What is a mutual fund?
A mutual fund is a type of investment fund. An investment fund is a collection of investments, such as stocks, bonds, funds or other types of financial instruments.
Unlike some other types of investment funds, mutual funds are “open-ended,” which means as more people invest, the fund issues new units or shares. A mutual fund typically focuses on specific types of investments. A fund may invest mainly in government bonds, stocks from large companies or stocks from certain countries for example. Other funds may invest in a mix of stocks and bonds, other mutual funds, or other products.
Why invest in mutual funds? When you buy a mutual fund, you’re pooling your money with many other investors. This lets you invest in a variety of investments for a relatively low cost. Another advantage is that a professional manager makes the decisions about specific investments. Also, mutual funds are widely available through banks, financial planning firms, brokerage firms, credit unions, trust companies and other investment firms. You can buy or sell most mutual funds at any time.
Like all investments, mutual funds have risk which means you could lose money on your original investment. The value of most mutual funds will change as the value of the fund’s holdings go up and down. Depending on the fund, the value could change frequently and by a lot. There are also fees that will affect the return you get on your investment. Some of these fees are paid by you, and others are paid by the fund.
It’s important to understand the costs of investing and when comparing options, it’s equally important to understand the value you receive for what you pay. The cost of a mutual fund is the Management Expense Ratio – more commonly referred to as “MER”.
Let’s take a look at the MER for two different series of a mutual fund – Series F and Series A.
Series F only reflects the cost of the fund itself. It is used in fee-based accounts, where your advisor charges a separate fee for advice and service. The MER for Series F includes the fee paid to the mutual fund company for investment management, the fund’s operating expenses and taxes. Let’s start with the investment management fee. In our example, the management fee is 60 basis points, or 0.60% per year.
We’ve used that figure because it’s the fee charged on a typical Canadian equity fund. A typical fixed income fund fee would be lower. So what does the investment management fee cover? It pays for professional investment management, research, risk management/oversight, the service and support for you and your advisor’s firm, and, the day-to-day management of the mutual fund.
Let’s look at the second component of the MER: operating expenses. Depending on the fund, these are typically in the neighbourhood of 10 basis points, or, 0.10%. Operating expenses include the costs associated day-to-day expenses such as recordkeeping, accounting and fund valuation, custody, audit and legal services, regulatory filing and costs of preparing and distributing annual and semi-annual reports and prospectuses.
The management fee and operating expenses are subject to tax at a rate that is determined by the tax rate in the provinces where the fund’s unitholders live. We’ve estimated 8 basis points, or 0.08% in our example given HST is generally between 10%-13%. So, adding up all the components, the total is 78 basis points, or 0.78% per year (0.60% + 0.10% + 0.08%).
Now let’s look at the MER for Series A. Series A reflects the cost of the fund AND includes a fee payable to your advisor for advice and service. In this case, the management fee is made up of an investment management fee – which we’ve already discussed – and a trailing commission. Instead of paying your advisor separately, the trailing commission is collected as part of the management fee and paid to your advisor’s firm by the fund company.
The trailing commission is an ongoing fee paid to your advisor’s firm and the Financial Advisor who provides ongoing financial advice and service. It is often called the “fee for advice.”. So what does the “fee for advice” cover? It can be broken down into three components:
- Advice: Your Financial Advisor provides you expert advice on a variety of matters like selecting the right investments to meet your needs as you plan for retirement, seek income, save for life events, building financial plans, tax planning, monitoring and rebalancing your portfolio – just to name a few.
- Access: This covers the infrastructure required by your financial advisor and their firm to support the distribution, sale and servicing of mutual funds.
- Service: things like trade confirmations, opening and closing accounts, issuing statements and other client communications and regulatory compliance activities.
In general, trailing commissions range from 0.5% to 1% . For an investment of $100,000, a 1% trailing commission would pay your advisor’s firm $1,000 for the advice and service they provide you.
The Trading Expense Ratio (“TER”) is a measure of a fund’s trading costs. Generally, the higher a fund’s TER, the more actively the fund manager has traded in a given year. The TER is typically expressed as a percentage. For example, if a $100 million fund incurs a total of $1 million in trading expenses for the year, the TER is 1% ($1M/$100M). When a portfolio manager buys and sells securities more often or invests in less liquid securities such as small or micro caps, these funds tend to have a higher TER. Funds with low turnover rates that invest in more liquid securities will tend to have a lower TER. The TER is independent of a fund’s MER. It typically does not apply to fixed income transactions since commissions for fixed income funds are already embedded in the price of most fixed income investments.
What is an ETF?
An Exchange Traded Fund (“ETF”) is a basket of securities who’s shares of are listed, bought and sold on an exchange. They combine features and potential benefits of stocks, mutual funds, or bonds. Like individual stocks, ETF shares are traded throughout the day at prices that change based on supply and demand. Like mutual fund shares, ETF shares represent partial ownership of a portfolio that's assembled by professional managers.
As it was once described to us – mutual funds and ETFs are like hardcover books and paperbacks – the contents are the same, and only the wrapper is different.
The first ETFs were passive index funds, which as the name suggests, replicated standard stock indexes such as the S&P/TSX Composite Index, the Dow Jones Industrial Average or the S&P 500. Over time, the ETF providers branched out to include virtually every stock market, every asset class, and every sector. They also include actively managed funds which attempt to beat the market through individual stock selection and market timing. Because of the higher turnover in these types of ETFs the MERs are typically higher.
Stay happy, stay safe, stay well!
The CM Group