This week we will discuss the many factors affecting your ultimate return from specific mutual fund investments.
This is the second in a two part series about taking a holistic view of all variables before making decisions. Last week’s column covered factors for deciding asset allocation and articulating those decisions in a written Investment Policy Statement.
There are many important factors that can help investors make wise mutual fund investment decisions.
The goal of a fund is to provide a strong return. This is done by increasing the fund’s value by producing revenue while managing its costs and expenses.
The fund’s management expense ratio commonly referred to as the MER is a combination of management fees charged by the management company and the fund’s operating expenses paid by the fund.
The MER costs are paid by the mutual fund and, therefore, reduce the return to the investor. In simple terms if your fund made $100 and the expenses were $5 then the net gain would be $95.
A fund’s operating expenses can be tricky because they have the potential for a conflict of interest. Some mutual funds have a fixed administrative fee charged by their firm to the fund.
Those firms either sub-contract that work to other firms or do the work themselves. There is a conflict because these firms receive more profit if the fees are high or they mark up the costs provided by other firms.
Having a fund structured where the manager profits from higher administration costs means fund investors and fund managers have a significant direct conflict of interest. On a “governance” basis this gets a failing grade.
A firm might promote their MER as being a specific figure. They may add to that fee because of their conflict of interest and their ability to make additional revenue from administration of that fund with no incentive to better manage expenses on behalf of the investors they serve.
The trading expense ratio (TER) covers trading commissions and fees. A more actively traded fund will have higher costs. These are in addition to the MER.
Trading can be expensive. These costs are harder to identify, not reported and can be significant disadvantage to the fund. They come from a need for immediate action such as purchases or sales within the mutual fund.
For example, there is difference in cost between the bid and ask for most security trades. The seller asks the higher price and the buyer offers a lower price.
A trade that is to be done to accommodate the need for immediate action usually accepts the negotiated market offer. While this cost is low, they do add up over the course of a year.
Also, if a fund is gradually buying or selling a stock, the normal pressure of supply and demand will push that stock price up or down from what the buyer or seller would hope to achieve.
This is particularly true with larger mutual funds that buy and sell large quantities of each security where the result can be that they are moving the market price during the period of trading activity.
Security lending is not understood by most investors, but it does happen. A mutual fund owning a security may elect to lend that security and receive revenue to the fund for doing so, which is reported in the fund’s annual financial report. It is an extra source of revenue for the investor.
When a fund holds cash, the investment returns can be reduced. For example, if a fund can make a higher return from investing in stocks over time then holding cash by say six per cent hurts the return. For every five per cent that is held in cash, the drag on the return is close to one-third of one per cent annually.
The final consideration is non-taxable accounts such as a Registered Retirement Savings Plan. Depending on how a particular fund is registered, they can pay foreign taxes that are not deductible from Canadian taxes
All of these expenses affect the performance return of your mutual fund.
Understanding all investment factors including fees and expenses of mutual funds can increase your ability to be an informed investor and help you make better investment decisions.