In my last post, I showed how index funds allow you to save more money by losing less of your investment returns to management fees.
Here is what different management expense ratio (MER) levels will cost you on an initial $10,000 investment at 10% growth compounded annually:
| 0.20% MER | 5 years | 10 years | 25 years | 40 years |
|---|---|---|---|---|
| Your investment | $16,105 | $25,937 | $108,347 | $452,593 |
| -0.20% MER | $146 | $468 | $4,819 | $31,775 |
| What’s left for you | $15,959 | $25,470 | $103,528 | $420,817 |
| 1.00% MER | 5 years | 10 years | 25 years | 40 years |
|---|---|---|---|---|
| Your investment | $16,105 | $25,937 | $108,347 | $452,593 |
| -1.00% MER | $719 | $2,264 | $22,116 | $138,498 |
| What’s left for you | $15,386 | $23,674 | $86,231 | $314,094 |
| 2.50% MER | 5 years | 10 years | 25 years | 40 years |
|---|---|---|---|---|
| Your investment | $16,105 | $25,937 | $108,347 | $452,593 |
| -2.50% MER | $1,749 | $5,327 | $47,364 | $272,150 |
| What’s left for you | $14,356 | $20,610 | $60,983 | $180,442 |
Now, 40 years is a long span of time, and most of us are probably not even thinking about that far out. However, even if you don’t plan on working for the next 40 years, chances are that you aren’t planning on consuming your entire nest egg by then, either. Therefore, as your nest egg continues to compound and grow, so too will the total fees paid.
These fees are invisible in a sense, because the difference is that instead of you receiving the full sum and then having to pay the fee back to the company, this is money that you lose out on because you never see it in the first place.
However, to add insult to injury, many mutual funds sold by banks and advisors come with additional fees on top of what you already lose out on through MERs!
Here are the most common types of fees:
- Sales charge (front-end load)
- Deferred sales (back-end load)
- Low load
- Early redemption fee
The last fee mentioned here is special, since it is typically used to recoup expenses for the fund, instead of as compensation to a broker or advisor for selling you the fund.
Sales charge (front-end load)
This type of fee is paid when you purchase units in a mutual fund. If a fund has a 5.5% front-end load and you invested $10,000, then you would pay a sales charge of $550 to the broker or advisor. You would only have $9,450 invested! Your investment needs to return at least 5.8% just to break even.
Deferred sales (back-end load)
This type of fee is sneakier than the front-end load, since it is paid when you decide to sell your units and withdraw or transfer your money. In this case, if a fund has a 5.5% back-end load and you invested $10,000, then you would pay a sales charge of $550 upon withdrawal of the funds. This type of fee may decrease over time to $0; for example, if the time limit was 5 years, then you could withdraw your original $10,000 without charge after 5 years. Anything invested more recently would still be charged a fee upon withdrawal!
Low load
This is similar to the back-end load, except that the fees charged may be smaller, and the time over which fees are charged is typically shorter.
Early redemption fee
Unlike the other three types of sales fees, an early redemption fee is not charged to reward a broker or advisor for selling the funds. It is instead charged in order to recoup costs for the funds and also to help discourage short-term buying and selling. Some Vanguard funds, otherwise known for their very low MERs, charge a 1% early redemption fee.
Investing it wisely
Avoid all types of sales fees by going with low-cost index funds. Many of the best investors of all time are aware of how the industry operates, which is why they often invest in the companies selling these products rather than in the products themselves. Many advisors don’t even know much about index funds, since they are trained to sell you funds that are more profitable for the bank. Since they are trying to make more money for the bank and for themselves, this is what they will try to push on you. Show that you’re educated and informed by letting them know what you want, and always verify that there are absolutely no sales charges associated with what you’re buying.
Further reading and references
- Andrew Hallam: Book Review: The Elements of Investing
- US Securities and Exchange Commission: Mutual Fund Fees and Expenses
So, have you ever had a negative experience with sales charges? We unfortunately have a couple of investments from our college days that have back-end load charges attached to them. At least we only tied up a couple of K this way, but lesson well learned!
I agree that actively-managed funds can be a rip-off for may investors. Overall, this seems to be the majority opinion (Buffet, Motley Fool, and sometimes even Kiyosaki depending on your strategy). It’s weird the temptation to dabble a little with the latest and greatest fund our investment advisers are selling can often have huge impacts on our nest egg in the long-run, as your table points out.
You’re right. It’s so easy to look through the rear-view mirror to see great performance, then suggest that a particular fund will then beat the market, but going forward, it’s not so easy.
