Tuesday, February 28, 2017

When is the MER not what you think it is?

Although I don't follow the model portfolios exactly, I am a big fan of the principles of the Canadian Couch Potato. It has demonstrated the virtue of staying invested in a diversified, low cost, small and easily understood set of broad index funds.  It is called couch potato since you rebalance about every year, but otherwise just leave it alone. The simple couch potato portfolio has had solid performance and limited volatility over the long run, bettering many mutual funds, all with very low fees.

I suspect most readers are already very familiar with the Canadian Couch Potato  but in case you are not, I urge you to regularly consult their website, and to give full consideration to their model portfolios. Recently they have also started a podcast series that I also recommend.

The folks at Canadian Couch Potato have model balanced index portfolios for conservative to aggressive investors. They show how to implement them using ETFs, Tangerine investment funds, or TD e-series products. Interestingly, the long term performance only varies slightly across the different risk portfolios, but that is a topic for another post.

The other day I was examining their ETF based model portfolio (see screen capture below), and I was struck that the values they gave for weighted MER for each portfolio seemed too low to me.
Screen capture (Feb 2017) of the Couch Potato model ETF portfolios. Note the weighted MER line.
Although I don't hold the BMO bond ETF ZAG, I had recalled that the MER for it was 0.23%, and I knew that the Vanguard Canada broad Canadian equities ETF VCN (which I do own) has a MER of 0.06% and the iShares All World Except Canada equity ETF XAW (which I also own) has a MER of 0.21.  Even without a calculator, there was no way, using these numbers, the weighted average MER on the conservative couch potato portfolio would be only the 0.12% stated.

Just to be certain, I first checked with both morningstar.ca and with BMO directly, and sure enough both currently (late Feb 2017) give 0.23% as the MER for ZAG. I proceeded to calculate the weighted MER for some of the portfolios using that value, and for the conservative model portfolio it was 0.209%, versus the Couch Potato value (see screen shot above) of 0.12%, while for their balanced portfolio, with 40% Zag, 20% VCN and 40% XAW, I calculated a weighted MER of 0.188 versus the stated value of 0.14.

I could see from the weighted MER values in the model portfolios that the difference must be in ZAG, since the differences were higher for the portfolios more highly weighted in that, so I dug around a bit more. The ZAG MER value that they used in their calculations was 0.10%, not 0.23%, I was able to determine by backward engineering from the weighted MER. If I assume that value for the ZAG MER, I obtained 0.118 for the conservative portfolio and 0.136 for the balanced one, both consistent with the weighted MER given on the Canadian Couch Potato site. So you ask, which is the correct value for the ZAG MER, 0.23% or 0.10%?

The stated MER for funds is normally obtained from audited financial statements.  Of necessity that is based on results from the recent past, since the auditors only get to work after the financial documents for the financial year have been completed. In the BMO ZAG case an asterisk notes that the MER is based on the 2015 year audited statements.

Since that time, BMO have announced lowering of management fees on a number of their ETFs, including this one. For ZAG, they lowered the management fee to 0.09, and they estimate that that will result in a current MER of about  0.10. Problem solved.

There are several implications for investors, however. The true MER is based on audited financial documents.  Since management fee is the dominant component of most ETF MERs, if that is announced as lowered, we can expect the MER will drop by a similar amount. For most ETFs the MER is pretty stable from year to year.  If the MER has dropped significantly, we need to evaluate whether we are confident that it will stay at this lower value, and if the return of the fund will change due to the different amount of investment advice, supposedly related to the management expense.

Secondly, when making long term ETF choices and comparing similar products, it is important to go beyond the stated MER, to make sure that there are not significant recent changes that will influence the current and future effective MER. For example, with the previous MER for ZAG, it appears obvious that the similar bond ETFs VAB from Vanguard Canada and XQB from iShares have lower MER values.  That situation is reversed, however, with the lowered management fees for ZAG.

While the MER is to be based on audited statements, the management fee can be adjusted to the current value.  An easy way to check if there has been a significant change is to examine both the MER and management fee for the fund you want.  Normally the management fee makes up most of the MER.  If they are very different, check around for announcements of recent management fee changes, and in particular check company statements about whether the lowered fees are temporary or a long term change.

Some readers will correctly point out that the difference here is small enough that it may well be lost in your overall financial fees.  If you had invested $10,000 in ZAG the difference per year in the two MER values would be $13.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds the following ETFs mentioned in this article: VAB, VCN, XAW and XQB.

Sunday, February 26, 2017

Review: The 3 Simple Rules of Investing

A few months ago I read the excellent book, The 3 Simple Rules of Investing, by Michael Edesess, Kwok L. Tsui, Carol Fabbri and George Peacock. In their book, they make the startling statement that "everything you've learned about investing is wrong".

