Investing on the cheap

Canadian mutual funds are expensive. The industry keeps denying it, putting forth all kinds of reasons why impartial third-party studies that conclude that we’re paying too much for money management are flawed. They’re not and we are.

I’m not talking about the commissions you may pay when you buy or sell a mutual fund. I’m referring to the absurdly high annual fees that insidiously eat away at your returns. If you own a Canadian equity fund, the odds are that you’re being dinged for more than 2.5 per cent a year by the company. Some of that is justifiable – money managers have to eat too so they need to be compensated. But a chunk of that money is going to pay for services you may not need and never use.

Take trailer fees, for example. These are stipends paid annually by the fund companies to your broker or dealer to recompense them for the advice they give you. For every $1,000 you have invested in an equity or balanced fund, you typically pay at least $10 for this and perhaps more. It doesn’t matter whether you made the purchase decision yourself and deal with a discount broker who doesn’t provide advice. You pay anyway!

Then there is the issue of scale. Logic would suggest that as a fund grows larger, the management fees could be reduced to take advantage of economies of size. It rarely, if ever, happens. The bigger a fund becomes, the more profit it makes for the company. With a management fee of 2.5 per cent, a $100 million fund earns $2.5 million a year for the sponsoring firm. If it grows to $1 billion, the income increases to $25 million. Does any of that get returned to investors in the form of a reduced fee? Do pigs fly?

The only way around these exorbitant costs is to become a savvy shopper. Be as price-conscious about the funds you choose as you are when buying a car. It will pay off in the form of higher returns, which will add thousands of dollars to your portfolio over time. Here are three low-cost ideas for frugal investors.

Invest with a low-cost company. A few (very few!) mutual fund companies have long-standing policies of offering low management fees. This group includes three Vancouver-based houses, Phillips, Hager & North (now owned by Royal Bank), Leith Wheeler Investment Management, and Steadyhand Investment Management. Calgary’s Mawer Investment Management and Beutel Goodman of Toronto round out the list. Perhaps not surprisingly, many of the funds offered by these firms are superior performers.

Some of the best bargains can be found among Phillips, Hager & North’s bond funds. PH&N has one of the best fixed-income teams in Canada and you pay peanuts for their services. The management fee for the D units of the low-risk PH&N Short Term Bond and Mortgage Fund is only 0.5 per cent and the total management expense ratio (MER), which includes all costs, is 0.59 per cent. This inexpensive fund has been in the top quartile of its category for six of the last eight years. Oh yes, it’s also no-load.

Mawer, which many people have never heard of, offers some of the country’s best stock funds. The Mawer Canadian Equity Fund has gained an average of 8.8 per cent annually over the past 10 years (to May 31), well above the category norm of 5.7 per cent. In the latest 12-month period, it added almost 26 per cent, more than eight percentage points better than the peer group. The management fee for this terrific fund is only 1 per cent, with an MER of 1.24 per cent.

Check out other funds from the companies I have mentioned and you’ll find many more examples of outstanding performance. The only drawback is that you’ll need more cash up-front to invest with these firms, at least $5,000. But if you have the money, take a look.

Buy index funds. These are designed to track the performance of a major stock index such as the S&P/TSX Composite Index or the Dow Jones Industrial Average. They’re called "passive funds" and they’re cheaper to run because there are no buy/sell decisions for the managers to make. They just have to set up a portfolio that emulates what the index is doing and rebalance it periodically.

The cheapest index funds are the "e" units offered by TD Asset Management, some of which have MERs as low as 0.32 per cent. The problem is that these units are notoriously complicated to buy although TD says it is working to improve the situation.

As an alternative, look at the index funds in the Altamira group, which is now owned by National Bank. They offer several choices with MERs in the 0.6 per cent to 0.65 per cent range plus, as with the "e" funds, there are no sales commissions.

Use ETFs instead of mutual funds. One of the attractions of exchange-traded funds (ETFs) is that they are cheap to own. In fact, some charge almost nothing! The iShares S&P/TSX Index Fund, which traces its history back to the first ETF in Canada and perhaps the world, has a management expense ratio of only 0.17 per cent. It tracks the performance of the 60 largest stocks on the TSX, making it our equivalent of the Dow. The trading symbol is XIU.

The iShares line-up also includes several first-rate bond funds with low MERs. Given the concern over the impact of rising interest rates on bond prices, my preference at this time is the iShares DEX Short Term Bond Index Fund which trades as XSB. It has an MER of 0.26 per cent.

A word of warning, however. Sector ETFs, actively-managed ETFs, and those which use leverage are more expensive to own. For example, the Claymore Natural Gas Commodity ETF (TSX: GAS) has an MER of 0.88 per cent while the Claymore Global Agriculture ETF (TSX: COW) comes in at 0.7 per cent. The actively-managed Horizons AlphaPro Gartman ETF (TSX: HAG) has a management fee of 0.75 per cent plus a performance bonus if the fund achieves certain objectives. The management fee for the Horizons leveraged bull-bear funds is typically 1.15 per cent.

As well, you will pay a brokerage commission whenever you buy or sell an ETF. So check out the total cost before making a decision. A no-load, low MER index mutual fund may be a better choice in some cases.

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