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.

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).

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.

Comparison

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).