So what are their three simple rules?
  1. Simplify Your Options
  2. Look Only Forward
  3. Tune Out Noise
You will need to read the entire book to hear their rationale, but not surprisingly they favour broad, low cost index funds over specialized investing instruments.  They also favour a long term approach, and to 'tune out' the vast majority of advice you will hear or read from financial writers and advisors.

By look only forward, they warn against placing too much faith in how a certain fund has done in the past. As we all know 'past performance does not guarantee future results'. For example, as David Berman (among others) has written, the simple strategy of investing in the Canadian big bank that performed worst in the past year, yields better results than trying to pick the best bank stock in more sophisticated ways, or holding a basket of banks.
As well as their three simple rules, the authors identify seven deadly temptations.   Some of these are obvious and widely accepted, such as 'Don't try to beat the market', while others may seem contrary to common sense.  They urge small investors to not follow what most wealthy and sophisticated investors do. This is not because it would be difficult or impossible, but rather because most high worth individuals use high powered financial advisors and typically pay large fees for expert advice. There is little indication that this advice has resulted in better investment returns. Warren Buffett has emphasized this point in his 2017 statement, making the claim that high worth individuals have spent $100 billion in unnecessary fees.

While I would not agree with everything in the book (for example, I believe they argue for too much simplification), I do support the main tenets. I certainly recommend that you read this book as one part of your investor education. As one Amazon reviewer has written "If you read only one investment guide in your life, make it this one elegantly boiled down to the essence of what makes sense and makes money."

I agree 100% with their statement: "Don't trust it all to the expertise of someone else". Indeed my decision to start this site was largely because I fear that too many trust too blindly in investment advice. You can, and should, learn about your financial options, and you should take ownership of your financial future.

It's interesting that they also warn about over reliance on modern 'scientific' financial theory. That will be a topic for some future column.

Some of their advice is very practical, and can be immediately applied to your portfolio.  They argue that it does not make sense to hold a large number of specialized funds for diversification, if in total they essentially mimic the entire equity market.  Why not just get one total market fund?

I highly recommend The 3 Simple Rules of Investing!

From time to time I will review investment books.  Have a favourite?  Why not leave a comment, and we will consider making it a topic for a future column (or if you prefer to review it yourself, we welcome guest posts.)  If you were going to read three Canadian investing books, what would they be?

This column is intended for education only. The reader is responsible for their own financial decisions.  The writer is not a financial planner and reading this column should not be interpreted as obtaining individual financial planning advice. For major financial decisions it is always wise to consult skilled financial professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader. 

Disclosure: I have read this book and have no association with the publisher or authors.  I did not receive a copy of the book, or any other benefit, for writing this review.

Saturday, February 25, 2017

If you can use Facebook, you can manage a discount brokerage account

The majority of individual investors have so far shied away from opening a discount brokerage account. I think the main reason is that they view the process as more complex than it really is.

I am an occasional Facebook user, but I must say, even though I consider myself overall moderately online sophisticated, I find aspects of the Facebook interface intimidating. Yet from early teens to grandparents, there are almost two billion Facebook users worldwide.  There is no doubt that most people can become proficient Facebook users, and value the experience. I would argue that operating an online discount brokerage account is no more difficult than using a Facebook account. Indeed, for me I find it simpler.

Overview of a Discount Brokerage Account

Let's start from looking at how a discount brokerage account works. With a discount brokerage account you purchase and sell individual stocks from the Canadian and US markets, as well as bonds, and exchange traded funds (ETFs).  Most discount brokerage accounts also allow purchase (and redemption) of mutual funds, and many also give you access to investment savings accounts and guaranteed investment certificates (GICs).

Most individuals will want to open several accounts, for example an unregistered account, an RRSP and a TFSA.  These will all show up in your list of accounts when you log on to your discount brokerage account. You will have an account number (and/or user name) and password to log in to all of your accounts at once held in your discount brokerage account. The display will show you the list of holdings in each account, along with information on how well each has performed.

Your discount brokerage account will also normally be linked to one or more external bank accounts, and you will transfer funds into or out of the brokerage accounts from these accounts. You fill out forms, and use a cheque, to initially set up these linked accounts.  For accounts with the same financial firm (e.g. Scotiabank bank accounts with a Scotia iTRADE account), the transfers will normally occur immediately, while linked accounts to another financial institution will normally take two days for funds transfer.

Each discount brokerage account will have a cash component, or possibly two, one in US funds and one in Canadian funds. These cash funds normally earn no interest, so you generally only keep small amounts as cash in the long term.

