Why is a 2.5% MER high?

In the grand scheme of things, there’s a much bigger difference between 2.5% and 100% than there is between 2.5% and 1% or 2.5% and 0.5%. What’s the big fuss over 1%, or fractions of a percentage on an MER?

What is an MER ?

MER is the acronym for Management Expense Ratio, and is an annual fee expressed as a percentage of the total of Your investment in a fund. So, a fund with an MER of 2.5% will charge you $25 for every $1000 you have invested in it every year. A fund with an MER of 1% will charge you $10 for every $1000 you have invested each year. And, a fund with an MER of 0.25% will charge you $2.50 for every $1000 you have invested per year.

The MER is the fee that investors pay, for the management of a mutual fund or exchange-traded fund (ETF) and any of the expenses associated with running it.  This includes the cost of legal, record-keeping and accounting fees, office space, marketing, taxes, and marketing.

The tricky part of an MER is that you don’t pay it the way you pay for almost everything else you buy.  MERs are a hidden cost that is skimmed or taken off the value of your investment’s growth before you see any returns.  You pay your MER fees by receiving less on your investment than it has performed.  As an example, a fund with an MER of 2% may have grown 8% over the past year.  But, instead of seeing those shares increase in value by 8%, they increase by 6%; 2% of your growth disappeared because of the MER.  This can be even worse in years where there is a recession, where the MER will compound your losses.  In a year in which the same fund contracted by 3%, the shares in your account will have lost 5% of their value.  MERs have also been made harder to quantify as well because account statements expressed fees as percentages until quite recently.  It was not until early-2017 that investment account statements were required to show the embedded commissions and fees investors pay for financial advice in dollars.  But the entire MER is not shown, only the fraction investors pay to their advisor for financial advice and planning.  The larger portion of the MER that pays for the management of the fund itself is not stated.

Why do we pay an MER?

In essence, the MER is the fee we pay for a mutual fund or ETF which provides convenient accessibility to a diversified portfolio of stocks and/or bonds.  Typically, a mutual fund or ETF holds anywhere from tens to thousands of individual stocks or bonds.  To hold a funds underlying assets directly, you would need tens of thousands of dollars at the bare minimum – but in most cases, hundreds of thousands of dollars or millions of dollars.  Mutual funds and ETFs make these diversified portfolios accessible to investors with tens of dollars.  Investors also get the convenience of not having to manage (buy and sell) each individual stock themselves, and not having to do any of the research and analysis to determine which stocks should be owned and when.  In short, an MER bundles together the costs of managing individual stocks and bonds yourself (time costs), the expertise needed to accomplish this (cost of knowledge) and passes down the financial cost of commissions of trading.

How should I approach MERs as an investor?

It goes without saying, that investors are looking for the maximum possible gain within their risk tolerances. No one is able to accurately predict price movements of individual stocks or the market as a whole with any consistency, least of all retail investors. The one thing that every investor is able to control is their costs.  Fees are also the only aspect of investing that you can predict with any precision, and there is a link between lowering your costs and increasing your profits. The MER is an extra weight or cost that investors have to carry in exchange for the advantage and convenience of a diversified portfolio.  If you are carrying extra weight, you want that to be as minimal as possible.

The MER is an extra weight or cost that investors have to carry in exchange for the advantage and convenience of a diversified portfolio.  If you are carrying extra weight, you want that to be as minimal as possible.

Quite simply, a 2% MER (or anything higher) is quite expensive.  There are two main reasons that it is difficult to justify in a fund with an MER this high: there are similar and comparable alternatives (robo-advisors and ETFs) with MERs far lower than 2.5%; and because a 2% (or higher) MER claws away such a significant portion of any growth.

Based off of historical data, the market as a whole averages roughly 7% of annual growth over a 10-year period.  The market can easily grow by  20% or more some years, while others may see negative growth.  However, the cumulative average over a decade tends to be close to 7%.

An average of 7% of growth each year over a decade, is a reasonable expectation for investors.  However, investors have to take into account their costs and fees.  This 7% of growth is before costs, so a mutual fund with an MER of 2.5% will only provide a return of 4.5%, and the investor loses over a third of their returns to fees. On the other hand, robo-advisor fees in Canada tend to be between .75% and 1.1% and would provide 5.9%-6.25% of growth in the same market conditions – giving their investors roughly 33% more growth than a big bank mutual fund.  Alternatively, an ETF portfolio would require moderately more maintenance by a DIY investor, but would yield closer to 6.75% (after fees of roughly 0.25% or even lower) in identical market conditions. These returns would be close to 50% higher than a mutual fund with an MER of 2.5%.

As you can see, over 10-year, 20-year and 30-year periods, lower MERs will have a massive effect on investment returns.  A DIY investor using ETFs can expect to see an initial $10,000 investment grow to roughly $71,000 over three decades and someone using a robo-advisor should see their’s grow to close to $62,000 over the same time frame.  However, $10,000 invested in expensive mutual funds, can only be reasonably expected to grow to $37,000!  Over thirty years, a DIY investor using ETFs can expect to end up with a portfolio almost twice the size, compared with what they would have with mutual funds.

Over thirty years, a DIY investor using ETFs can expect to end up with a portfolio almost twice the size, compared with what they would have with mutual funds.

The chart above has a nice clean and straight curve, but it should be noted that the chart above represents a theoretical growth of a portfolio.  The market does not consistently grow at the same rate.  Year-to-year, the market will grow or even shrink at different rates with are spurts and pullbacks, so a real thirty-year growth curve will look more like the graph below.

2% looks like a number, but it’s hard to appreciate how much it costs you until you look at the MER as a percentage of your expected gains.  Investors lose more than 40% of their portfolio’s expected growth each year to fees when they have an MER between 2 and 3%.  This lost growth is compounded every year as well.  This means that your mutual fund will need to beat the overall market’s growth by 30-40% every year for you to be better off than if you had passively invested in index funds or robo-advisors. Unfortunately, the fund managers that are able to consistently generate those kinds of returns are not accessible to normal retail investors like you and me.

Why are some mutual funds so much more expensive?

In general, the claim is that the fees are higher because they offer more value to investors. These funds are actively-managed and offer investors the opportunity to beat the market (though it’s also possible to get poorer returns or returns that match the marker), before fees. The problem with actively-managed funds, is that they seldom outperform their benchmarks, even before fees.  (Read this post to read more about the difference between active- and passive-investing approaches.) Further, investors who purchase these mutual funds typical get a full-service package including financial planning, so there is an aspect to these high-fee mutual funds that is unquantifiable with a 2.5% MER.

The problem with actively-managed funds is that they seldom outperform their benchmarks, even before fees.

However, it’s important to ask yourself how much that advice is worth and if you can get the advice at a lower cost (you can, from a fee-based advisor). Most Canadian retail investors will get More Bang 4 There Buck, from passive indexed investments like robo-advisors or ETFs with low-MERs, than they would get out of a typical 2.5% MER mutual fund.  At the end of the day, I believe an MER above 2% is very expensive, and anything that is closer to 3% or even higher is highway robbery and extortion.


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