Did you know that 95% of investment dollars go into funds with 5/5 star Morningstar ratings (given for great recent and historical performance). But if you could have adjusted your portfolio to only hold five star funds (dropping those that don’t retain their stars and adding those that are newly added to the club) that you would have made 6.9% annually from 1994 to 2004. With the S&P 500 index, you would have made 11.0% during the same time period. Add the further taxable liability (in taxable accounts) for the actively managed funds, and you have pure silliness representing itself. (pgs. 89-90, Bogle, The Little Book of Common Sense Investing)
But back to my original statement: 95% of new mutual fund money flows into Morningstar’s five star funds. It’s a recipe for long term disaster—perpetuated mostly by unaware advisors.
What do you think are the long-term impacts of 95% of new investment money flowing into these five-star funds? Are a lot of people in Wall Street merely employed because many investors are unaware? Do these actively managed funds redistribute total stock market returns toward index funds by competing and driving the market, while disappointing their own investors with subpar returns?
Fees can be a killer- and the table you created really shows it well.
Whenever I buy a mutual fund, I look at the expense ratio. It’s amazing how some of these ‘advisers’ try pushing loaded funds on you, with promises of fantastic returns.
Good article!
Everyday Tips,
Do you buy actively managed mutual funds? If so, why?
I personally focus on index funds as a part of the equity portion of my asset allocation strategy. To me, the fees with actively managed funds makes them less impressive from the outset. I have had some good luck in a few managed funds over the years, but still tend to focus on index funds.
I’ve been looking more at ETFs, but I do have some mutual funds (mostly in my 401K).
I think if I were to buy index tracking investments, I would consider an ETF over a mutual fund!
I definitely stay away from front load (sales charge) mutual funds!
Vanguard has a calculator which you can use to compare costs: https://personal.vanguard.com/us/faces/JSP/Funds/Tools/FundsToolsEtfCostSelectionContent.jsp
It’s interesting to look at to see if ETFs or the corresponding mutual fund would be the better buy for you.
Nice post Kevin!
I keep kicking myself about my 20’s invested in mutual funds. I got smarter (I hope?) in my early 30’s and started to get out of them, into ETFs, index products, basically anything that mirrors market performance and doesn’t charge me anything over 0.5% in my RRSP to do it.
Gail Bebee, in her book “No Hype – The Straight Goods on Investing Your Money” has a good example about what you wrote above.
If,
-$50,000 invested,
-in the BMO Canadian Equity Mutual Fund (for example),
-assume it returns 8%,
-you hold the fund over 10 years,
-and, MER is 2.29%…
Profit before fees = ~ $57,900
Profit after fees = ~ $36,400
Total fees paid = ~ $15,400.
Ouch. Big difference between an ETF that charges 0.2%-0.5% and 2.29%.
Ouch! Most of the bank mutual funds look to be big ripoffs. I recently cleaned out most of my unregistered investments in order to pay for the downpayment; as I rebuild, I believe I will be going into ETFs and low-cost index funds. I already have my RRSPs setup to go with the lowest cost and most efficient funds possible.
Since Vanguard mutual funds are not available here, I might just buy the corresponding ETFs, but I’ll have to watch out for exchange fees.
Great post. I hate Mutual funds with a passion. Long live DIY investing.
I don’t hate mutual funds, but it is a buyer beware situation. Fools will be gamed by short-term performance into buying what is hot at the moment, only to see it perform dismally after they buy. You must select very carefully and there are shareholder friendly funds out there……. That being said, I split my money 50/50 between indexes and actively managed funds. The actively managed funds have outperformed the indexes even when factoring in capital gains, but I hedge my bets.
Glad to see that you are not enthralled by short-term performance. Why did you decide to buy those particular actively managed funds?
The investment philosophy of the fund managers was very similar to mine. They are all committed value investors who tend to buy out of favor companies with under-appreciated assets or companies undergoing a turnaround. They tend to be low volatility funds that have outperformed the market over 5, 10 and 15 year periods of time. Nothing flashy about them. They are just very solid funds.
Great article on mutual fund fees. Here’s another article that describes how management expense ratios are higher for actively managed sector funds versus just index funds that mimic the S&P 500.
Expense ratio includes common charges such as administrative fees, manager/investment advisor fees, 12b-1 fees, etc. An industry standard average for an actively managed fund is 1.25% of total investment purchase. This percentage varies from one fund to another and is usually lower for an index mutual fund that tries to benchmark the returns of an Index such as the S&P500 or the Dow Jones Industrials.
Source: http://www.bestperforming-mutual-funds.com/mutual-fund-expense-ratio.html
On the other hand, an actively managed mutual fund requires the services of a sophisticated & qualified mutual fund manager who actively manages individual investments to make the highest capital gains possible. This is why actively managed funds tend to have higher expense ratios than Index funds.