You use funds available in the cash component to buy stocks, ETFs, bonds or other items.  The process for a stock or an ETF purchase are identical, since they are both traded on a stock exchange.  You purchase these in numbers of units, and you must find the code for the stock or ETF you wish to purchase. For example, if you wanted to buy the Bank of Nova Scotia on the TSX the code is BNS (sometimes written as BNS-T to indicate the Toronto Stock Exchange).

 In a future post we will talk about how to decide how much to offer to pay, but in general you will use what is called a Limit price, which means you set the maximum amount that you are willing to pay. You can also specify how long you want your offer to purchase to remain open, from the current day up to several weeks in the future, and may select options such as only complete the trade if it is possible to trade the full number of units.

Before it is confirmed, you will have an option to check your order, making sure that the code for the stock and the price/time period are both correct. Normally you use a second code, different from your password, as trading confirmation.

When the discount brokerage finds a seller willing to sell that stock or ETF at your limit price, they will conduct the sale on your behalf, and the units will then show up in your list of holdings.  It is possible that they will purchase the units from several different buyers, so they may not all show up at the same time (or ever). You have an option to cancel an order that has not yet been filled.

You pay a commission on most purchases (there are exceptions we will cover in a future post), both when you buy the units and when they are sold.  For this reason, it is normally not wise to purchase small numbers of units, but rather save until you have sufficient funds to buy a larger number.  The commission charged typically ranges from about $5 to $15.

When you are ready to sell stocks or ETFs, the reverse process is similar.  You set a price, and time period, and your discount broker will seek to find a buyer, and when the units are sold they will disappear, and cash will appear in your cash part of your discount account, where it can be transferred to other bank accounts.

Note that there is a delay between when the sale or purchase occurs, and when the transaction has settled.  It is only when it is settled that the funds are available to transfer out, although your discount brokerage may allow you to use the funds for another purchase in the interim.  The delay from trade date to settle date is normally 3 to 4 days for stocks and ETFs.

With most discount brokerage, unless you pay a higher fee, you must place the order during regular trading hours (9:30 am to 4:00 pm Ontario/Quebec time).  You can set the time period as over a number of days or even weeks, but you must place the order when the stock exchange is open.

Purchase of mutual funds is similar but simpler.  These are normally purchased in dollars (rather than number of units), and you don't set the price as it will be at the current price automatically. The mutual fund will have a code which includes letter for the fund company and a number for the type of mutual fund.  For example, MAW104 is a balanced mutual fund from Mawer. You can place the mutual fund order at any time, but there will be a certain time that is used to determine which day's fund price will be used for the purchase.

The bond process is somewhat similar, but different enough we will not cover it here.  Our recommendation for most individuals is to hold your bonds through ETFs, rather than through direct bond holdings.  We also have not covered items such as margin accounts, which we do not recommend, at least for someone beginning with a discount brokerage account.

What a Discount Brokerage Account is NOT

A discount brokerage account is not a financial advisor.  While there are tools that will allow you to research information on mutual funds, stocks, exchange traded funds and ETFs, a discount brokerage account is not intended to offer you any advice on what you should hold in your portfolio.  It is a tool to buy and sell investments, not guidance on what those investments should be.

You are in charge, and you make the decisions of when and what to buy and sell. Your discount brokerage should provide an easy to use interface to do this,  at a reasonable cost. It should provide transparency on your holdings and their performance over time.

Canadian Discount Brokerage Companies

The major banks offer discount brokerage accounts, as do a number of other companies.  Here is a list of some of the main players in the Canadian market.
Rob Carrick regularly reviews discount brokers.  Moneysense also review discount brokerages.  I strongly recommend reading these reviews to narrow your choices, but then consider the list below on what to look for in a discount broker to see which is the right fit for you, rather than simply going by the overall letter rating.

