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How to avoid the danger of hidden fund fees Add to ...

This past year, Derek Moran sat down with a client who was looking for investment advice.

The good news was that the client’s portfolio was worth about $2-million. The bad news? The portfolio consisted largely of mutual funds with management expense ratios (MERs) of about 2.75 per cent.

When Mr. Moran, a registered financial planner, broke the news that she was paying about $55,000 in fees annually – a staggering sum that was quietly leaving her account every year – she was understandably upset.

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“She was disappointed that she’d been led to believe that [2.75 per cent] was a fair and competitive fee,” said Mr. Moran of Smarter Financial Planning in Kelowna, B.C. “She was also disappointed in herself for not knowing better and for not asking more questions.”

With RRSP season in full swing, many investors would do well to take a hard look at the costs they are paying. Studies show that about half of mutual fund investors don’t know they’re paying any fees at all. Those that are aware of fees often believe that higher costs are the price for higher returns, when in fact keeping costs low is a key ingredient for investing success.

An annual fee can look small in percentage terms, but when applied to a growing portfolio over many years the impact on returns can be enormous.

Consider an investor who puts $200,000 into a low-cost index fund, then makes additional contributions of $250 per month. Assuming the index fund returns 8 per cent annually – roughly in line with the stock market’s long-term performance – after 20 years the portfolio would grow to $1,132,615.

Now consider what would happen if the investor instead purchased a mutual fund that holds a similar basket of stocks but charges an additional two percentage points in fees, for a net return of 6 per cent. After 20 years, the portfolio would be worth $777,551. So that two-percentage-point difference in fees would have eaten up $355,064 of the investor’s potential returns.

In a move that industry critics say was long overdue, this past year the Canadian Securities Administrators introduced new rules requiring better disclosure of investment costs and performance. For example, firms will be required to provide an annual summary showing, in dollar terms, all of the costs the investor paid.

However, the rules are being phased in over three years and in the meantime many investors still don’t know how much they’re paying.

In some cases “the costs are hidden so people really don’t see them. Some advisers aren’t forthcoming about it,” said Garth Rustand, chief executive officer of Investors-Aid.coop, a website that provides information about investment products and services.

Investors are also partly responsible for keeping themselves in the dark. “People don’t want to think about costs, so they don’t,” he says.

What is a reasonable amount to pay in fees?

For investors working with an adviser or portfolio manager who charges a fee based on assets, a good rule is to aim for 1 per cent annually, Mr. Rustand says. Generally, the larger the portfolio, the more wiggle room the client will have.

His advice is to “negotiate. You do it on cars, you do it on appliances, just do it on your investments. It’s the same as anything else,” he says.

For active mutual funds, several companies – including Mawer, PH&N and Steadyhand – offer no-load funds with MERs between 1 per cent and 2 per cent (or less in some cases).

Investors who manage their own assets can cut their costs even more. A portfolio of index exchange-traded funds (or index mutual funds) should cost no more than 0.4 per cent annually, including commissions to buy and sell, Mr. Rustand says. Investors who shop around can pay as little as 0.25 per cent for a well-diversified index ETF portfolio.

As for Mr. Moran’s client – after her rude awakening about fees, he put her in touch with a portfolio manager who charges less than 1 per cent.

“She’s thrilled,” he says.

 

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