Websites that offer MER (Management Expense Ratio) calculators and others that offer advice on low MER funds available have resulted in many investors trying to figure out if they are paying too much for their mutual funds or if the MER they are paying is actually eroding their investments over time.
They're right to worry aren't they? Well, sort of.
Let's start off by explaining what an MER is.
Simply put, it is a measure of the total costs of operating a fund as a percentage of average total assets.
In a nutshell, this is the cost that an investor pays indirectly for investing in a fund.
The key is indirectly.
I'll get back to that later.
The MER covers investment management, marketing, administrative costs, and fees to salespeople (called trailer fees).
It is important to note that when you see returns posted in the financial section of the newspaper or on a website.
The returns are almost always quoted net of fees.
This means that the MER has been deducted before the returns are quoted.
In effect, this kind of levels the playing field.
Here's an example: 123 Fund Earnings before expenses 12% 123 Fund MER 2% Reported Return 10% When I said earlier that an investor indirectly pays the MER, what I meant by that is that it is not a voluntary payment or one that is negotiable.
It is taken by the fund company to cover expenses and you as the investor have no control over this.
This is not a bad thing, but you should be aware of the MER you are paying.
As an investor you normally do not receive any benefits for this expense other than the underlying performance of the mutual fund such as the ability to deduct it from your income like some other professional fees.
When it comes to mutual funds, and ETFs (Exchange Traded Funds) for that matter, MERs are just part of life, like it or not.
If you subscribe to the point of view that nothing in life is free then you shouldn't have a problem with MERs, unfortunately many people are having issues with the fees they are paying and sometimes this anger leads to some bad decisions.
Here's another example: 123 Fund Earnings before expenses 12% 123 Fund MER 2% Standard Deviation 8.
99 Reported Return 10% XYZ Fund Earnings before expenses 12% ABC Fund MER 1.
5% Standard Deviation 8.
99 Reported Return 10.
5% Looking at the 2 funds above, we can learn a few things.
They both had the same Return before expenses (12%).
They both have the same risk (standard deviation of 8.
99).
But they have different MERs (2% vs.
1.
5%), which results in a higher net return of XYZ fund.
In this example it is clear, the benefit of a lower MER cannot be argued.
Unfortunately it's rarely this cut and dry.
All things being equal, it is obvious that an individual would choose a mutual fund with a lower MER, but that's the problem, things rarely are equal.
There can often be a great deal of overlap between 2 mutual funds but it is almost impossible to find 2 mutual funds with identical holdings.
This point alone make it impossible to base fund selection on the cost of a fund's MER.
Now let's take a closer look at 2 actual mutual funds.
Fidelity Canadian Disciplined Equity 1 Year: 9.
90% 3 Year: 17.
79% 5 Year: 18.
45% 10 Year: N/A Inception: 15.
54% (September 1998) TD Canadian Value 1 Year: -2.
51% 3 Year: 11.
36% 5 Year: 14.
22% 10 Year: 6.
30% Inception: 9.
30%(December 1993) *All figures as of April 30 th 2008.
Source: Globefund.
com Here's an actual example using 3-year figures: Fidelity Canadian Disciplined Equity Earnings before expenses 20.
02% MER 2.
23% Standard Deviation 11.
5 Reported Return 17.
79% TD Canadian Value Earnings before expenses 13.
45% MER 2.
09% Standard Deviation 11.
6 Reported Return 11.
36% Again, looking at the 2 funds we can learn a few things.
They are both Canadian Equity funds that have roughly the same degree of risk over the past few years, but oddly, the fund with the higher MER also has the higher reported return over the 3-year period.
We can also read between the lines and determine that the holdings within each fund must be different to result in such a broad range of performance over the past 3 years.
So, what does this do to the theory that a lower MER is better for the investor? The answer is that it is not conclusive proof that a lower MER is better or worse for an investor.
The above is only one of thousands of examples.
Some examples will show that a lower MER provides a higher net return and some wont.
So where does this leave us? The answer may upset you, but here it is.
MERs are irrelevant! To put this in perspective, and to make sure you don't get the wrong idea, I'd better explain what I mean.
Again, all things being equal, a lower MER is in an investor's best interest.
We all know things aren't equal and human beings manage mutual funds and some human beings are better than others at their jobs and the world doesn't always react the way we expect etc etc.
The bottom line is that it's the net return to the investor that's most important.
Obviously a company that has lower fees will have an easier time delivering a higher net return but there's no guarantee that this will always be the case.
If you build a portfolio that focuses first on sourcing funds with the lowest MERs, you may actually be doing yourself some harm.
First, focus on funds that provide the highest consistent return in any category with the least amount of risk.
Beyond that things can get a bit more complicated when you consider that you want to reduce duplication in management style while maintaining exposure to as many different asset classes and diversifying geographically at the same time, but that's another story.
The bottom line is that MERs shouldn't play as big a part in your selection of funds.
Instead, focus on the net return.