Costs add up

Many people don’t pay enough attention to costs when making mutual fund purchase decisions. Ironically, some people place too much emphasis on expenses. You need to find the right balance.

There are actually two parts to the cost equation. The first one that you encounter is the commission structure — the amount you pay your advisor when you buy or sell fund units. Many people try to avoid this expense by selecting only “no-load” funds but in doing so they eliminate some of the top performers from consideration. Although it is possible to create a good no-load portfolio, we suggest keeping open all the options. There are three types of sales commissions.

Deferred sales charge (DSC). Buying DSC units means you pay no commission up front. However, you will be assessed a fee if you sell before a certain period of time has elapsed (typically seven years). The biggest concern with DSC funds (also known as back-end load units) is that they lock you in for several years. It’s true that the fee can usually be avoided by moving to another fund within the same family but your financial advisor may charge a switching fee of up to 2 per cent. Also, if the fund is performi so badly that you are desperate to bail out, you may find it uncomfortable to stay within the same group.

Service charge (SC). These are more commonly known as front-end load funds. They require the payment of a sales commission at the time of purchase, usually no more than 5 per cent. The amount of the commission reduces the money you actually put to work, so a $1,000 investment with a 5 per cent commission actually buys only $950 worth of units. Some financial advisors now offer SC units at zero commission. They do this to “build their book”, adding to their assets under management. The incentive is the “trailer fees” that are paid by the fund companies. Typically, these amount to 0.5 per cent of the value of the assets in an advisor’s “book”. That may not seem like a lot until you do some math and realize that works out to $5,000 a year in revenue for every $1 million under management.

Low load. Low load units are a type of DSC option, but are a more attractive choice. They have a much lower fee structure and usually reach zero commission after three years. Most investors are unaware this option even exists and, if they know about it, they are under the impression it is only available to high net worth clients. Not so. If you are considering buying DSC units, ask your advisor if the fund company also has a low load option. You can also check the fund prospectus on-line at www.sedar.com, a website that publishes financial documents for all mutual funds and public companies.

The other main element of fund cost is the MER. Some investors have become so obsessed with MERs that they will only buy units in funds that have below-average annual costs. That effectively eliminates some fine mutual funds from consideration. There are many excellent low-MER funds — just because they’re cheap does not mean they’re bad. There are also many higher-MER funds that are chronic underperformers. So this is not a case of you get what you pay for. A high MER doesn’t mean the fund is any better than one with a low MER. It may just be less efficiently managed or the fund company is boosting its profits.

Also, some MERs appear to be unusually high because they are inflated by performance bonuses. These are extra fees paid to management when certain targets are surpassed. Most funds don’t have this provision but some of the smaller companies include it in their prospectus. An example is the Sprott Canadian Equity Fund which has an MER of 5.63 per cent. The fund’s average annual compound rate of return of 31.2 per cent for the five years to May 31 makes the high fee easier to swallow for investors but if performance should falter unitholders would likely be up in arms.

You can see the MERs of all mutual funds on websites like Globefund and compare them to others of the same type. The Report on Mutual Funds that is published annually by The Globe and Mail includes the average and median MERs of all the funds in each category. For example, at the end of 2004, it showed the average Canadian equity fund with an MER of 2.83 per cent with the median being 2.87 per cent.

When it comes to MERs, what matters is how much is left in your pocket after the fees and expenses are deducted. A fund with a high MER that has produced above-average returns over a long period of time should certainly not be dismissed out of hand. Some fund companies that are well-known for low MERs include Saxon, McLean Budden, Phillips, Hager & North, Mawer, Leith Wheeler, Chou, ABC, Beutel Goodman, and Sceptre. In all cases, their MERs are well below where CI will end up at the end of the day.

The bottom line is that the pennies represented by basis points really do count but they aren’t the whole story. I used the Globefund filter feature to see how many open-ended, non-segregated Canadian equity funds had done better than the one-year return of Synergy Canadian Class, which has an MER of 2.55 per cent and a 12-month gain of 16.7 per cent. There were a total of 40. Of those, nine were no-load, including one fund that was restricted to education workers and another with a $150,000 minimum. Of the no-load funds that are available to the general public, only three had an MER under 2 per cent: RBC O’Shaughnessy Canadian Equity, Sceptre Canadian Equity, and Sceptre Equity Growth. All the other overachievers were load funds with relatively high MERs.

So don’t be blinkered when it comes to costs. Just be sure that if you pay a higher price, you get good value for your money.