Cut your costs to the bone

Never pay a sales commission of more than 4 percent.Watch out for high management fees – they’ll eat away at your returns.Let’s not kid ourselves. It’s going to cost you some money to invest in mutual funds. The people who sell funds, manage the money and put out your monthly statements don’t work for nothing. They expect to be paid, like everyone else. And the reality is, there’s only one person who can pay them – you, the customer.So don’t get hung up (as many people do) on the idea of no-load funds somehow being free. They’re not. They don’t have any sales commission attached, but you’ll pay in other ways as I’ll explain.In fact, there are a range of charges associated with mutual funds. Some are obvious, some are not – but all will have a direct impact on the return you receive on your investment.

Broadly, these charges break down into three categories: management fees, sales commissions (loads), and miscellaneous costs. Here’s a rundown on each group:

Management Fees. Every fund has a management fee of some kind. These are the charges levied against a fund to comnsate the people who make the investment decisions. They’re normally expressed as a percentage of a fund’s total assets. Money market funds usually have the lowest fee; labour-sponsored venture capital funds the highest.

Many critics of the industry feel the management fees charged in this country are far too high compared to the U.S.. Fund managers respond that they don’t benefit from the same economies of scale, so must charge more. But competition is slowly forcing some changes that benefit investors and several companies now actively promote their low charges including Scudder, Bissett, Sceptre, and Phillips, Hager & North.

When you’re considering a mutual fund, know what the average fee is for the category. You’ll find this information in the monthly fund report in The Globe and Mail. For example, the average for a Canadian equity fund is 2.3 percent. The average bond fund comes in at about 1.7%. If the fee for the fund you’re considering is higher, make sure it’s worth the extra cost.

Sales Commissions: These can take several forms, so be on your guard.

Front-end loads: These commissions are charged at the time you make your investment and are deducted from the amount of money you put up. The amount of the commission is normally calculated as a percentage of your investment. So if a salesperson charges a 5 percent front-end load, 95c out of every dollar you invest will go towards the purchase of fund units, while the other 5c is taken as commission.

The amount of commission charged will be determined by two factors:

1) The maximum commission structure authorized by the mutual fund company. The normal range for Canadian mutual funds has been between 2 and 9 percent, although many companies have reduced their maximum to the 5 to 6 percent range in recent years. Posted maximum rates often decline as the size of the investment increases.

2) Your negotiating skills. In most cases, the posted commission structure has the same effect as a manufacturer’s suggested retail price. The rates are only guidelines; retailers may sell for less if they wish.

In the case of mutual funds, they usually do. Brokers, financial planners and other fund sales representatives will generally charge a lower commission than the suggested rate, if you ask. You should never pay a front-end load of more than 4 percent, even if you’re only investing $500. If you buy on-line or through a discount broker, you’ll pay even less. Don’t base your decision purely on monetary considerations, however; if you’re receiving exceptional service from a sales rep, an extra point or two of commission may be good value for the advice you get.

The only situation in which you won’t be able to negotiate a discounted rate is if the fund is sold exclusively by a so-called “captive” sales force – representatives directly employed by the company. This applies to insurance company funds and to those sold by organizations such as Investors Group. Usually in these cases, the posted rate is what you can expect to pay. Sometimes the commissions are unreasonably high; however, some companies are reducing them to be more competitive.

You may also find there is little room to manoeuvre if you buy your mutual funds through a discount broker. That’s because these companies have already cut their rates substantially.

You should also be aware that if you purchase no-load funds through a broker or financial planner, you may be asked to pay a handling fee. Some sales reps will acquire the funds for you without charge, as a goodwill gesture. But others will want to be compensated for their time. That includes the discount brokers.

Front-end loads will cut into the return on your invested money, sometimes significantly. The table below shows how much a $1,000 investment will be worth after five years and 10 years in three funds, each of which posts a 12 percent average annual compound rate of return. Taxes aren’t taken into account for purposes of this illustration.

As you can see, the longer the time frame, the more significant the impact of the front-end load on the fund’s accumulated value.

The effect of front-end load charges is not taken into account in the performance records of mutual funds published in the business press. But you should be aware of them because they may affect your decision as to which fund to purchase.

Back-end loads: When you purchase a back-end load fund you pay no sales commission, so all your money goes to work for you immediately. But if you redeem your fund units before a certain number of years have passed (usually five to 10), you’ll be assessed a redemption fee (also known as a deferred sales charge) at that time. This fee is usually structured on a sliding scale; the longer you hold your fund units, the less you’ll pay.

The back-end load has proved to be extremely popular with investors. However, you shouldn’t be too quick to make this decision. There’s no question that, all things being equal, a back-end load fund will cost you less than a front-end load fund will. The problem is that things are not always equal. In fact, deciding between a front and back-end load option has become quite difficult in some cases. That’s because, despite the attractiveness of paying nothing up-front, back-end load funds have certain disadvantages. They are:

I Inflexibility: Because of the way back-end loads are structured, investors are often unwilling to switch their money elsewhere, even if it makes good sense to do so. A back-end load fund locks you in by setting a high premium on redemptions in the early years.

Inconsistency: Back-end loads are not always calculated in the same way. You’re sometimes charged on the basis of the market value of the fund at the time of redemption. However, some fund groups base the redemption fee on the original price you paid for the units. Find out which policy is used by the fund you’re considering; all else being equal choose a fund that bases the redemption charge on your original investment.

Non-negotiability: Unlike front-end load charges, back-end loads are usually non-negotiable.

Higher management fees: Another minus to watch for is a management fee step-up. Some back-end load funds are assessed a higher management fee than their front-end brothers. What it means to you is that, if two funds produced exactly the same return, the person who purchased back-end load units would end up with less in net yield.

Miscellaneous Charges: There are a number of additional charges that may apply to the particular mutual fund you select. Inquire about them before making a purchase decision. The most common ones are:

Penalty fees: A few funds have adopted the unpleasant policy of locking you in for a lengthy period by imposing a hefty penalty if you sell your units before a certain time. These penalties are over and above any normal redemption fees.

Redemption fees: You could find yourself having to pay a redemption charge even if you don’t own any back-end load funds. Some discount brokers assess a fee to redeem units of any no-load fund except their own. Also, some funds (including some no-load funds) charge a redemption fee if you sell your units within a short time after purchase – 90 days is common. The cost may be as much as 2 percent of the value of your assets. If you need to cash out early for some reason, check the prospectus before you place the sell order to avoid an unwelcome surprise.

RRSP/RRIF fees: If the fund is held as a Registered Retirement Savings Plan or Registered Retirement Income Fund, a small annual trustee fee may be levied, although some companies have waived it. A fee may also be charged for RRSP cancellation.

Set-up fees: You may be assessed a charge for opening an account with a company. Altamira is one that operates in this way.

Switching fees: You may be permitted to switch from one fund to another within the same company, but a charge will sometimes apply. Note that some companies, including Altamira, limit the number of free switches each year. If you’re dealing with a discount brokerage, you may be assessed a fee even for switches within a no-load fund group.

Systematic withdrawal charges: Some investors wish to receive regular payments from their fund. These are called systematic withdrawals. Some companies charge an annual fee for the service, others charge a fee for each payment, and a few hit you for both.

Termination or closing fees: Some plans assess a nominal fee for closing an account. This practice is becoming more widespread.

Transfer fees: This is a charge for transferring a registered account, such as an RRSP, to another financial institution or mutual fund group. It’s also becoming increasingly common.

Withdrawal fees: A few funds charge a nominal fee for any withdrawals made from your account.

Adapted from Making Money in Mutual Funds by Gordon Pape, published by Prentice Hall Canada.