Analytics





The true cost of funds


Most mutual fund investors know that cheaper funds are better funds. After all, if a fund is gouging its investors with exorbitant fees, it will likely underperform its peers over the long term. Yet, just how should we measure fees? Usually, we look at one simple number: the management expense ratio, or MER. This number is readily available on financial Web sites and you can spot it quite easily in fund literature. But, unfortunately, the MER tells just part of the fee story.

To gain a better understanding of the real cost of a fund, you must also look at its trading cost. Whereas an MER pays for a fund's management and marketing expenses, the trading cost covers things like brokerage commissions and the market impact of buying and selling a massive number of shares. More often than not, your fund's MER will pale next to its trading cost, which is not included in the MER. Thought you had a relatively cheap small-cap growth fund that charged an MER of 2%? Think again: once you factor in the trading cost, you might be forking over a whopping 5% of your assets every year.

Clearly, investors should know the total cost of owning a mutual fund before buying it. Unfortunately, trading costs can be tricky to ascertain because-surprise, surprise-they are not disclosed in mutual fund prospectuses. But fear not. I will outline two simple steps you can take to estimate your fund's real cost.

First, determine your fund's basic investment style. There are five major groups: large-cap value, large-cap growth, small-cap value, small-cap growth and index (or passive). As you can see in the chart The hidden cost, each investment style tends to have its own typical trading cost. This cost can range from a low of 0.65% (in the case of large-cap value funds) to a high of 3.12% (in the case of small-cap growth funds). Simply add this typical trading cost to your fund's MER to get the approximate total cost of your fund.

The hidden cost provides a few insights into the somewhat secretive world of mutual fund fees. As you can see, the trading cost of growth funds is twice as high as the cost of value funds. Similarly, the trading cost of small-cap funds is twice as high as the cost of large-cap funds. The reason? Small-cap stocks are usually less liquid than large-cap stocks. That is, they trade less frequently and with lower volumes. Sometimes even a relatively small buy- or sell order by your fund manager can cause the stock price to move up or down substantially before the trade is complete, resulting in higher acquisition costs or lower sale proceeds.

Perhaps more surprising is the fact that the trading cost of a typical index fund is twice as high as the cost of a large-cap value fund. This might come as a shock to those of you who believe that index funds are the cheapest funds going. The reason for the steep trading costs has to do with the structure of an index fund. For example, in the case of an index fund that tracks the S&P 500, each dollar of new money received by the fund must be allocated to 500 different companies, resulting in endless lists of small trades. (In fairness, some index funds do a better job than others at keeping these costs at a minimum.) After total costs are tallied up, a low-MER large-cap fund-such as Scotia Dividend or PH&N Dividend (each with MERs of about 1%)-is as cheap as most index funds that track the S&P 500 or S&P/TSX 60.

Since typical trading costs provide just a rough estimate of the total cost of a fund, you should also look at a fund's annual report to get its portfolio turnover. This precious piece of information is the first thing I look for when I open a fund's annual report, although it's usually buried on an obscure line like "other information." Portfolio turnover measures the volume of trades executed during the year as a percentage of total assets. For example, a portfolio turnover of 100% means that, on average, the fund manager sells his or her entire portfolio of stocks over the course of one year. A portfolio turnover of 200% means the fund owns a typical holding for only six months; 50% means the fund, on average, holds a stock for two years.

A fund with a low portfolio turnover-50% or less-means the fund incurs low trading costs. In other words, the fund's total fees won't be significantly more than its MER and it will probably perform well next to its more expensive peers. By the same token, a high portfolio turnover-more than 100%-means that the fund incurs much higher trading costs that will dwarf its MER. These funds will likely underperform cheaper rivals.

According to Bill Sharpe, a highly respected academic who has done extensive research on U.S. mutual funds, portfolio turnover is one of three crucial factors that can determine how successful your fund manager will be in the future. (For the record, the other two factors are MER and risk-adjusted return.) I agree. I strongly encourage you to consider a fund's portfolio turnover before buying it. In the chart No trading, no cost, I have listed a number of top-performing Canadian equity funds with low turnover rates that deserve your attention. They're cheap. And cheap is good.

Investment style

Typical trading cost

Large Cap Value

0.65%

Large Cap Growth

1.59%

Passive (Index Fund)

1.38%

Small Cap Value

1.60%

Small Cap Growth

3.12%

source: Journal of Investing Consulting, June 1999

 

No trading, no cost: these mutual funds tend to hold onto the stocks they have. With low turnover rates, they don't rack up big trading costs. The result? The funds are cheap

Fund name

Five-year annual return

Annual MER

Turnover rate

PH&N Dividend Income A

9.06%

1.16%

23%

Mackenzie Cundill Canadian Security A

8.82%

2.17%

31%

Saxon Stock

7.82%

1.75%

11%

BMO Dividend

7.60%

1.86%

1%

Standard Life Canadian Dividend Growth A

6.61%

1.93%

5%

C.I. Harbour Sector Shares (U.S.$)

6.52%

2.47%

13%

Mackenzie MAXXUM Dividend

6.44%

2.46%

23%

O'Shaughnessy Canadian Equity

6.36%

1.72%

4%

Royal Dividend

6.21%

1.82%

16%

C.I. Harbour

5.85%

2.47%

13%

source: GlobeHySales and FundScope