There are three important costs related to mutual funds:
- Management fees and operating expenses, paid by the fund for professional portfolio management, investment research, marketing, accounting, record keeping, and legal advice
- Trailer fees, fees paid by the fund to mutual fund dealers
- Loads or commissions, paid by investors when they buy and sell mutual funds
Mechanics of Management Fees
A management fee is a sum that a mutual fund pays its investment fund manager for supervising the portfolio and administering its operations. Although the investor does not pay the management fee directly, it is paid by the mutual fund.
Investors should be concerned about management fees because they reduce the rate of return earned for investors in a fund.
For instance, if a fund earns a 10% return over a year before management fees, and then pays out a 1.5% management fee to its management company, the return to investors will be only 8.5%. The higher the management fee, the larger the reduction and the lower the investors’ return.
When the net asset value per unit (NAVPU) or rates of return are given for a fund, management fees have already been deducted. For instance, the unit values and rates of return printed in financial publications or advertisements have already taken management fees into account.
Despite the above, investors need to be advised by their dealing representative that returns will be affected by management fees. In fact, when choosing investments for your clients, it is prudent to compare management fees of similar funds that share the same financial objectives.
Management Expense Ratio (MER)
|To help investors compare management expenses for different funds, the Management Expense Ratio (MER) provides a standardized measure that expresses the costs of a fund as a percentage of its average net asset value during the fiscal year. To look at it another way, the MER allows you to calculate what percentage of each dollar of fund assets is being used to pay for management services.Mutual funds are required to calculate the management expense ratio by reference to the financial statements for a financial year or an interim six-month period.The management expense ratio is obtained by dividing the total expenses of the fund before income taxes, as shown in the Statement of Operations, by the daily average net asset value for the relevant period.|
|MER = total annual fund expenses per statement of operations ÷ average net asset value for the year x 100|
|*For the purposes of MER calculation, total fund expenses are before income taxes and do not include commissions and portfolio transaction costs. National Instrument 81-106 (NI 81-106) requires a fund to disclose the MERs for the last five years in its management report of fund performance.|
Components of the Management Expense Ratio (MER)
The MER includes the total expenses paid by a fund to a management company and other service providers including the following:
- management fee, including:
- administration of fund operations
- portfolio advisory services
- marketing and promotion
- financing costs
- trailer fees
- operating expenses, including:
- registrar and transfer agency fees
- safekeeping and custodial fees
- accounting, audit, and legal fees
- fund valuation costs
- costs associated with registered plans
- independent review committee fees and expenses
- costs of preparing investor communications
- regulatory filing fees
- bank and interest charges
- interest charges and taxes (GST and sales tax)
Although commissions or brokerage fees and other portfolio transaction costs are shown as an expense in the Statement of Operations, they are excluded from the calculation of the management expense ratio. These fees are captured in the Trading Expense Ratio (TER) and can be found in documents such as the Fund Fact Sheet.
Impact of Fees and Expenses on MER
How Fund Assets Affect Fees
Because fees are based on assets under management, portfolio managers have a strong incentive to increase fund assets. The more successful they are, the more they earn in fees.
For instance, the manager of a fund with $100 million in net assets and a management fee of 1.5% earn $1.5 million in a year. If those assets are doubled to $200 million, the fund manager earns $3 million.
This growth in assets can take place in two ways:
- capital appreciation of the existing assets or
- an increase in the sales of fund units
A fund manager can also increase profits by controlling the costs associated with operating a fund, although these controls have less of an impact on profitability than increasing assets. When costs are lower, there are more assets available for investing against which management fees can be charged.
MERs and Performance
The MER is used to express what it costs to manage mutual funds. Funds that are actively managed, such as equity funds and asset allocation funds, tend to have MERs of 2.5% on average. Money market funds and passively managed funds designed to replicate a particular market index tend to have MERs at or below 1%.
When mutual fund performance data is published, the rates of return reflect the funds’ returns after the MERs have been deducted. Therefore, two funds with the same returns before expenses, but with different MERs, will have different returns after the management expenses have been deducted. The fund with the higher MER will have lower net returns. The management expenses are charged whether or not the fund is performing well, even if it is going down in value. To the mutual fund investor, it is the net rate of return that determines how much his or her investment will be worthwhile staying invested in a fund.
Limitations of the MER
It is important to be aware of the limitations of the management expense ratio. Although the MER is an extremely helpful measure of the cost of owning mutual funds, it falls short of being all-inclusive. For instance, it does not include:
- commissions paid on the purchase of units under the front-end sales charge method
- redemption fees when redeeming units purchased under the deferred sales charge method
- fees payable directly by the investor to the dealer
International Comparison of MERs
It is sometimes argued that the management expense ratios of Canadian mutual funds are among the highest in the world. The truth is that the international comparison of MERs is very difficult.
The MER reflects the prevailing commercial practices, which differ from country to country. Managers and dealers are rewarded differently from one country to another. Unitholders use mutual funds for different purposes. In some countries, mutual funds are long-term investments. In other countries, they are used as substitutes for chequing accounts.
For these reasons, it is very difficult, if not impossible, to adjust for all the differences in commercial practices to allow a meaningful comparison.
Trailer fees are designed as an incentive to dealing representatives and mutual fund dealers to continue servicing fund clients after sales have been made.
