As it relates to investment, do you know what a management expense ratio (MER) is?
If you do, do you know what your MER is? If it’s more than 1%, you’re paying too much.
First - a definition. The MER is a fee, paid by you, the investee, on your investment. You pay this fee whether the market increases or decreases, whether your fund or investment does well or poorly. There’s a parable of an investor walking along the docks, being shown all the boats of the kings of the financial markets. He asks “Where are the investor’s boats?”. The MER is what pays for the financial industry’s profits and wages, and they are high indeed.
Typical ratios range from as low as 0.1% or less on an index fund or ETF, and 2-3% on mutual funds, and I’ve even seen incredibly high ratios of 5-6% with private fund management firms (often private or hedge fund fees are broken down in 2/20 relationships - 2% and 20% of profits). To explain their impact on your wealth, let’s consider an average investment over a 30 year time frame.
Let’s say you are a high growth, aggressive investor. You decide you want to primarily invest in equities in the stock market, and you’re going to invest $5000 per year with this investment. (You might have other diversified investments, but that’s a conversation for another day).
We’ll review 3 choices. An low-fee index fund that tracks the market (S&P 500), a well performing mutual fund and a high-fee private investment fund (which, as an aside, would typically require you have investable assets of $250K-$1M to give you the time of day).
As an aside, in a future post I’ll review the concept of ‘alpha’ - which is the idea that only a very, very small percentage of fund managers (think Warren Buffet) beat the market over any extended period of time. But for the purposes of this illustration, we’ll assume, since 99.9% of mutual funds underperform them market, that our mutual fund does so by 2%, and that being extremely generous* our high-fee private investment fund beats the market by an incredible 3%.
Index fund: 0.1% - see the Vanguard series of funds for a good typical example.
Mutual fund: 2.5% - see the mutual fund prospectus of almost any bank-offered fund as an example.
Private fund: 4%.
Remember that they take this fee whether the market goes up or down. Some fees are front end loaded, some are annual, some are back-end loaded, but you pay the fees. Every time.
I’ve used a return of 10.7%, which Is roughly what the S&P 500 returned from 1985 to 2015 if you reinvested your dividends along the way.
Index fund total value (after fees): $1.12M.
Mutual fund total value (after fees): $465K.
Private fund total value (after fees): $933K.
The difference between the index funds, mutual funds and private funds - what you pay in fees, and the variance in return. Mutual funds especially are a typically foolish place to put your money, which is why so very few of them have long shelf lives or strong rates of return.
A couple of closing notes - I’m not a professional financial advisor, but you can read many of them and they should all talk about fees. When you talk to your advisor, ask them how they get paid - it’s a reasonable question. The projections above are crude and do not take into account tax rates or inflation, both of which will have a significant impact on your investment. Also, if you have a lot of money (>$500K) to invest, you can often negotiate your fee structure.