Drowning in fees

Percentages are a peculiar thing. When you see '1 percent' it's almost insignificant. When you're charged a 1 percent annual trailer fee on the $1 million dollars in mutual funds you've scrimped and saved for all your life it's $10,000 each year -- and that's very significant.

It's those slivers of percentages that fuel the financial services industry. How they impact your investments is what Your Money Month is all about.

The Ontario Securities Commission is attempting to show the impact of fund fees through its Investor Education Fund website, gettingsmarteraboutmoney.ca. The site includes a mutual-fund-fee impact calculator that tabulates -- to the penny -- how fees add up over time.

The biggest chunk of a mutual fund fee is deducted each year as a percentage of the amount invested through the management expense ratio, or MER. As more funds are added to the portfolio, and it grows in value over time, the fees can grow to dizzying heights.

For example, a $1,000 investment with an annual return of 8 percent over 20 years would produce a profit of $3,661 without fees -- but only $1,807 after a typical 2.6-percent MER.

The MER goes toward paying the fund's operating expenses, which include trading fees, salaries and commissions for staff. It also pays for those slick marketing ads with people climbing mountains or sailing into the sunset.

The average MER for a Canadian equity or balanced fund is about 2.5 percent. That number tends to be higher for segregated funds, which are like insurance products that guarantee all or part of the principal.

Some funds simply cost more to run. International equity funds have higher MERs to compensate for managing a portfolio on a global level, which often involves hiring regional managers. MERs could hit 20 percent or higher for performance-based funds, but most investors don't mind since the fund should perform proportionally well.

Aside from performance-based fees there is often little correlation between an MER and a fund's performance.

Mutual fund companies are required to provide a prospectus for each of their funds containing details on its objectives, strategies, risks, performance, distribution policy, fees and expenses, and fund management. The prospectus can be found on the issuing company's website.

Mutual fund investors can compare MERs through independent websites. The two most popular Canadian mutual fund websites, Morningstar Canada and Globefund, also provide basic information about funds along with analytical tools that rank past returns, fees, risk level, sector and geographic weightings, holdings and management rankings.

It's important not to judge MERs on returns alone but you can start by comparing returns with the correlating benchmark to see whether a portfolio manager has squeezed out enough of a gain to justify the fees. You can also research criteria, including management experience, investment style, risk and past returns.

Mutual fund companies are required to display the MER prominently in a fund's description. However, one detail tucked away within the MER is the annual trailer fee -- the portion that goes to the person who sold you the fund.

In most cases the beneficiary is your friendly neighbourhood financial adviser, who may or may not be giving you advice on that particular fund each year.

Trailer fees, which are fairly unique to Canada, vary from fund company to fund company but could be as high as 1 percent.

Investors might also pay other fees outside of the MER called back-end and front-end loads. A front-end load is a percentage of the initial investment, and a back-end load is a percentage of the total value of the investment at the time it is sold.

In some cases investors can choose between the two, and they are often tempted to forego the front-end payment and pay instead when it is sold. Back-end loads tend to drop percentage-wise after several years but often end up being higher than front-end loads if the fund appreciates in value.

Investors who want lower MERs should consider exchange traded funds (ETFs), for which MERs are generally below one-half of a per cent. Basic ETFs track indices according to geographic regions or sectors. ETFs trade on exchanges just like stocks, so investors pay a standard trading fee when they are bought or sold.

Unlike mutual funds, however, ETFs are passively managed and exposed to the whims of the broader markets, without the benefit of an experienced portfolio manager at the helm.

For a closer look at investment fees, and how to keep more of them in your pocket, Portfolio Builder features an interview with The Globe and Mail personal finance columnist Rob Carrick. Check it out.