Trailer fees are paid by the investment fund management company to its distributors and are in addition to sales commissions. All, or a part, of these fees then flow to the mutual fund dealer and, ultimately, to the dealing representative who is currently servicing the client. The dealer can receive a trailer fee for as long as the investor holds the units of the fund.
The trailer fee is paid by the manager out of the management fees and it is expressed as a percentage of the dealer’s assets under administration, i.e. the market value of the units of the fund sold through the dealer and not redeemed.
The size of the trailer fee depends on the option under which the units were sold. Those figures apply to equity, specialty and balanced funds. Bond funds and money market funds command lower trailer fees.
Does a fund’s management expense ratio (MER) include trailer fees? Above, we listed the fees and expenses included in the MER. Although trailer fees were separated from management fees for illustration purposes, and are not otherwise explicitly included, the manager pays trailer fees out of management fees. As a result, trailer fees are indeed included indirectly in the MER.
Short-term Trading Fees
Mutual funds are intended to be held as a medium to long-term investments. In order to discourage short-term trading in mutual funds, a short-term trading fee is applied by fund managers. In general, short-term trading is defined as selling or switching a mutual fund within a few days, usually between 30 to 90 days, of purchase. The fee charged is between 1-3% and is paid directly to the mutual fund itself. As such, short-term trading fees benefit other investors who are holding the fund for a longer period of time. Short-term trading fees are usually not applied to money market mutual funds.
Fund of Fund Fees
A fund of funds is an investment portfolio where money is pooled and invested in a number of other funds. This type of investment can potentially increase investor diversification and access to investment opportunities. However, the fees charged will include the management fees for the underlying funds as well as a fee for managing the fund of funds. The cost of the higher management fees needs to be considered alongside the benefits of additional diversification access to investment opportunities.
Commissions, also known as loads, are fees that are paid directly by the client. Since loads can take a number of forms, the client decides at the time of purchase how he or she wants to pay this fee. The investor has the choice of either front-end or deferred charges. The time the investor expects to hold the units will be the main factor influencing his or her decision. For a short-term purchase, the front-end option may be preferable, since the percentage charged is likely to be less. However, for a long-term investment the deferred charge may be best because potential redemption charges will gradually decline or be eliminated.
Front-end Sales Charge
The front-end sales charge is a percentage, between 0% and 9%, of the amount of the purchase, payable to the distributor from the investor’s investment amount at the time of purchase. This fee is also known as a front-end load. It is usually negotiable and generally decreases as the size of the purchase increases.
The following formula is used to calculate the purchase price of a front-end sales charge transaction:
|purchase price per share = NAVPU ÷ (1 – front-end sales charge)|
Deferred Sales Charge (DSC)
These are redemption charges that decline the longer an investor owns units or shares. Most deferred sales charges (also known as contingent deferred charges) start at 6% or 7% and fall to zero over time. A redemption fee schedule illustrates how the deferred sales charge decreases the longer you hold on to the mutual fund. Since the fee is not payable until the fund is redeemed, a deferred sales charge is also known as a back-end load. These charges may be calculated based on the price of the original purchase or on the market value of units or shares when redeemed. Deferred sales charges are paid by the investor to the manager of the fund.
Low-load Sales Charge
This fee model is similar to the DSC option described above since redemption charges are payable when units of the fund are redeemed. However, the fee redemption schedule is shorter in length, and the value of the deferred sales charges begins at a lower amount.
10% Free Redemptions
As mentioned earlier, fund units purchased using a deferred sales charge option are subject to redemption fees for the first few years. However, many fund companies allow investors to redeem up to 10% of the value of the fund each year. The amount that may be redeemed will vary among fund companies. In some instances, an investor may be able to redeem 10% of the original purchase price; in other instances, an investor may be able to redeem 10% based on the market value – usually based on the value as of December 31st of the previous year. The 10% redemption amount may be calculated based on the number of units purchased or the dollar value of the investment. The redemption amount is commonly allowed once per year and cannot be carried forward to subsequent years.
The amount redeemed can be used for a number of purposes, including:
- purchasing front-end load versions of the same mutual fund
- purchasing other mutual funds offered by the fund management company
- transferring the redemption value to other investments available with other companies
Many fund companies will automatically switch investors’ 10% free redemption amount into a front-end load fund version of the same mutual fund. In order to comply with MFDA rules, these automatic switches must be done with the consent of the client and with full disclosure of any increase in trailer fees or taxes that will result.
Some funds, known as no-load funds, charge no commission or service fees. A mutual fund is considered to be a no-load fund if an investor does not have to pay any fee or charge to buy or redeem securities of the fund. However, some fees and charges that may be levied when an investor buys units of a no-load fund include the following:
- optional fees or charges for specific services
- redemption fees for funds that are not money market funds if the redemption occurs within 90 days after purchasing the fund
- an account set-up or closing fee to cover the initial administrative costs of opening or closing the account
No-load funds are generally sold by banks and trust companies, although some independent mutual fund firms now offer no-load funds.
Under the commission-based model, the dealer is compensated by means of:
- commissions as front-end loads, or deferred sales charges
- trailer fees paid by the fund manager
Under the fee-based model, the dealer is compensated by means of an overall fee paid directly by the client. The overall fee is expressed as an annual percentage of assets under administration and covers all services provided by the dealer, whether in respect of advice or transactions. There are no additional commissions when the client purchases or redeems his or her mutual fund units.
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