Investing in Mutual Funds? Here’s How the High Fees Are Costing You

Most mutual funds just aren’t worth it. Here’s why.

Index funds

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When I turned 18, my parents told me to “go invest.” I didn’t know who or what to trust, so I naively went to my local bank and spoke to a “financial advisor” (aka salesperson). After being asked some know-your-client questions and filling out a questionnaire, I was presented with a list of mutual funds.

I remember the advisor taking pains to highlight the great past returns of the actively managed (read: more expensive) options. When I asked about fees, I received a simple calculation of how much the annual management expense ratio (MER) would take out of my holdings.

Eight years later, I now know that the impact of the high MER doesn’t end just there. Turns out, it can cost you dearly in terms of missed returns in the future. I have since switched to a low-cost exchange-traded fund (ETF) portfolio, and today I’m going to explain why you should as well.

Understanding MER

The MER is simply the combination of a management fee paid to the mutual fund’s manager and the other trading/administrative expenses they incur. It is expressed as a percentage taken out of the underlying assets under management (AUM) on an annual basis.

For example, a passively managed index mutual fund with an MER of 1.0% (the average in Canada), will cost an investors with a portfolio valued at $100,000 a fee of $1,000 annually. A passively managed index ETF with the same holdings might have an MER of just 0.10. This will cost that same investor just $100 annually.

So, right off the bat, we see a huge difference, and that’s just the passively managed cheaper funds. The actively managed funds that try to “beat the market” can have an MER of up to 2%, despite the fact that the majority of them fail to outperform an average index fund.

The opportunity cost

There is a concept called “the time value of money.” Put simply, a dollar invested today is worth more years down the line. If we apply this line of thinking to high mutual fund fees, we see right away that we are losing a substantial amount of potential future gains.

Consider this example: I have two fund both tracking a globally diversified portfolio of equities that earns a CAGR of 7%. One is an ETF, and the other is a mutual fund. The ETF’s MER is 0.24%, and the mutual fund’s MER is 2.23%. Let’s assume that two different investors put in $10,000 each to start and an additional $500 monthly for 25 years.

The difference is astounding. The second investor lost out on six figures’ worth of gains because of the higher fees they paid. For a retirement portfolio, this could mean the difference between retiring earlier or a higher safe withdrawal rate. The 2.24% MER was a significant source of drag, essentially burning money that could have been compounded.

The Foolish takeaway

Ditch the mutual funds, unless the MER is low (below 0.50%). Being able to buy fractional shares and set up auto-contributions has completely negated any advantage they might have had.

Canadian investors are better off writing an investment policy statement to follow and then setting up a self-directed investment account at one of the various brokerages.

From there, you can invest in a globally diversified, passively managed portfolio of stocks and bonds using low-cost ETFs, with MERs of 0.24% and lower.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

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