What to Look For in a Discount Broker

We could write a number of columns on what to look for when selecting a discount broker, but at this time will offer a list of some features.  You should decide which are most important to you.
  • Commissions Since most trades will result in commissions, both at the time of purchase and sale, it is important to be clear on these costs.  Some companies will have different commissions depending on how active you are as a trader, and/or how much you have invested, so be sure to know the commission that will apply to you.
  • Other Fees  Some companies have other fees for certain types of accounts if the amounts held are less than a certain minimum.  There will also normally be fees for closing an account.  Be clear on the other fees that you are likely to incur.
  • Exchange Rates  If you plan to hold US dollar stocks or ETFs find out how currency exchange works, and whether you can hold cash in US dollars (for example if you sell a US stock, and then want to use that money to buy another US stock, can you keep it in US funds to not incur two currency exchanges).
  • Ease of Use  Some discount brokerage accounts are easier to use than others, so try to use independent ratings to narrow your search to two or three finalists, and then have them demonstrate their platform before you make your final selection.
  • App Most discount brokerages have some sort of app to use with their accounts, but this may have limitations compared to the full web access.  If this is important to you, check out the features and ease of use of the associated app on your platform of choice (iOS or Android).
  • What Can You Buy  If you plan for your portfolio to hold mutual funds as well as stocks and ETFs, make sure that your discount brokerage allows this (and not just for mutual funds from that financial institution). If you would like to hold GICs within your investing accounts, see if that is available.
  • Research While there are many sources of research outside of your discount brokerage, it is certainly convenient if you can get detailed research information, including analyst reports, within your discount brokerage account.  Ask what is available before you make your final decision.
  • Reports You don't want to have to separately manage reports so that you will know how much income your LIF or RIF accounts will generate in the next year, or what the overall past performance of your different accounts have been.  Make sure that this, and more, is readily available. When you sell instruments you will need to pay capital gains income tax on the profit, so it is important that Realized Gain/Loss is also readily tracked.
  • Linked Accounts Make sure the process is easy to link ideally more than one bank account to your discount brokerage.  If you find everything else about equal, there are advantages to setting up your discount brokerage account with the institution you currently bank with.
  • Stability It is cumbersome to change discount brokers, so make your initial choice carefully.  Consider how stable the institution is, and how confident you are that they will still be operating in the discount brokerage field in 20 years (or whatever your investment horizon is).
  • Special Features  Almost all of the companies will offer special features, like inducements to set up an account (agreeing to pay transfer fees or offering so many free trades), items that will have no commissions on purchase or sale, etc. Is a practice account important as you get familiar with trading, and if so is one offered? One advantage of the TD Direct Investing is that it provides access to the TD e-Series. Scotia iTrade have about 50 commission free ETFs if you set up your discount brokerage account with them.

Final Thoughts

If you still feel that a discount brokerage is not for you, you may want to consider a financial advisor who will, in addition to offering advice on what you should hold in your investment portfolio, assist with the mechanics of purchasing stocks, ETFs or mutual funds on your behalf.  Discount brokerage firms such as Scotia  iTRADE have forms that allow you to designate someone as a trading authority on your account.  The account will be yours, but they will be able to make trades on your behalf (but not withdraw funds from your account).  It is sort of like learning to fly, having a pilot and co-pilot, either one of which can run the show.  If you feel comfortable giving this role to a trusted family member, your designated trading authority does not need to be a financial professional.

If you don't want to get involved at all in a discount brokerage account, then a robo-advisor might be the best choice for you. We will cover these in a future column, but essentially you provide a profile online about your situation, plans, risk aversion, etc., and the robo-advisor will make a choice on how you should be invested, and purchase the instruments (usually ETFs) for you.

Another option is to use a balanced mutual fund, which can be purchased through an institution or advisor or directly in some instances such as the Tangerine Investment Funds).

But our central argument is that operating a discount brokerage account is not rocket science.  If you do online banking to pay bills and transfer funds, you can learn to handle a discount brokerage account. If you use Facebook proficiently, you are already over-qualified, in my opinion! With a discount brokerage account you will have access to many excellent low-cost investment vehicles that are not otherwise available to you.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column has a number of discount brokerage accounts, registered and unregistered, held through Scotia iTRADE, and has been a long term investor using that platform since its inception. No compensation by any company, organization or individual has been offered, requested or received for writing this column, and no association is implied.

Wednesday, February 22, 2017

Diversification: Don't Grow Only Tomatoes!

Returning to our garden metaphor, let's assume you have a large parcel of agricultural land and that you want to make money by growing crops on it. While an analysis could be done to indicate, from crop yield and historical crop selling prices, what one crop would give you the most money per area for your farm land. Indeed, if your only goal is to have the largest statistical return on your farm investment, growing that one crop is the best choice.

Let's say you have determined that the optimum crop is tomatoes. If you have only one crop though, your risk will be higher when you grow just tomatoes than if you had a mixed garden. The reason for this is an event such as a late frost, a blight, or a pest that affects only tomatoes could wipe out almost the entire crop for a year.

If instead you grow a number of different crops, it is likely that environmental or other factors will not affect them all equally.  In fact, a cold wet season that is bad for some crops may be good for other crops.


The idea of investing in different sectors to limit risk is called diversification. For individual investors while return on investment is important, limiting risk is also crucial.  For those in or near retirement, the need to limit investment is even more critical, since there is less time to rebuild after major stock losses.

A similar situation applies to investments, where diversification across different investments can help limit the amount of risk.  This is because changes in the economy affect different regions and industries differently. While rising interest rates might be negative for one industry, it  might be positive for another, while another is not interest rate sensitive at all.

