These studies conclude that investors would be better off investing in funds that track the index itself and save on the high cost of MER fees.

3. Assets Under Management

Wow, only 6% of these assets are invested in ETFs. The rest are in mutual funds.
Although sales in ETFs are accelerating, as more investors are learning about their benefits, the move to ETFs is not happening quick enough.

Why do the other 94% of investors continue to pay the high MER fees of mutual funds?

I see two reasons for this.

1. Hidden MER fees.

Are the 94% of investors that hold mutual funds just dumb? No.
The MER fees of mutual funds have always been somewhat hidden from the client.
For example, an investor looks at the year-end results of his equity mutual fund and sees that it went up 6.6% for the year. “That’s pretty good”, he thinks.

What he doesn’t realize is that the underlying securities that the fund is invested in, actually went up 8.9%. The remaining 2.3% was gobbled up by MER costs. Many investors simply are not aware of this hidden cost.

The Mutual Fund industry has no incentive to share this cost with you. The 2.3% MER is how they generate their profit. Your financial advisor, who sells you the mutual fund, has no incentive to share this cost with you. He may receive a front or deferred sales commission. He may also receive a 0.5% – 1.0% trailer fee for each year that you continue to hold the fund.

2. Fear. I’ll let the Experts handle it.

Even when investors are fully aware of the MER costs involved, there is another factor that is holding them back. Fear. For example, I’ve heard the following comment, “I know nothing about investing, so I’ll let the bank handle all of my investments. After all, they are the experts and they know what to do.”
There is an inherent cost in thinking like this.

There are MER fee calculators, like this one at GetSmarterAboutMoney.ca. The calculator illustrates how much of your total nest egg is lost to investment fees.


How much am I saving?
Yes, we want to be aware and quantify the amount of money that we can save.
But, I wanted to look at this from a different perspective. Time.
In other words, the money that we do save, brings us closer, in time, to the goal of financial independence.

In the next post (coming soon), you’ll see the calculation that looks at a sample case study, of an average Canadian couple, that is invested in mutual funds. Over their working lives, the couple paid off their mortgage and were excellent savers. In this scenario, they invested their savings in mutual funds and retired comfortably at the age of 64.

However, what if the couple had invested their savings in low-fee ETFs, instead of mutual funds. What would happen in this scenario?

The calculation shows that with ETFs, they would have gained 27% more money in their retirement nest egg.. That’s a lot of additional savings! Those types of savings go directly into your pocket and not towards your bank or mutual fund company.

How does this amount of savings relate to Time?

If the couple is saving 27% more money over the course of their working lives, then the calculation goes on to show that this couple could have retired at age 61, … 3 years sooner.

That’s right. These savings can literally take years off of your working lives.

Conclusion:

My Best Financial Tip.
If you want to save more money and retire sooner, avoid high MER fees.

Take action. Become a do-it-yourself (DIY) investor.
Do not let fear hold you back. It’s not that difficult. It’s not that time consuming.
Get rid of your high-cost mutual funds.
Set up a basic ETF portfolio, like the Easy ETF portfolio, or a Couch Potato portfolio.

Remember the benefit.
You’ll be able to retire much sooner!