A 2007 study concluded that Canadian investors pay the highest mutual fund fees (as measured by Total Expense Ratio) among 18 western nations.

Many Canadians do not realize how much they are paying in annual fees, or how ‘fee compounding’ erodes their portfolios over the long term.  We all remember learning about compound interest back in school.  Interest paid on prior interest payments, accelerates the rate by which savings grow.

A similar effect – but in the opposite direction – can be seen with fee compounding:

• Let’s say you lose 2.5% of your investments to fees in the first year (a typical value in Canada).

• In the second year, you are charged another 2.5% on the same investments. You also lose 2.5% of new contributions in year 2.  Plus, you lose the gains you would have had on year 1 fees, had you not been required to pay them.

With each subsequent year, the amount of potential gains lost due to fees paid in previous years is magnified, and another 2.5% is taken.  How does this look over the long term?

The chart illustrates the long term impact of excessive fees:

• Point A represents the average investor who pays no attention to fees.
• Point B is the fee-conscious investor who reduced annual investment fees by 2%.  Over 35 years, (s)he accumulated approximately 50% more in savings (without actually saving any more).
• Perhaps Point A ($360,000) represents all the savings you’ll need for retirement. Point C illustrates that by reducing fees by 2%, you could retire 5.5 years earlier. Paying those extra fees equates to working 5.5 years for your advisor!  (I hope he or she is worth it).

The investor who follows the curve leading to Point A loses almost $200,000 by not reducing annual investment fees by 2%.  A rough breakdown of the loss indicates an extra $100,000 is paid in fees, and another $100,000 is lost opportunity cost – paying the extra 2% meant there was less cash in the account to grow each year.  This example assumes a 7% growth rate with $4,000 deposited every year. For simplicity, the effects of taxation on gains are ignored. (If the account was an RRSP, then taxation is not an issue).   Weigh House Investor Services offers an underperformance calculator and a compound earnings calculator that may be of interest to those who wish to evaluate their own situations.

Many Canadians do not realize that mutual fund companies levy annual management fees. Returns are often reported net of fees, which makes them hard to find.  For obvious reasons, the industry prefers obfuscation – you’ll likely never see mutual fund fees included on your account statement.

So what can be done?  Enter the ETF!

Exchange Traded Funds (ETFs) have many advantages over mutual funds:

• Management fees for ETFs are much lower (typical fee = 0.25% – 0.50%).
• ETFs tend to outperform mutual funds over longer time periods (five to 10 years).
• ETFs are easier to trade, more tax efficient and a better choice for buy-and-hold investors.

ETFs are bought and sold over the stock market, which means to invest with ETFs one will have to open a brokerage account.  Here is a listing of companies providing online discount brokerage accounts in Canada.

ETFs are bought and sold in the stock market, which means you require a brokerage account to invest in them. While trading ETFs may seem like a big step up from mutual fund investing, it’s actually quite easy.  If you need assistance, Weigh House offers a Do-It-Yourself Coaching Program that provides a personal financial plan, investment policy statement, and help to get started with online trading. The service includes quarterly coaching sessions to assist with investment decisions.

Do-it-yourself investing with ETFs represents a very attractive alternative to mutual funds. Perhaps it’s worth $200,000 in savings to give it a try.

~ Neal