Mutual Funds Fees 101

Some of my friends, not all since I probably lack credibility in their eyes - the bastards -ask me my opinion on investments from time to time.

For example, somebody asked me about fees in mutual funds and what they represent. I thought this would be a good topic to post about here for novice investors on The Commentator - sponsored by nobody. Incidentally, if you want to advertise on this blog please contact me at 555-4242. That's 555-haha.

I sponsor myself. I answer to no one.

Ok. Moving along.

The fees (known as Management Expense Ratios (MER)) on mutual funds are an important consideration when buying them. They can significantly impact your return on investment. In a way, an MER serves as a reoccurring tax on your return because they're expensive and you pay them on a yearly basis.

When a mutual fund is considered, there are three popular choices to purchase it:

1) Front-end (you pay up front and are not on a schedule giving you the option to sell anytime), 2) Back-end (you defer the payment. Choosing this option puts you on a schedule. Usually five years. If you decide to sell such a fund you will be subjected to a deferred sales charge or redemption chargers based on the original amount invested or the Net Asstet Value (NAV) of the fund at the time of redemption. As your schedule date draws nearer, the sales charge diminishes along with it)
3) No-load typically sold by banks and management companies.

Of course, there are other types but mentioning these is enough for our discussion on MERs.

On top of this, are the MERs charged - not including a broker commission if you use one. More on this later regarding tralier fees and distribution charges.

ADVICE: ALWAYS READ THE PROSPECTUS provided to you. Be careful, while it may seem logical to go with a no-load fund, other factors come into play. For instance, a no-load fund may not be as good as a performer as, say, a front-end one. You have to do your homework. Moreover, no-load funds can (and often do) charge higher MERs. Someone has to pay the broker's trailer fees. What God giveth he taketh.

Dad, what's a trailer fee? I told you son, I paid that trailer 100 bucks now go haul wood chips! Seriously, a trailer fee is a commission paid annually by mutual fund companies to sales representatives for on-going services to the client. They generally range between 0.25% and 1% based on the assets of the customer. They're paid out from the MER or through something called a "Distribution Charge" which can be paid out quarterly or yearly. Either way, they both impact your returns. You can debate whether a trailer fee is necessary (conflict of interest between broker and company immediately springs to mind) amongst yourselves. As a point of interest, investment advisors can earn a living of these residuals alone.

Back to MER's. What? You thought that was it? So young. So impressionable.

Uusally, as a very rough rule of thumb, the best way to view an MER is to subtract it from the annual return of a particular fund. If a fund claims it returns 8% and the MER is 2.5%, you reduce it by this amount. In this case, you're left with 5.5% return.

Life is all about context, at this point you have to compare what that 5.5% return represents with other forms of investments like real estate and bonds. But that's not the point of this post. Given how MER's are calculated (generally on the asstes held in an entire management portfolio and not the performance), if you have an underperforming fund, the combo between fees and bad returns can be devastating in the long-run.

What does the MER pay for? Stuff like the mutual fund manager's salary, legal and custodial fees, audits and commissions as mentioned earlier. It costs money to run things, you know.

MER's charged are higher in Canada than in the U.S. (surprise, surprise) and run anywhere from 1% to 3%.

In the past, I have spoken to mutual fund reps about any plans to cut MER's. All of them admitted they were high and that companies were working towards lowering them but according to them, the costs of running a fund are extremely high.

Hope this helps. If it doesn't, buy my murder-mystery book and DVD titled "Who Murdered My Returns?"