So, you own a mutual fund and you understand some basic things about it. You know your money is invested in a variety of stocks and bonds. You know the purpose of the fund is to make your money grow. You know the people who manage the fund and take care of your account are paid for what they do. As an investor, you know you contribute to these ongoing services through the fund. You may also be familiar with the term used to describe these ongoing costs: Management Expense Ratio (MER). But what you might not fully understand is exactly how these costs are calculated, who is paid, and for what.
For the purpose of this post, we will reference how traditional mutual fund MER’s work. How is my advisor paid to manage my investment funds? covers a variety of ways an investment advisor may be paid including fee for service, and other arrangements where investors choose to pay ongoing investment and advice fees separately.
Because the MER is paid through the mutual fund itself and not paid separately by the investor, it is natural for a mutual fund investor to ask: How are each of these people and companies compensated for the work they do towards helping my money grow? In short, what are my costs of owning a mutual fund?
Let's take a closer look inside the MER. The MER (Management Expense Ratio) is used to report the ongoing costs associated with owning a mutual fund. The MER is typically calculated as the percentage of asset value an investor would pay annually to own and participate in that fund. It is the amount you pay everyone associated with the fund to work on your behalf and help your money make money.
MER’s are laid out in fund facts documents for each fund. You should note that your investment return on your statement is usually reported net of the MER, unless stated otherwise. Meaning, your mutual fund statement typically shows your rate of return earned after the MER has been deducted. So, for simplicity, if your investor statement shows a 7% rate of return, and your fund has an MER of 2% this means the overall fund would have earned 9% and after the 2% MER was deducted, the remaining 7% is the investor return in pocket.
As a general rule of thumb you can typically expect higher risk funds which require more day to day active management to have higher MER’s, than lower risk funds requiring a lower level of maintenance. This is based on the premise that a higher level of work behind the scenes would be associated with a higher MER charged for the work done to earn the potential return.
So what exactly does the MER pay for? The fee is generally paid out to these different parties:
Investment Management –paid to professional investment management team at the investment company (i.e. CI, TD, Manulife, Fidelity, etc.) for the work involved in making effective investment decisions including investment research, strategy, ongoing monitoring, governance and risk management.
Operating Expenses – cover the cost of the day to day expenses to operate the fund including document filing, transaction processing, client reports, regulatory requirements and services provided through the investment company (i.e. CI, TD, Manulife, Fidelity, etc.)
Dealer Compensation and Advisor Compensation – the mutual fund dealer (i.e. Manulife Securities) is paid a portion of the MER for dealer expenses including documents, reporting, compliance, and support. This portion is also sometimes referred to as trailers, servicing or trailing commissions.
The mutual fund dealer then pays a portion to the Financial Advisor (i.e. Farrow Financial) who directly services the account for the client and provides ongoing service and advice, including monitoring, rebalancing, market insight, financial planning etc. This portion paid to the advisor covers operating costs of the advisor practice including, staff, facility, customer service and support etc.
Tax – sales tax is applicable on management and administration fees and is included in the MER
So even though you don’t receive a separate bill for these expenses, and they are paid through the fund itself, it is important to have a general understanding of how the MER is first taken off the overall return before your investor return is reported to you. This is how you pay your MER.
This illustration courtesy of TD Asset Management is a good tool to show the breakdown of an MER.
You can see the MER and TER reported on your fund facts.
Image by David Schwarenberg from Pixabay