Can you afford to invest in mutual funds?
Many people simply don't realise how much of the returns from their investment portfolios are eroded by mutual fund fees and taxes. They wrongly assume that the only expenses they incur are the funds' published annual Management Expense Ratios (MERs.) This article attempts to describe and estimate all of the expenses that mutual fund owners incur. It then shows how severely these costs impact on the ultimate performance of their portfolio.
Investing's Seven Deadly SinsThe various expenses that mutual fund investors incur have been characterised as the investment industry's Seven Deadly Sins1. Here's a brief description of each sin:
1. Management Expense Ratio (MER)
The MER is calculated as a percentage of a fund's assets. This is the fee that most investors are familiar with. It's usually displayed prominently in the fund prospectus. MERs in Canada generally range from about ½% to over 3%. The average Canadian equity fund has an MER of 2¼%.
2. Front-end (FE) or back-end (DSC) fees
Likewise with back-end load fees. These too are built into the fund's MER. Investors only have to repay these fees if they redeem funds before their Deferred Sales Charge (DSC) schedule expires.
3. Trading costs
4. Insurance fees
5. Wrap fees
6. Taxes on distributions
It's difficult to come up with a single number to account for the affect of these taxes since each type of distribution is taxed at a different rate and the rates themselves vary according to the tax payer's income bracket as well as province of residence. Financial journalist Duff Young calculated2 that "the after-tax rate of return on funds has been just two percentage points lower than the pretax returns that are generally quoted in ads and in the newspaper listings." While he concluded that this 2% point penalty was "not bad," as we'll soon see, it's really quite the opposite.
Many investors pay taxes on these distributions outside of their investment accounts. That makes it much more difficult to appreciate the negative effects that these taxes have on portfolio returns.
7. Taxes on redemptions
It's difficult to generalise about the effect of redemption taxes. Realise however that these taxes are incurred only when you sell a fund. Those who buy-and-hold can shelter accrued capital gains taxes for many years.
So what does all this cost me?We'll try to answer that question by estimating how much these costs subtract from your annual returns. Then we'll show the effect this has on your ultimate portfolio performance over the course of your investment career.
Suppose you own a typical actively managed Canadian equity fund. Your fund charges an MER of 2%, it incurs a further 1% in trading costs, and you pay an average of 2% annually in taxes on distributions. Your returns are eroded at the rate of 5% per year.
To show how the effects of this erosion, Malcolm Hamilton, an actuary and pension consultant with William M. Mercer Ltd. provides this handy "rule-of-40"3:
Take 40. Divide by the [total annual expense rate that your mutual fund incurs.] And presto, you've got the number of years it takes [fund] expenses to consume one-third of your investment.
Using the rule-of-40 it's easy to see that it takes only 8 years for you to lose 1/3 of your portfolio. And remember that when you redeem fund units there are capital gains taxes to pay on top of that!
Here's a chart4 that shows how your portfolio erodes over time for a variety of annual percentage costs:
May the Force be With YouThe mantra of John Bogle, Senior Chairman of Vanguard, is that mutual fund costs matter. Hopefully this article has helped you to see just how much they matter. Remember that the returns for such indexes as the Toronto Stock Exchange 300, Standard & Poors 500, Dow Jones Industrial Average, etc. that you see in the newspaper or on TV do not include any of investing's seven deadly sins.
Albert Einstein was once asked, "What is the most powerful force in the universe?" He replied, "Compound interest." You benefit from the power of that force when you invest for the long-term. But remember that when it comes to investment costs the force can be equally powerful in the opposite direction.