Canto 10

Costs

I've talked about lots of ways to invest, and lots of kinds of investment. One thing they all have in common is that it costs money to invest in them. There's nothing inherently wrong with that. There are people employed to organize these investment systems and they deserve to be paid. Many investors also need help with investing: advice on where to put their money, retirement planning, tax planning, and other services. If you need that help, you should certainly pay for it. You should not be paying for help you don't need, however, and you should have your eyes open about what the costs actually are.

What kinds of costs are there?

There are costs associated with buying or selling an investment, including:

There are also costs associated with holding an investment, including:

There are also fees you pay to an advisor who helps you determine what investments to buy and sell. Some advisors work on a fee-only basis, charging you a flat rate or a percentage of your assets. Others make their money from commissions on the things they get you to buy and sell.

Why is this important?

Let's say you've done your homework on asset allocation and realized that to meet your goals, you probably need to invest $5,000 in a stock fund. There are lots of mutual funds and ETFs to choose from. In Canada, most mutual funds are sold without an upfront fee, so we'll neglect that cost. On average, the total of ongoing management fees and expenses (called the Management Expense Ratio, or MER) is about 2.1% per year for Canadian mutual funds. If you decide to buy an ETF instead, you'll have to go through a broker so you'll pay a commission. Online brokers charge as little as $10 for an ETF transaction. The average MER for Canadian ETFs, many of which are index funds, is about 0.42%, or roughly a fifth of the MER for mutual funds.

If the 2.1% MER mutual fund and the 0.42% MER ETF both invest in the same collection of stocks and they have average performance (for Canadian stocks), they will both rise about 9% per year on average before expenses. In the first year, the mutual fund will earn $450 and will charge you $105 for management and expenses, so at the end of the year it will be worth $5.345. With the ETF, we'll assume you took the $10 commission out of the investment, so you actually started with $4,990 in the account. The earnings are therefore only $449. But the management and expense fees are only $20.96. At the end of the year, you would therefore have $5,418.14 in the account. If you kept them both for 10 years and the returns continued at 9%, you'd have about $9,744 in the mutual fund. The ETF fund would be worth about $11,366, more than $1,600 more.

So, all things being equal, investing in more expensive types of accounts is going to cost you an enormous amount of money over the course of a lifetime of saving and investing. Costs are something you can control if you pay attention, so you should pay attention to them.

Are all things equal?

Investment advisors and sales people will try to convince you that the mutual funds that charge high management fees do so because their managers are really smart and will beat the market compared to the low-cost funds. They are lying. They have a good reason to lie. Part of the MER charged by mutual funds goes into something called "trailer fees." These are fees annually paid to the advisor or salesperson who sold you the fund. The higher the MER, the more the fund can afford for trailer fees and the more money goes into the pocket of the advisor. It's possible that many of them believe the lie themselves and genuinely believe their products will outperform lower-cost funds, but if so they just haven't done the math.

On average, the managers of large investment funds will not beat the market, because they are the market. Only about a third of shares (this stat is from the U.S.) are owned directly by individuals. The rest are in mutual funds, ETFs, company pension funds, government funds, or are owned by international investors. So the professional money managers make most of the market. On average, they cannot outperform themselves. Some will do better than others for a few years, but the longer the period you examine, the less likely it is that a particular fund will continue to stand out.

Jim Yih on the website retirehappy.ca has studied Canadian mutual funds and how their average returns related to their MER. His results have been fairly consistent over several different periods. Most recently he found that of the top-performing funds over a 10-year period, 72.5% had low MERs and 27.5% had high MERs. For fixed-income funds (bond funds) the difference is even more stark. 97.5% of the best funds over a 10-year period at below-average MERs. Large studies in the US have found the same thing. On average, a mutual fund with a 2% MER will return about 1% less net return to its investors than a mutual fund with a 1% MER.

If a manager of a high-cost fund wants to try to beat the market, he has to find some kind of edge. In an efficient market, research can only have limited benefit, because the information is widely available to everyone and is supposed to be released at the same time for everyone. Typically, to get the edge they need they end up investing in riskier securities to chase higher returns. That can pay off for a while, but in the long run some of those risks come true. I think that's why the funds that outperform for a while eventually fall back.

Therefore, I think the answer is yes, all things (except costs) are basically equal. Assuming you're choosing from among funds with the same basic strategy (like investing in large Canadian stocks, for example), it's a crapshoot to try to pick the one that's going to outperform for the next ten years. Maybe it will be one that did really well for the last ten years, or maybe it will be one that did poorly for the last ten years and is about to turn around. The point is that you can't predict that, because past performance doesn't necessarily indicate future performance, but you can predict costs, because the past MER is likely not going to change much in the future.

What costs should you be paying?

If you really feel out of your depth, you might need an advisor. Fair enough. Before you hire one, try to figure out what the total cost is going to be. This should include not just the fees the advisor charges directly, or any commissions s/he makes on your transactions, but also the MERs of the funds s/he is going to recommend to you.

If you are buying things through a broker, you can choose anything from an on-line discount broker to a full-service broker with an office you can visit. If you use the on-line brokers, some of them charge as little as $10 commission for a transaction, but the tradeoff is that you're pretty much on your own to figure out how to do it. If you need more help, it might be worth the money to go to a full-service broker.

If you are investing in an inefficient market where better information is probably going to improve performance, you might need to use a fund with active management. Examples might be funds that invest in emerging markets or very small companies.

What's the bottom line?

I think you should be cheap. You can't predict the performance of a fund, so you should try to keep your costs down. If you need more help, by all means pay for it, but make sure you understand how much it is. You might find that it's worthwhile to do some learning, so that you don't have to pay someone else to do something you could learn to do yourself. The hourly rate you effectively pay yourself for doing the work will be surprisingly high!


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Last Updated: 19 December 2014
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