Tuesday, 15 October 2013

How Much Do Mutual Funds Cost, and Relative to What? Part Two

The point: management expense ratios do a poor job of communicating the price you're paying for a mutual fund and the value you're getting in return. This is the second of a two-part rant, and you can find the first part here.

If you walked into the grocery store tomorrow to buy chicken, and instead of seeing $2.99/lb on the price tag you saw "2.25%", would you buy it?

Dumb question. Of course you wouldn't - at least not yet. You'd collar someone and ask them "2.25% of what" and "what are you doing changing the price tags and wasting my time?" Unless you're in an enormous hurry to get out of the store, you take some time to understand if the price you're going to pay is a good one for the value you'll receive, right?

When you buy mutual funds, you're buying something with two price tags. How much time did you spend with the advisor figuring out how much you were paying and whether it was a good price?

I thought so.

This isn't an enormous guilt trip. Your intentions were good when you walked into the bank or had the investment guy over to your house, but it's extremely unlikely that either one gave you an unbiased primer on how to buy mutual funds before you signed the account opening forms. When you asked questions, I'd bet a good-sized chunk of money that the answer was given in the form of a product plus a stack of paper disclosure booklets.


When you buy mutual funds, you're buying something with both an up-front cost and an ongoing cost*. It's like buying chicken that you not only pay for up front, but keep paying for as long as you have it in your fridge (now there's a way to combat food waste).

Your ten thousand dollars buys you units of a fund, at a price that reflects the market value of all the stocks and bonds (and possibly other securities) that the fund owns, divided up among all the owners. The second price tag is what the fund as an entity pays for ongoing management expenses, and is expressed as a percent of the net value of all of the investments the fund holds.

The trickiest thing about the second price tag is that you never, ever see it. It's disclosed once - when you purchase - and has already been paid once the performance of the fund is reported to you. This means that unless you're paying attention, you'll never know how much you paid for the second biggest asset you'll ever have (possibly first, depending on if you own a home or not and how much you end up saving.) 

What did I just buy, again?
So what is your management expense ratio actually paying for? It's paying for a company to manage the fund (duh), hire staff to pick out and trade stocks and bonds, comply with securities law, keep the books, advertise the fund, collect and remit GST/HST, pay lawyers, and compensate advisors (or bank branches) with an ongoing annual commission for selling you the fund in the first place.

Now, I'm going to venture to guess that you don't pay securities lawyers often enough to really understand how to evaluate their performance, or run a compliance department on a regular enough basis to have a good handle on the associated costs. That's probably why you (and I) invest in mutual funds in the first place. It's a little difficult for regular people to look at any one fund in isolation and declare the MER to be "worth it".

In fact, when it comes right down to it, who cares how much the lawyers cost? Or how expensive regulatory compliance is? What you and I and every other mutual fund investor out there really cares about is performance: how much money is my mutual fund investment making me? And - related - how much did it cost me to get it?

Except (again) it's almost impossible to evaluate a mutual fund in isolation. If your CIBC Managed Balanced Fund reported a -1.93% return for 2011, what does that really mean? It only has meaning when you compare it to other managed balanced funds, or to the market as a whole.

Enter benchmarking.

Bench-whatting, now?
Benchmarking is the price comparison and review website of investing. It tells you how your fund performed against other, similar funds, and against the market as a whole (well, the relevant parts, anyway.) The difficulty with traditional benchmarking (the kind you find underneath the "Performance of $10,000" section on the fund fact sheet your advisor just handed you) is that you can't buy the benchmark. There's no way for you to compare what actually buying your Monthly Income Fund with real, actual dollars would be like compared to actually buying "the benchmark" with real, actual dollars.
 
For regular investors, I use TD e-series mutual funds fill the benchmark role, because you can actually buy them with real, actual dollars. They have a ten year performance record that you can easily find online. You can weight the Canadian, US, International, and bond index funds the same way the fund you're comparing it to is weighted.

It's not perfect, because it's not replicating the exact investment strategy that your particular mutual funds are following. It doesn't take into account reinvestment of returns, or regular contributions. It assumes that you held the precise valuations that you hold today for the past ten years, and furthermore, it assumes that past performance is going to continue into the future. Short of a crystal ball however, it's still a pretty good way to evaluate what kind of value you're getting for the price you're paying.

When you compare the calendar year returns of the CIBC Managed Balanced Portfolio and the calendar year returns of a comparably allocated TD e-series, you get this result for an investment of $10,000 and MERs of 2.25% and 0.44%, respectively:

Click to enlarge, or risk damaging your vision permanently. Don't say I didn't warn you.
What you're seeing is the cost to buy inferior performance. Remember, returns are posted after expenses have already been paid, so the CIBC Managed Portfolio - after fees - fared worse than the TD e-series index funds every single year for the past ten years. In addition, if you had held that portfolio for ten years (subject to the limitations of the model above), you would have paid $1,818.65 more to earn $2,231.73 less

That's horrible! Someone should make some laws or something something!
Before we get all hot and bothered about how horrible one fund may or may not be, let's think for a minute about what that $1,818.65 paid for, since that is, after all, the whole point of this exercise. We already covered the legal costs, reporting, et cetera, but let's talk about time and convenience. If you're willing to pay to avoid the hassle of opening up a discount brokerage account and rebalancing it occasionally, and you think $1,818.65 is a fair price to do so, then well and good.

Keep in mind that the results aren't always so clear, either. My choice of a managed portfolio increased the likelihood that the fund would underperform the index funds, but that's not always the case, and it's precisely why you should be aware of the cost you're paying to invest. You're not an idiot for investing in mutual funds, although I'm sure you've been made to feel that way if you've ever lurked around on the internet before. You are an idiot if you continue to pay the cost blindly and never once think about what you're getting in return.

*That is, unless you're talking about mutual funds with front-end or back-end loads, which are as appealing as their names suggest, and which charge you a third fee on top of the other two, either when you buy or when you sell. Kind of like a grocery store with a cover charge or a membership fee.
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