This post is the first in a five-part series outlining the primary benefits of the Couch Potato strategy.
Mutual funds are a great investment tool—in theory. They allow small investors to pool their money and buy stocks and bonds that would be far too expensive to purchase individually. They’re managed by professionals who—presumably—use strategies that are more sophisticated than those the average investor could employ. No wonder so many Canadians own them.
Unfortunately, mutual funds have a fatal flaw: they’re too expensive. Especially in Canada.
Equity mutual funds offered by the big banks typically charge 2% to 2.5% in management fees, often considerably more. Fund companies that sell their products directly to investors—such as Phillips Hager & North, Beutel Goodman and Mawer—charge lower fees, but 1.2% to 1.5% is still typical.
Canadians, in fact, pay the highest fund fees in the world: a recent report by Morningstar graded fund expenses in 16 countries and gave Canada the only F. “Canadian investors are comfortable with the fees,” the report says, “because they don’t know how low these fees should actually be.” Now doesn’t that make you feel like a chump? You can almost hear your advisor snickering.
Even index funds in Canada are too expensive, given that it takes no special talent to manage one. In the US, where investors are far more sensitive to costs, companies such as Vanguard, Fidelity, Charles Schwab and T. Rowe Price offer index funds with annual fees under 0.20%. By contrast, CIBC and BMO charge over 1% for all of their index funds. Even the reasonable costs of index funds managed by TD, RBC and Altamira (between 0.50% and 0.70%) would be considered absurdly overpriced in the US.
That’s why ETFs are such a game-changer: Canadian investors are starting to ask their advisors why they should pay 2.5% for a large-cap mutual fund when they can buy the iShares Canadian Large Cap 60 Index Fund (XIU) for 0.17%. What’s more, although Canadians can’t buy the super-cheap mutual funds available to Americans, we can buy US-listed exchange-traded funds. The Vanguard Total Stock Market ETF (VTI), for example, holds more than 3,300 US stocks and charges a microscopic 0.09%. That’s just $9 annually on a $10,000 investment.
Using only ETFs, it’s possible to build an extremely well diversified portfolio for under 0.25% in fees. (We have several suggestions on the Model Portfolios page.) That’s about one-tenth the cost of a similar portfolio of mutual funds.
Make no mistake: saving 2% annually in fees can make the difference between success and failure in investing. If you put $300 a month into an RRSP for 30 years and earn 7% annually, the money would grow to $368,000. Subtract 2% per year, and your nest egg shrinks to $250,000. That’s right: a 2% annual fee can cost you one-third of your retirement savings.
Part 2: Pure asset allocation
Part 3: Transparency
Part 4: Flexibility
{ 5 comments… read them below or add one }
1st time here… interesting. I’ll be back!
Great article!
I love that stat that shows what a 2% difference makes over 30 years.
Hi there,
I have recently started taking a much more active interest in my investment portfolio. After I discovered how much the MER on my mutual funds can cost me over the long run – and how cleverly they are hidden in the fund itself – I was a little choked. The good news – I am 29, and have a very long horizon ahead of me, so now is the ideal time to learn and switch things up.
Periodic investing has worked well for me because it’s so easy – I don’t have to do anything. I want to shift my investments to index funds, but here’s the problem: I don’t want to pay the high MERs for my growing portfolio (which currently doesn’t have index funds, yet…), but ETFs are not practical for periodic investing only because the brokerage fee on $250 invested bi-weekly would negate the cost savings. So here’s my solution – move my existing portfolio to indexed ETFs, and continue periodic investments in indexed mutuals until there is sufficient capital to convert to an ETF that the brokerage fee is less than an MER on mutual funds. I hope to God that made sense.
National Bank Securities (my current provider of mutual funds) offers only a handful of index funds, some with MERs above 1%, and many of which don’t even track broad based indices. Here’s my question: what are the best alternatives to National Bank Securites that a) offer a variety of indexed mutual funds, with b) MERs that are more reasonable than 1%, and c) that track indices that are more broadly-based than the Dow (like the S&P 500, Russel, or anything with total market exposure)?
Any suggestions for fund dealers would be appreciated. Thanks!
Ashley: You’re definitely right to recognize that ETFs are a poor choice for biweekly or monthly investors. Your plan to contribute to index mutual funds until you’ve saved enough to buy ETFs is a perfectly good solution. Do the math to figure out at what point the ETF trading commission is offset by the lower MER and go from there.
You could also look at Claymore’s preauthorized cash contribution (PACC) plan, which does allow you regularly purchase ETFs each month without trading commissions, so long as your brokerage allows it:
http://www.claymoreinvestments.ca/etf/investment-services/pacc/
National Bank owns Altamira, which offers several very inexpensive index funds with broad market exposure (see the Canadian Index Funds page on this blog). All discount brokers offer wide access to index funds from other providers, but if you’re opening a new account, consider TD Waterhouse so you can access their e-Series funds, the cheapest in Canada.
The return generally reported on a fund reflects the “after fees return”. Therefore the MER does NOT reduce the return that is reported. The article above suggests that a 2% MER has a significant negative impact on the growth of your fund investment. Not true. However, beyond management expenses related to running the fund, part of the MER is destined as a trailer fee to the Financial Planner for his “expert” advice and service. It is not unreasonable to have pay for the Financial Planners advice and service if you require it. You cannot expect it for free. However, caveat emptor! I conclude that for a fund to deliver a return to match an appropriate index, the fund would have to have a gross return at least equal to the index return + the funds MER. This should be expected based on the active management and selection of investments by experts…..but is seldom the case!
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