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Performance incentive, or ball and chain?

Behind-the-scenes fees can add up fast. Dale Jackson tells how to evaluate MERs and keep them from eating up your fund returns

The Ontario Securities Commission isn't the sort of organization to lecture retail investors on the hazards of mutual fund fees. Canada's main market regulator has bigger fish to fry.

Instead, the commission is attempting to show the impact of fund fees through its Investor Education Fund website. The site includes a mutual-fund-fee impact calculator that tabulates - to the penny - how fees add up over time.

The biggest chunk of a mutual fund fee is deducted each year as a percentage of the amount invested through the management expense ratio, or MER. As more funds are added to the portfolio, and it grows in value over time, the fees can grow to dizzying heights.

For example, a $1,000 investment with an annual return of 8 per cent over 20 years would produce a profit of $3,661 without fees - but only $1,807 after a typical 2.6-per-cent MER.

"Every percentage that an MER charges is a percentage that you don't earn in your returns," says Thomas Hamza, president of Investor Education Fund, which is an independent offshoot of the securities commission.

The MER goes toward paying the fund's operating expenses, which include trading fees, salaries and commissions for staff, and those slick marketing brochures you get in the mail.

"The bigger the fund company's marketing budget the more expensive the fund," says Mr. Hamza.

MERs on the Canadian market range from zero to 14 per cent. The average MER for a Canadian equity or balanced fund is about 2.5 per cent. That number tends to be higher for segregated funds, which are like insurance products that guarantee all or part of the principal.

Some funds simply cost more to run. International equity funds have higher MERs to compensate for managing a portfolio on a global level, which often involves hiring regional managers. MERs could hit 20 per cent or higher for performance-based funds, but most investors don't mind since the fund should perform proportionally well.

Aside from performance-based fees there is often little correlation between an MER and a fund's performance.

The Northern Rivers Innovation Fund LP, for example, has grown an average of 34.7 per cent annually for the past five years, and it has an MER of 1 per cent. The Dynamic FocusPlus Recourse Fund has returned 33.7 per cent over the same period and charges investors 4.65 per cent.

Near the bottom of the five-year performance spectrum lies VenGrowth II Investment Fund, which has charged investors 4.7 per cent to lose an average 6.6 per cent annually. And CIBC Global Bond holders have paid 1.96 per cent to lose 3.8 per cent annually.

It's important not to judge MERs on returns alone, however. Mr. Hamza suggests comparing returns with a correlating benchmark to see whether a portfolio manager has squeezed out enough of a gain to justify the fees. He also suggests researching other criteria, including management experience, investment style, risk and past returns.

Mutual fund companies are required to display the MER prominently in a fund's description. However, one detail tucked away within the MER is the annual trailer fee - the portion that goes to the person who sold you the fund.

In most cases the beneficiary is your friendly neighbourhood financial adviser, who may or may not be giving you advice on that particular fund each year.

Trailer fees, which are fairly unique to Canada, vary from fund company to fund company but could be as high as 1 per cent.

Mr. Hamza says he believes that most investment advisers recommend the best fund for their clients regardless of the trailer fee, but he admits the temptation to push funds with the best commissions might be too tempting.

"In most cases they're not paid by how well the portfolio is doing," he says. "They're paid by how much they sell."

Investors might also pay other fees outside of the MER called back-end and front-end loads. A front-end load is a percentage of the initial investment, and a back-end load is a percentage of the total value of the investment at the time it is sold.

In some cases investors can choose between the two, and they are often tempted to forego the front-end payment and pay instead when it is sold. Back-end loads tend to drop percentage-wise after several years but often end up being higher than front-end loads if the fund appreciates in value.

Some studies have found Canadian mutual fund fees to be among the highest in the world, but industry groups including the Investment Funds Institute of Canada say the fee structure in Canada is like no other and can't be compared.

It's hard to know who is right, Mr. Hamza says, but no one can deny the facts. "The truth of the matter is there's a lot of funds that a lot of people have that cost way more than can be justified by their performance," he says.

Mutual fund fees have been coming down in recent years, but Mr. Hamza says they remain high. "The changes are very minor, and they're certainly not substantial enough to merit you not looking closely at what your costs are."

Investors who want lower MERs should consider exchange traded funds (ETFs), for which MERs are generally below one-half of a per cent. ETFs track indices according to geographic regions or sectors. ETFs trade on exchanges just like stocks, so investors pay a standard trading fee when they are bought or sold.

Unlike mutual funds, however, ETFs are passively managed and exposed to the whims of the broader markets, without the benefit of an experienced portfolio manager at the helm.

Funds with bang for the buck

Example of mutual funds with decent returns and relatively low management expense ratios.

5-year average
Fundannual returnMER
Northern Rivers Innovation Fund LP34.70%1.00%
TD Latin American Growth34.10%2.76%
Sceptre Equity Growth A32.30%1.58%
RBC Global Resources32.10%2.40%
Scotia Latin America31.40%2.51%



Dale Jackson is a producer at Business News Network.

© 2007 The Globe and Mail. All rights reserved.

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