We can diversify by making sure we hold enough different stocks, and that those stocks represent different types of companies from different regions.  It is also critical to hold bonds as part of your diversified portfolio, and possibly other investment types.  The next section provides more detail.

Types of Diversification

So how do you effectively diversify?
  • Stocks and Bonds  Generally speaking high quality bonds go up in value when stocks go down, and vice versa, so having a mix of stocks and bonds is the first rule of diversification.  The exact mix will depend on your risk tolerance and financial situation, generally holding a higher amount in bonds later in life.
  • Different Industries Sometimes overlooked is the importance of having a good mix of different types of industries represented in your portfolio.  You could be invested across the entire Canadian stock exchange, and still not have good industry diversification, since financial institutions and energy play such a large role in the exchange.
  • Different Regions While the global financial world is interconnected, and it is likely that major stock losses in one region will influence others, that does not mean that they will be equally affected.  As well as Canada and the United States it is important that you have holdings in the rest of the developed and emerging markets too.
  • Alternative Investments While stocks and bonds have been the traditional base for most investment portfolios, alternative investments, things like real estate trusts (REIT) or infrastructure, can further diversify your portfolio. These alternative investments can be particularly important if you need regular income from your investments.
  • Types of Bonds As well as having bonds as part of your diversified portfolio, those bonds themselves should be diversified.  Your rate of return will be higher on bonds with longer durations, but longer duration bonds will be more sensitive to interest rate changes.  Also, a mix of government and corporate bonds is probably appropriate. Finally, it may make sense to hold some bonds, or similar instruments, that adjust their value according to interest rates.
  • Different Sizes Sometimes the largest companies in a market perform better or worse than the smaller companies.  Therefore we can add a bit of diversification by having instruments that hold companies of varying sizes, not just the largest 60 in the TSX or the largest 500 in the Dow stock exchange in the US.
  • Commodities I do not personally hold commodities in my investment funds, but some argue that this is yet another way to diversify, especially if one holds a mix of precious metals, oil, minerals and other commodities.
  • Cash-Like Instruments Sometimes overlooked is the importance of having some funds in things like investment savings accounts or GICs.  With these a part of your portfolio is fully protected, and they can help you weather a significant stock market crash. If you use your investments to fund your retirement through income, we recommend at least a year worth of funds in these instruments.
Our list is somewhat longer than many diversified portfolios. In our view the current economic climate, with interest rates very low, the major developed economies having high valuations, and considerable political and economic uncertainty around the world, we feel it is important to be more diversified than was required in the past.

Achieving Diversification

Upcoming posts will show how you can achieve a diversified portfolio using different instruments - mutual funds, ETFs and other options.  At this point we will briefly mention two possibilities that may appeal to starting investors.
  1. Tangerine Investment Funds  If you are a Tangerine customer, it is easy to add one (or more) of their balanced investment funds. These have relatively low MER, are easily purchased in small amounts, funds can be transferred from existing accounts, and you don't need a discount brokerage account. There are a family of funds with differing stock to bond ratios.  For example, their IN220 Balanced Fund has 40% Canadian bonds, 20% Canadian stocks, 20% US stocks and 20% international stocks.  The fund has a 5 year average annual performance of 8.1%, and the MER is 1.07% with the TER an additional 0.02% (see here for a description of these terms). There is no exposure to alternative investment classes in this fund.
  2. Balanced Mutual Fund There are thousands of balanced mutual funds, we will mention only one  choice here as representative of the better choices. The PH&N RBF1350 fund, now part of the RBF family, is a solid balanced mutual fund with a reasonable MER of 0.88% (if purchased in the D form through your discount brokerage). It holds about 36% bonds (mainly Canadian), 29% Canadian stocks, 17% US stocks and 15% international stocks, along with a few percent in cash. Over the past five years it has averaged almost 8.7% return. You may need a discount brokerage to get this MER with no other fees, but you can readily buy forms of this fund through financial institutions. You can start with as little as $500 initial investment.
  3. Balanced ETF Fund While there are ETFs that are a balance of stocks, bonds and other investments, as Andrew Hallam has lamented, the time is long overdue for a simplified, effective couch potato type of balanced ETF. iShares do offer a number of options, including the XGR Growth Core Portfolio ETF that is well diversified, including alternative investment classes. It has a comprehensive MER of 0.64%, and the 5 year average annual performance has been 5.5%. You will need a discount brokerage to purchase it, and unfortunately it is only thinly traded so you may need to be patient or pay a bit of premium to get units of it.  Two other 'fund of funds' from iShares that you may want to consider as a one stop ETF are CBD and CBN.  We will analyze these in more detail in a future post, but CBD has a tilt towards bonds and other income products, while CBN is tilted towards a balance of equities from around the world.
  4. Set of ETFs Of course it is easy to build your own diversified balanced set of holdings within a discount brokerage. The Canadian Couch Potato provide guidance on how you can do exactly that, at a very low cost. I am a fan of their approach, and especially for those far from retirement, I think one of their model portfolios makes good sense.  Nearer or in retirement, I personally choose to add some additional types of diversification (see above). In a future post I will look at ETF options for balanced accounts in more detail.
Final Thoughts
While the degree of diversification depends on your investment horizon (how long until you probably need to access funds), all of us need diversification. Any one type of investment vehicle can suffer possibly large losses, and while often markets rebound quickly, this is not always the case. Also, emotionally large shifts in book value are difficult to take calmly.  A major theme in our site will always be on ways to lessen volatility while maintaining a reasonable expected performance and low investment costs. So keep following us at fundsgarden and @FundsGarden!

