Management expense ratio (MER) — whose bottom line is it?

A great deal has been said over the years regarding investment management fees and mutual funds. Much of it revolves around how fund managers motivate and reward sales efforts. Until a fool-proof system of legislating trust can be devised, however, you’ll have to practise buyer beware. It’s up to you to ferret out how much of the MER is for investment management and how much is for other mutual fund expenses indirectly borne by investors.

How well is your fund, or one you’re considering, managed? It’s more than just a matter of past investment returns. We think the administrative efficiency of a fund’s management, as expressed by its expenses, is another important factor. You can also infer something about a fund’s sales force from its expenses.

There’s a saying that goes, “if you don’t know your product, you’d better know your salesperson”. Unfortunately, when it comes to financial services such as mutual funds, there will always be a lot of truth to that statement.

Canadian securities regulators are currently engaged in research that many investors hope will lead to a crackdown on trailing commissions in the mutual fund industry. These are fees used to motivate and reward mutual-fund salespeople. But we think it will be a long time before governments can legislate trust. In the meantime, what do you need to know?

When you consider mutual fund investments, you’ll find a summary of charges in every fund’s prospectus. This chart-like summary comes in three parts — a summary of the mutual fund expenses, a summary of investor expenses and a summary of dealer compensation, if any.

Management expense ratio (MER)

A mutual fund typically pays a fixed annual fee, as a percentage of the assets in the fund, to its fund management company. The fund may incur further administrative expenses such as bookkeeping and legal costs that result in a total management expense to the fund. That expense, expressed as a percentage of the assets in the fund, is the fund’s “management expense ratio”, or the fund’s expenses. We show the management expense ratio, or MER, of each of our Top-40 funds in our monthly Planning Guide.

A typical management expense ratio might be 2.3 per cent, with the investment management fee being a fixed 2.0 per cent per year, and the remaining 0.3 per cent being other variable, or operating, expenses. You should keep two things in mind when you look at a fund’s MER.

First of all, when a fund calculates its compound annual growth rate, which it does each month, it first removes the expenses. That suggests that a fund with a relatively high expense ratio might be forgiven if it also shows consistently high returns. But not necessarily.

The controversial trailer fee

The second consideration is much more subjective. The investment management fee can be used to pay a wide assortment of expenses, such as various forms of sales motivation and compensation, even among so-called “no-load” funds. The most common such expense is the controversial “trailer fee”, paid by most mutual funds to dealers that sell their funds. These fees, usually a fixed annual percentage of the assets in the fund held by the dealer’s client, can be substantial. Simply put, when you buy a mutual fund through a fund dealer, the fund manager pays the dealer a percentage of your holdings each year, as long as you hold the fund.

Many investor advocates feel these fees create at least the potential for serious conflicts of interest between mutual-fund sales advisers and their clients.

As an example, if your fund charges an annual investment management fee of 2.0 per cent, and pays a trailer fee of 0.5 per cent, it’s actually experiencing administrative expenses of 1.5 per cent and paying a sales incentive fee of 0.5 per cent out of its administrative levy. Is that misleading? Perhaps.

All we can do now, however, is repeat that we feel legislating trust will prove difficult. If you’re looking at a fund that seems to have a high management expense ratio compared with similar funds, it’s quite likely there’s a generous portion of that fee reserved for sales efforts. What’s more, in times of poor markets, funds with relatively high fees are likely to experience performance pressures. In times of strong markets, investors seem much less concerned with these relatively small charges. But over the years they can make the difference between a superior and an inferior fund.

We can’t judge a fund on the size of its fee alone. But it’s one of the factors we try to include when assessing a fund’s performance prospects.

The second summary of expenses in a prospectus, the investor expense, is straight forward. You may be required to pay a frond-end sales commission, a deferred or redemption fee, and expenses relating to switching between funds of a family. Other investor-paid fees may include RRSP, RRIF and TFSA administrative charges and account setup fees.

Dealer compensation explains things

Finally, the summary of dealer compensation is where you find details of the trailer fees. It also includes details of how dealers get paid when they sell a deferred-load fund. But remember, as part of the fund’s investment management fee, trailer fees come out before the fund calculates its performance.

As with all goods and services that you buy, from cars to groceries to services such as investment advice, sales efforts will usually enter the picture. And you can bet you won’t know the details. All you know is the price.

Canadians have always had a predilection for big government, set up to protect the individual from anything they might not like — such as an investment that does poorly. That’s why Canadian regulators are currently researching trailer commissions.

Indeed, regulators are looking at whether these fees should be banned altogether. Certainly this has happened elsewhere such as in the U.K. There, investors now compensate their advisers directly for the advice they receive.

We agree that trailer fees should be eliminated. As it is, these fees tend to erode long-term returns and can lead to biased advice in cases where advisers recommend funds that pay trailer fees over ones that don’t, simply because the former are more advantageous to their pocketbooks. But it remains to be seen whether or not regulators will continue to study the issue of embedded commissions to death as they have in the past. For now, it remains buyer beware.

 

Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

Comments are closed.