Mutual funds are still incredibly popular in the investment world, and I’m sure many of you have at least a portion of your investment portfolio in funds (I do). As of May 2017, there was $1,428 billion of assets under management in mutual funds. There’s some hate against mutual funds in the finance community but, in my opinion, they can be a good option, especially for beginner investors or those who are not willing to put in the time researching other options themselves.
Think of a mutual fund as a collection of other investments such as stocks and bonds. Most funds will have a specific mandate that they follow that will limit them to a specific risk tolerance or market sector; for example, you’ll get funds that are based in Canadian equities, US small cap companies, corporate bonds, or dividend generating investments. The fund will be run by a fund manager who decides what to hold and when to buy and sell particular holdings. That expertise is what you’re paying for, and I’m ok with that. Part of being a responsible investor is understanding how these fees work and ensuring you are getting your money worth. There are a couple of different fees you will be charged by a mutual fund; sales charges and MER’s…so let’s get into what those actually are.
There are a few different ways you can pay to buy a mutual fund and which option you choose will be determined you and your advisor.
The first versions are front end (FE) or initial sales charge (ISC) funds. For these, you will pay your investment advisor a commission to purchase the fund for you; this can range anywhere from 0% to about 5%. FE funds would be used in accounts where you don’t pay your advisor an additional management fee; they would get paid via the commission and the trailer fee (more to come on that). Feel free to negotiate this fee with your advisor but do keep in mind what sort of other work they do for you. If you are getting retirement or tax planning advice at no extra charge, then FE funds could very well be how you are paying for their services.
Next up are back end or deferred sales charges (DSC) funds and, for these, you won’t pay anything up front for the fund, but you will have to pay a penalty if you pull your money out of the fund too soon (in the 5-7% range). Usually, you have to keep your money in the fund for 5-7 years to avoid the penalty, but a lot of companies let you take out 10% of your holding free of charge each year and switch between funds in the same company over that same period. DSC funds are the black sheep of the mutual fund world, and many companies are eliminating them altogether. Other than potentially avoiding a commission charge, there is no benefit to investors in choosing DSC funds over FE funds…there’s only downside with the locked-in component. If your advisor is recommending DSC funds, you should absolutely question the advice and potentially look elsewhere for help.
There are also low load (LL) funds that are very similar to DSC funds (penalties to withdraw), but with shorter terms. Most LL funds will charge you about a 3% penalty and will fully mature after three years. Again, not an option I would necessarily recommend so make sure you understand the reasoning behind why your advisor would be suggesting.
Finally, there are no load (NL) funds. These won’t charge you any sales charges to buy or sell and also have lower MER’s than the above alternatives. Sounds ideal right? There’s a catch though. These are only offered in fee-based accounts where you would be paying a management fee directly to your advisor.
For most mutual funds you will be able to buy the same fund by any of the above means. For example, you could buy Cdn Bond Fund-DSC, Cdn Bond Fund-FE, Cdn Bond Fund-LL, or Cdn Bond Fund-NL and they will all be the same except for the sales charge you pay (hold the same investments and be managed by the same person).
Management and/or Operating Expenses (MER’s)
The mutual fund also has certain expenses that they have to pay (salaries, bookkeeping, reporting, etc.) so they pull the cost of these expenses straight out of the fund’s earnings. Usually, these charges will go unnoticed by the investor as they don’t show up on your account statements. Instead, they just lower the rate of return of the fund. There has been a push for more transparency in the industry (especially regarding fees), so you will now receive what is called a ‘Fund Facts’ document prior to purchasing a mutual fund. The ‘Fund Facts’ will list information on the fund including current holdings, the risk level, and the associated fees.
Most MER’s are between 1% and 3%. This depends on the type of fund and how actively traded it is. For example, bond funds tend to be more conservative with less volatility, so there isn’t as much trading done by the manager, and they would have a lower MER than a mutual fund with more stock holdings. Usually the more conservative a fund, the lower the MER. If a fund you hold is charging an MER of 2% and that fund had a rate of return of 9% for the year, the actual rate of return you would see after fees would be 7%.
The majority of the MER goes to operating expenses for the fund, but there is also a trailer fee that is paid back to the advisor who sold the fund. Usually, the fee is between 0.25% and 1.25% and is kind of like a finders fee for bringing you in as a client for the mutual fund company. The trailer fee would be eliminated if you are buying the no load version of a fund and would be replaced by the management fee your advisor would charge you directly, however, the rest of the MER would still be charged.
There’s no escaping fees if you are investing in mutual funds but understanding what and how you’re being charged can help you in determining the best options for your portfolio.