This posting is intended for education only. The reader is responsible for their own financial decisions.  The writer is not a financial planner and reading this column should not be interpreted as obtaining individual financial planning advice. For major financial decisions it is always wise to consult skilled financial professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds funds in the RBF1350 Balanced Fund and in the iShares CBD, CBN and XGR ETFs mentioned.  I am a Tangerine customer, but do not hold any of their investment funds at the current time.

Sunday, February 19, 2017

MER (Management Expense Ratio)

One key to sound investing decisions is to not over-pay for services.  The management expense ratio (MER) is the most important measure of the expense charged by a mutual fund or ETF. We introduce that term, and other fee related concepts, in this posting.

What is the MER?

This term MER is used for both mutual funds and ETFs. If the MER is 1.00% it means that for every $100 invested in the fund you will pay $1.00 in fees each year. These fees are automatically deducted from the value of the fund, so you won't actually get a bill for these fees.  However, a high MER will detract from the return on your investments,  perhaps significantly so.

Where does the MER go?  It provides a salary for the advisor who manages the fund (not to be confused with your personal financial planner), may include the costs associated with buying and selling stocks or bonds in the fund (but see TER below), accounting and reporting costs, legal fees, communication and marketing, and other day to day costs.

Fortunately, MERs have been steadily falling on mutual funds, and to a lesser degree on ETFs where they were already relatively low. With new fee transparency regulations coming into force, it is expected that fees will continue to fall.

How Much is Reasonable?

The obvious question to ask is: How high a MER is reasonable?

There is unfortunately no simple answer to this question.  A number of mutual funds have MERs of 2% or more, although many financial commentators consider this too high.  The lowest ETF MERs are about 0.05%, but these only apply to index ETFs which track a developed stock exchange.  For example the iShares XIC and the Vanguard VCN both track the composite main Canadian stock market, and have MER values of 0.06%.

As a general rule, we suggest you question whether you are getting value for your fee especially if a mutual fund MER is much more than 1.0, and if an ETF MER is much more than 0.5. That being said, it is important to realize some investment vehicles have legitimate reasons to charge higher fees.  Some of these issues are listed below.
  • The lowest MER usually are associated with stock only funds that track the Canadian or US stock markets.
  • Bond index funds are also low, but usually not quite as low,
  • Passive funds that track an index should, and usually do, have lower MER than active funds where a manager makes decisions on what to hold.
  • Generally speaking foreign funds have higher MER.
  • Specialized funds with smaller amounts invested have higher MER.
  • Also, not unreasonably, funds that pay out monthly income generally have higher MER than those with annual or semi-annual payouts.
  • A balanced fund that holds a mix of investment instruments will generally have a slightly higher MER, although there are excellent mutual fund choices around the 1% MER level in this category (we will write about these in a future column).
  • Some funds hedge against foreign currency fluctuations, generally at an added cost.
The superb Canadian Couch Potato site focus on reasonable fees for index funds, and we recommend you take some time on their excellent site.

MER vs Management Fee

Many mutual funds report a management fee separate from the MER.  The management fee reflects the direct costs of management of the fund, while the MER includes that as well as things like accounting, legal and communication costs as well. In most cases the management fee is most of the full MER, but it will always be at least slightly less. John Heinzl of the Globe and Mail has written a clear article on the difference.

What is the TER?

There is also something called the Trading Expense Ratio (TER), that reflects the actual commissions paid as the fund buys and sells stocks, bonds and other financial instruments.  This is a bit higher when the fund is active, with more buying and selling, and rebalanced frequently, but in most cases the TER is much less than the MER.  In general the TER for mutual funds is not included in the MER, and you will have to dig through the financial records to find it as not all summaries will even show it.  Fortunately, the TER is normally much less than the MER, although there are examples, such as covered options funds, where it can be a significant part of the total costs.

