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And there are management expense ratios, also known as MERs or simply expense ratios: those are the fees that must be paid by those who hold mutual funds or exchange traded funds (ETFs). They typically fall between 0.07 per cent to 0.50 per cent for ETFs and up to 2.5 per cent annually for mutual funds.
What they all have in common is that, all else being equal, the bigger the fee, the bigger an enemy it is to your returns. And the longer your time horizon, the bigger the cumulative impact it will have.
It’s a reality that investors new and old often struggle to grasp, but for those who have crunched the numbers, it is as stark as it gets.
“Consider this: $1 million invested over 30 years at a return of seven per cent annually results in about $7.6 million,” says Barbara Stewart, a chartered financial analyst (CFA) who writes the Portfolio Confidential column with Canadian Money Saver. “$1 million invested over 30 years at a return of 5.5 per cent will give you ballpark $5.1 million.”
In other words, that 1.5 per cent difference, compounded out over 30 years, adds up to a small fortune.
“I can’t think of any reason to invest in mutual funds with fees that high — you give up one third of your potential return,” says Stewart, who notes she manages her own money through “set-it-and-forget it” ETFs.
The 1.5 per cent example isn’t just an arbitrary number, either. A 2017 Morningstar report revealed that Canada received the lowest score regarding investment fees and expenses among 25 different countries. It’s a trend that has continued, with recent Morningstar research showing the average management expense ratio (MER) in Canada is still significantly higher than in the United States.
Today, most mutual funds in Canada still come with trailing commissions of 1.13 per cent (due to one per cent commissions plus HST in most provinces). Trailing commissions are an ongoing charge for services and advice provided by an investor’s rep and their firm. These high fees remain the norm in Canada for several reasons, including persistent misinformation campaigns that leave many less sophisticated investors buying into the notion that active management consistently and reliably adds value.
Adding insult to injury, there is longstanding evidence that higher-cost active investment strategies actually fail to outperform cheaper strategies such as passive index investing.
In The Arithmetic of Active Management, a paper written more than 30 years ago, Nobel laureate William F. Sharpe showed that the average passively invested dollar must by definition outperform the average actively managed dollar.
“Let’s say the TSX has an average expected long-term return of seven per cent,” says John De Goey, portfolio manager with Designed Securities Ltd. and author of Bullshift: How Optimism Bias Threatens Your Finances, in explaining Sharpe’s thesis. “If the average cost (MER) of all ETFs that track the TSX is 30 bps (0.3 per cent) then the average return of those ETFs will be 6.7 per cent (seven per cent minus 0.3 per cent).”
But here’s where it gets interesting: if the passive investor’s return is the benchmark, then by definition the average active investor must earn the benchmark, too. All that’s left to differentiate them is fees.
As De Goey explains, if the average cost of all compensation-free mutual funds that are benchmarked against the S&P/TSX composite index is 1.1 per cent, the average return for an active strategy would be just 5.9 per cent. As such, on average, the passive approach beats the active approach because it costs less (80 bps less in this example, to be precise). It’s like getting an expected 0.8 per cent return enhancement with no change in risk.
De Goey calculates that a standard 60/40 split portfolio’s base return of 5.6 per cent becomes 4.3 per cent with an advisor who uses passive ETFs as building blocks, and only 3.5 per cent for an advisor who uses commission-free or F-Class mutual funds. “You may be stunned,” says De Goey. “If you have a time horizon of over 20 years, the impact almost certainly will be staggering.”
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So why have Canadian fees remained so stubbornly high? Culprits include misinformation about the value that active management brings to returns, and the possibility that financial advisors may truly believe they can add value. More likely, De Goey says, is that advisors have an “ongoing and strong preference for a business model that involves embedded compensation … so that the higher-cost products are recommended disproportionately relative to the lower cost versions that strip out the compensation.”
The lesson for the next generation of investors? As Vancouver-based fee-for-service certified financial planner Colin Ritchie puts it succinctly: “Fees always matter.”
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