– The way the marketing hype has it these days, you’d think investment
costs have dropped to zero. What with all the do-it-yourself platforms out
there hawking their black boxes and promising, at least implicitly, huge
savings on costs, novice investors can be forgiven for thinking that buying
mutual funds or setting up an ETF portfolio is somehow cost-free – just
open an online account, fill out a form or two, and click a “buy” button.
Unfortunately, it’s not quite that simple. Here’s a summary of the costs
that you’ll still pay for when buying that mutual fund or ETF.
Many mutual funds still apply a “front-end load” when you buy. This is a
commission you pay to whoever is selling you the fund. The load is
expressed as a percentage, and is taken off the top of the amount you
invest. So if there’s a 3% front-end load on a mutual fund, and you have
$10,000 to invest, $300 will be deducted from your investment and given to
the fund salesperson as a commission, leaving your total investment in the
fund at $9,700. “No load” funds are typically sold by fund companies
directly to the investor, without any front-end commission to a
salesperson, and are favoured by do-it-yourself investors. But that doesn’t
mean you get off scot-free.
This is where the “management expense ratio” (MER) comes in. The MER
consists of the fees that the fund pays for various operating costs. The
biggest of these is typically the cost of investment management. This
compensates managers for researching, trading, and reporting the portfolio.
Usually, the more active the fund or the more complex its investment
strategy, the higher the MER will be.
Investment funds may also pay commissions, or trailer fees, to financial
advisors, brokers, dealers, and fund salespeople for their planning and
asset selection services they provide for you, their client. However, given
all the bad publicity around trailer fees, these are going the way of the
In addition to the fee paid to the portfolio manager and investment
salesperson, the fund must also pay basic operating expenses, such as
legal, administrative, and accounting fees. In addition, Harmonized Sales
Tax (HST) must be paid on all of these items, and this also forms a part of
the MER for a fund.
The “trading expense ratio” (TER) is a more obscure measure, but is likely
to command more attention under the new fee- and expense-reporting rules.
The TER is essentially a measure of a fund’s transaction costs expressed as
a percentage of the fund’s average asset value over a given reporting
period. So, for example, a TER of 0.04% on a fund with average asset value
of $500 million over a year, means the fund pays about $200,000 in
The transaction costs include, of course, brokerage commissions that the
fund manager pays for trading securities as well as custodian transaction
fees. Again, in the case of equity funds, the more active the fund, the
higher the TER will be. (Note that in Canada, “TER” refers to “transaction expense ratio,” but in the U.S., it refers to “ total expense ratio,” a different measure, and not to be confused
with the “TER” used in Canada.)
A growing number of investors like the idea of exchange-traded funds (ETFs)
because of their low MERs. ETF MERs are on average around 0.5%, compared
with around 1.5% for mutual funds, but many ETFs boast MERs much, much
lower than that. The reasons are relatively simple.
First of all, the cost of operating an ETF tends to be lower than operating
a mutual fund. The administrative costs of bringing a new investor on board
a mutual fund are high because the fund has a direct fiduciary arrangement
with the investor – all investor applications, confirmations, deposits,
redemptions, and regulatory requirements must be met and paid for directly
by the mutual fund. The fund must then invest the new money in the market,
incurring trading costs.
ETFs incur no such costs, because investors buy and sell shares of ETFs
through a brokerage firm, which places a trade order on the market on which
the ETF is listed. In other words, investors trade ETF shares with each
other on the open market just like any other stock, and not with the fund
company. A mutual fund company, on the other hand, can issue more units at
any time (hence the term “open-end” fund).
The majority of ETFs track an index, so there is very little in the way of
portfolio management expense, which gobbles up a large portion of a mutual
fund’s MER. The ETF’s managers in most cases do not have to do the
research, make the macro calls on the market, or trade in and out of
specific securities. They simply track their underlying index, rebalancing
holdings as the index does. To be sure, that’s changing somewhat with the
advent of so-called “actively-managed” ETFs, where MERs tend to creep up
along with the costs of managing the portfolio.
Essentially, all funds make their money by charging a fee against assets
under management. But because ETF companies charge very low MERs, they
basically must make their money on volume. The
iShares S&P/TSX 60 Index ETF (TSX: XIU), for example, has some $9.9 billion in assets as of May 2, and doesn’t
need more than its low MER of 0.18% to reap massive annual revenues.
But in order to trade ETFs (or any exchange-traded security, including
stocks), you have to have an account with a brokerage firm. Most
do-it-yourself investors will use one of the many online discount brokerage
services. Brokerage commissions are all over the lot, depending on the type
of account you have, how big your portfolio is, and how active a trader you
are. Generally, you’ll pay a brokerage commission somewhere between $4.95
and $24.95 per trade. With such a wide spread, it pays to really dig into
the details of the commission rates before opening a discount brokerage
Portfolio management options
To meet the demand for low-cost investments, a number of ultra-low-fee
online investment management firms have sprung up in recent years. A number
of independent firms along with most of the big banks now offer a kind of
“black box” approach to portfolio management to those who are looking for
extra-low-cost portfolios. Generally, these are pre-packaged portfolios of
low-cost ETFs that aim to match an investor’s risk profile and investment
objectives. Typically there is no self-directed investing involved, and
investors’ assets are placed in a “portfolio” or “pool” that reflects their
risk profile – for example, “low volatility,” “balanced,” “growth,”
“income,” and so on. Understandably, personal advice tends to be limited
with these arrangements, and more sophisticated investors with larger
portfolios may feel somewhat restricted.
For investors with investment assets ranging from $250,000 up, who find the
process of do-it-yourself management too demanding, and the black-box
method too restrictive, a fee-based account with an accredited financial
advisor has become the preferred method of money management. For a set
annual percentage of assets under management, usually somewhere between
1.5% and 2.0%, the advisor will handle all transactions, trades,
commissions, and reporting. This can work out to be very cost-efficient,
especially for actively traded accounts and those who desire a higher level
of personal attention from their advisor.
Robyn Thompson, CFP, CIM, FCSI, is the founder of
Castlemark Wealth Management a boutique financial advisory firm specializing in wealth management
for high net worth individuals and families. She is also listed as a
MoneySense Approved Financial Advisor. Contact her directly by phone at 416-828-7159, or by email at
for a confidential planning consultation.
Notes and Disclaimer
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The foregoing is for general information purposes only and is the opinion
of the writer. Securities mentioned are illustrative only and carry risk of
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limitation, investment, financial, legal, accounting or tax advice. Please
contact the author to discuss your particular circumstances.