Royal Bank have a clear statement of management fees, management expense ratio and trading expense ratio for their mutual funds here.

For ETFs some have an additional TER, while others include it in an all-inclusive MER.  Fortunately, the largest provider of ETFs in Canada, iShares, do include it in the MER.

If you do need to determine the TER, it takes a bit of digging, but John Heinzl leads you through the process here, using the resources from http://sedar.com.

Finding MER Information

Fortunately, it is very easy to find the MER for any mutual fund or ETF. One way is to go to a resource such as https://www.morningstar.ca/, find the mutual fund or ETF from its name or code, and then use the Quote tab. The MER will be shown near the right top of the information provided.

Alternatively you can go to the website of the ETF or mutual fund.  This is shown for the iShares XTR ETF below, with the MER highlighted.
Note that the management fee is also shown, which for this fund is 0.55% while the overall MER is 0.60%.  Since this is an iShares ETF, the MER is comprehensive, and does include the TER.
Showing MER information for iShares XTR.

Don't Forget Other Costs

While for long term holdings the MER will be the dominant cost, there are additional costs.

  • For ETFs there is the commission charged by the broker to buy and sell the ETF units. 
  • Also, there may be foreign currency fees if the ETF is in US dollars, or at least a small foreign currency buy and sell rate difference.  
  • While not a fee per se, the difference between what an ETF sells at and buys for may be significant in low volume ETFs. 
  • For mutual funds there may be initial or trailing fees, or some other commission. 
  • If you have a fee-only financial planner, their fees will be in addition to the mutual fund (or ETF) fees.

An  Example

Let's see how the fees work with a realistic example.

Assume that you have a discount broker that charges $10 commission for each trade (for simplicity of calculation we assume that this is the cost with taxes included).  If you bought $10,000 of the XTR ETF five years ago, held it for those five years reinvesting all gains in the XTR through a no-cost DRIP program, and then resold the units, how much would you have paid in fees?

The MER for this fund (see above) is currently 0.60%, and for this simplified example we assume that was constant over the entire period (MER rates usually only slightly change from year to year).

The 5 year performance for this ETF according to morningstar.ca is an annual average of 4.70% (that is based on NAV, or net asset value, which takes into account both dividend payouts and change in the value of the ETF - more on this in a later column). For simplicity in this calculation we will assume that the performance has been constant in each of the years, although of course it is not at all constant.

The actual situation would have different fees and performance in each year, but the final results should be only slightly different from that shown here. XTR is an instrument usually used for regular income, but we assume that all income generated by the fund is put back into reinvestment of the fund for purposes of this example.

Because of the assumed $10 trading commission, we would only have $9990 to invest, as shown in the end of year 0 value in the table. After the first year we assume that the investment value has increased by 4.70%. The MER of 0.60% on this value indicates that we paid $62.70 in ETF fees.  We don't subtract that from the $10459.53, since the MER is already calculated into the quoted performance figures.

We extend similar analysis for each of the four other years, and then incur another commission charge of $10.00 when we sell the ETF.

Overall with the assumptions made you would have gained about $2558 on your original $10,000 investment, having paid about $365 in fees, including both the MER of the fund and the trading commission of your broker.

It is important to note that while we selected a specific ETF, and simplified with approximations like a constant return each year, this should not be taken as a detailed analysis of the XTR ETF.

Final Thoughts

We will have much more on fees in future columns.  If we had held similar stocks and bonds to the ETF used in the example in a balanced mutual fund which charged a MER of 2.4% (near the upper end of mutual fund fees), we can see that nearly half of the total investment return would have been absorbed by fund fees.  If a fee-only advisor had charged an additional fee of 1 or 1.5% for their services, we could be in a situation where the majority of the investment gain is taken up with fees.

As in most consumer choices, the cheapest investing vehicle is not necessarily the best one.  We should however, know what fees we are paying, and see if they are competitive with alternatives.

This posting is intended for education only. The reader is responsible for their own financial decisions.  The writer is not a financial planner and reading this column should not be interpreted as obtaining individual financial planning advice. For major financial decisions it is always wise to consult skilled financial professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds funds in the ETFs mentioned in this column (XIC, VCN, XTR).

Saturday, February 18, 2017

Mutual Funds vs Exchange Traded Funds

While purchase of individual stocks and bonds makes sense in some investing plans, for most seeking a diversified investment portfolio, mutual funds or exchange traded funds (ETFs) will be the choice.  In this post we introduce these products, and examine the differences and similarities between these investment vehicles.

