How much do management expenses matter?

Management expenses take a chunk out of your mutual funds’ asset values—year after year. But the real question should be whether what you get after costs is worthwhile.

When buying a fund, make sure you understand all the fees you will pay, including any deferred sales commissions.

When you’re considering funds for investment, how much emphasis should you place on the fees?

Much has been said and written about mutual-fund expenses. Mutual funds publish an expense schedule in the prospectus and management expense ratios, or MERs, show up in most online sources featuring mutual funds.

The MER shows all expenses as a percentage of the fund’s net asset value, excluding trading expenses. Management expenses include the fund manager’s fee plus other, outside expenses incurred by the manager on behalf of the fund. These include legal and accounting services. The manger’s fee includes the cost of managing the portfolio plus other aspects of the fund such as keeping track of investor accounts, legal matters, details of distributions and income-tax implications; and yes, advertising, promotion and sales motivation.

Most funds publish the change in asset value after deducting all fees and expenses. So what you see, in most cases, is the net return to investors.

Consider suitability first

When you choose funds, your first consideration should be your investment personality and your goals and needs. That means consider funds that match your tolerance for risk and time horizon. And consider funds that add real diversification to your overall portfolio. In short, choose suitable funds.

But if you’re comparing, say, a few large-cap Canadian stock funds for your portfolio, should MERs weigh on your decision? Yes, but only as a tie-breaker.

Within a category of suitability, the final difference between funds will be performance, plain and simple. In retrospect, the fund that provides the highest return after expenses and with the appropriate level of risk will have been the right choice. Problem is, of course, that in retrospect, it’s too late to make the choice. You have to choose in the beginning.

You can look at past performance in comparison to a similar fund—an indicator of management capability. But as the ads always say, it’s no guarantee of future performance. It is, however, an indicator.

But an expense ratio is more than an indicator. It’s a guarantee that investment performance will be reduced by a greater or lesser amount.

When you look at past performance, you’re already looking at expenses—even if indirectly. After all, you’re looking at the manager’s capability to cover expenses. And a manager with a consistently superior performance has produced superior results after expenses, whatever they may be.

But a low-fee fund has a head start that gives it a predetermined advantage.

A fund that outperforms its peers more often than not does so after expenses. So always choose a fund that seems to have superior management. But if the differences are slight, a low fee could tip the balance.

Watch those deferred sales commissions—DSCs

Some of the common fees that mutual fund investors may pay when buying or selling units of a fund include front-end sales charges (when you buy) and back-end sales charges (when you sell). The latter are commonly referred to as deferred sales commissions, or DSCs.

When you buy a fund on a DSC basis, you may, or may not, have to pay the deferred load when you sell your fund units back to the fund. Fees typically range from, say, 6.0 per cent in the first year to zero after the sixth. Exact figures will vary from company to company and from fund to fund.

But look carefully at the prospectus, or ask your sales agent, jut what that 6.0 per cent is based on.

Some investors feel cheated when they decide to sell and find out that it’s a percentage of market value at the time of redemption—not of the original cost. That can make a substantial difference to your outcome.

The advantage of a DSC if you’re a small investor, of course, is you don’t have to pay an upfront fee to achieve the benefits of professional management. But the downside is you have to pay hefty fees if you want to sell sooner than the six years. The controversial nature of these fees has led every province in Canada to ban them with the exception of Ontario, which is nonetheless considering some rule changes.

This is an edited version of an article that was originally published for subscribers in the October 16, 2020, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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