Mutual fund fees can seriously eat into your long-term profits, but are an unavoidable part of mutual fund investing

Mutual fund fees are unavoidable for mutual fund investors. Mutual fund buyers pay a yearly fee or Management Expense Ratio (MER) of perhaps 2.5%, or even more, of the value of most mutual funds they invest in.

One and a half percentage points generally stays with the fund company, to pay for management of the funds, record-keeping, administration and so on.

One percentage point goes to the securities firm where the investor bought the fund, to be shared between the firm and the salesperson. The idea is that this fee goes to pay for continuing advice to the investor.

The fund company continues to charge the 1% to the investor, and pays it to the brokerage firm, every year for as long as the investor owns the fund.

This 1% part of the mutual fund fees, or the “trailer fees,” are “embedded” in the fund investment. It’s part of the deal when you buy. Recently, securities commissions have raised the idea that investors should have to agree separately to pay the yearly fee. After all, paying that extra 1% every year takes a surprisingly big bite out of the growth in your investment. Many investors might only agree to pay this extra 1% if they felt they were getting something for their money.

The brokerage industry in general likes things as they are and would certainly make less money if the trailer portion of mutual fund fees were not in place. The industry argues that under this system, investors with large fund holdings subsidize the brokerage industry’s cost of providing continuing advice to small fund holders. If the trailer fee becomes optional, numerous fund investors might choose not to pay it. Small investors would then lose their access to continuing advice, according to the industry.

However, in fact, small investors rarely get meaningful financial advice. Brokers typically focus on servicing more prosperous fund investors who may have additional funds to invest.

For that matter, discount brokers also collect the trailer fee, even though they provide little or no advice or service to fund holders.

“Best interest” compared to suitability

Under current regulations, brokers can sell a wide variety of mutual funds to investors, so long as they satisfy the “suitability” standard: the investment must be seen as “suitable” to the needs of the investor.

However, suitable investments come with a wide range of fees. Some reward the broker and his or her employer much more than others. That’s because high-fee investments are generally riskier than average-fee investments. Their sponsors have to pay extra to get brokers to sell them. This introduces a clear conflict of interest: what’s best for the broker is not always what’s best for the client.

In contrast, portfolio managers must live up to a “best interest” standard (also known as a fiduciary standard). They can only place their clients’ funds in investments that are in the client’s best interest.

When buying mutual funds—regardless of the fees—here are some tips to follow:

1. Avoid mutual fund managers who trade heavily

Some of the most dangerous funds are those run by managers who honestly believe they can increase their performance by frequent in-and-out trading. Many of these managers fail to realize how close their mutual fund’s performance comes to disaster each year, until disaster finally strikes

2. Avoid buying mutual funds with a lot of dead weight

When a fund’s portfolio shows page after page of obscure speculative stocks, particularly thinly traded ones or recent new issues, you can be exposed to a concealed, but very serious, risk. If the market drops, and too many investors want their money back, the mutual fund may have to sell some of its assets to raise cash.

Obscure speculative holdings will prove hard, if not impossible, to sell when prices are generally low. This may force the mutual fund managers to dump their best holdings at a time of market weakness.

3. Avoid buying mutual funds with anonymous managers

This includes buying mutual funds run by committees. The trouble here is that the brains of the mutual fund may leave, and investors would never know it until they saw the drop in their mutual fund’s performance.

INVESTOR BONUS—ETFs versus Mutual funds:
                                          
We now think that for most investors exchange-traded funds (ETFs) offer better value with much lower fees than most mutual funds.

So we feel that most fund investors should shift into ETFs wherever possible. For that reason, we have shifted our focus in our Canadian Wealth Advisor newsletter to ETFs.

ETFs are highly efficient mutual funds. Fees are low because investors don’t pay for active management. Instead, ETFs aim to mimic the performance of a market index, by holding the same securities in the same proportions used to calculate the market index.

Do mutual fund fees affect the way you invest your money? What is the maximum trailer fee you are willing to pay? Share your experience with us in the comments.