Mutual Funds

Mutual funds are offered by all of the major financial institutions, as well as by companies operating only in the mutual fund space. The folks at FundLibrary keep track of the Canadian funds available (using the Fundata Canada database), and as of early 2017 there were 17,471 different mutual funds operated by 449 companies in Canada. The actual number of funds is larger still, since a number of funds have different clones that hold essentially the same products (there may be a form of the fund when it is sold through a discount brokerage, and a different form for those sold through financial advisors).

You can purchase mutual funds through your financial institution, through some financial advisors, or through a discount brokerage (in a few cases those with large holdings can purchase them directly from the fund company).

The expense structure for mutual funds can be complicated, but the situation is becoming simpler and much more transparent due to recent legislation. You will pay a percentage of the holdings each year to account for the operations of the mutual fund (the costs of purchasing and selling stocks, administrative costs, etc.) There may, or may not, be charges at time of purchase or redemption in addition.  We will look in detail at the costs of mutual funds and ETFs in a future column.

Some mutual funds track an index (e.g. the TSX Canadian stock index, or a bond index), but many have a more complicated structure, aimed at for example providing regular income or providing the right mix of stocks and bonds for a certain retirement age.

If one is going to just hold a few financial products, a balanced fund, that holds a mix of stocks, bonds and possibly other instruments, can be the simplest choice. For example, the Phillips Hager & North (PH&N) balanced mutual fund RBF1950 holds a mix of about 36% bonds, along with equities from Canada, the USA and internationally. By going to the information sheet linked above you can see the holdings, cost, and past performance of the fund.

Exchange Traded Funds (ETFs)

As the name implies ETFs are bought and sold on a stock exchange.  For most individual investors it will only be economical to hold ETFs if you have a discount brokerage account (a topic for a future column).  You purchase and sell ETFs through this brokerage account.

In Canada the major players in the ETF field are iShares by Blackrock,  BMO Asset Management, First Asset, Horizons ETFs, and Vanguard Investments Canada,

The idea of an ETF is that it holds a number of financial products, usually stocks or bonds, in a package. In most case the products held match some index (or compilation of several indexes according to a formula).

For example, the iShares XIC ETF tracks the Canadian composite stock index, so in one product you hold essentially a bit of each company on the TSX, in proportion to the size of that company.

As another example the Vanguard VUN ETF tracks essentially the entire US stock market, with an index including companies of different sizes and from all sectors.  It holds a little more than 3500 individual stocks.

Some ETFs hold bonds, with a common example being the Vanguard VAB ETF, which invests in high quality government and corporate Canadian bonds with a variety of durations.


As the above demonstrates some ETFs and mutual funds will hold very similar products, although in general more mutual funds are active, in the sense of not simply tracking an entire stock exchange index. They have a lot in common, in that they both hold a number of products, usually at least 50 and often thousands of individual stocks.
  • How bought/sold:  ETFs are bought and sold on a stock exchange, while mutual funds can be bought and sold without a brokerage account. You sell ETF's in terms of number of units, while you redeem mutual funds in dollar amounts generally.
  • Price: The price of a mutual fund is set once a business day (at end normally), and you redeem or purchase at this price in dollar units (there is usually some minimum price).  The cost of an ETF will, like a stock, go up and down throughout the day. 
  • Guarantee/Risk: There is no guarantee on the value of either a mutual fund or an ETF. These are not like investment bank accounts and GICs and they do carry risk that you can lose principal value. The amount of risk depends on what the holdings are in the ETF or mutual fund, rather than one being in general more risky than the other.
  • Costs: We will explore this in more detail in a future post, but in general the annual management costs will be lower in ETFs and in mutual funds. However, there will be a per transaction cost so when you buy and sell ETFs there will be this additional cost (there are exceptions we will explore in future columns). In general it does not make sense to do frequent trading in small amounts of an ETF due to these costs.
  • Transparency: In general both products are transparent regarding holdings, past performance, etc., although the situation is most clear for ETFs that track an index.
  • Reinvestment: Normally ETFs will offer a DRIP option to reinvest dividends in additional units, if that is your wish, and normally mutual funds can be set up similarly if desired.
  • Name: Most ETFs have a three letter stock exchange designation, such as VAB or XIC, while in general mutual funds have a combination of letters and numbers in a longer name such as RBF1950, with the first letters designating the mutual fund company (RBF means Royal Bank Fund, who handle PH&N funds now) and the latter part being the number of the actual mutual fund.
This posting is intended for education only. The reader is responsible for their own financial decisions.  The writer is not a financial planner and reading this column should not be interpreted as obtaining individual financial planning advice. For major financial decisions it is always wise to consult skilled financial professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds funds in the mutual fund (RBF1950) and all ETFs mentioned in this column (XIC, VUN, VAB).