utual fund investors may assume a fund's Management Expense Ratio (MER) incorporates all costs associated with holding a fund. This is not correct. The MER includes management fee paid for its portfolio management expertise, plus operational expenses such as record keeping, custodial fees, legal and audit costs. It is expressed as a percentage of the fund's total value. If the fund is worth $100 million and the management fee and operational expenses amount to $2.5 million, the MER is 2.50%.
But there are two key costs you pay which are not counted in MER calculations. These costs are brokerage commissions and GST, expenses you would pay if you managed your own portfolio. Thus the MER reflects the added cost you incur by using mutual funds.
One of the main influences on brokerage costs is portfolio turnover, how actively the manager trades investments in the fund. A passively managed portfolio will trade relatively infrequently and incur lower transaction costs than an actively managed portfolio traded frequently.
The second Canadian edition of the book Investments by several noted authors including Nobel economics laureate William F. Sharpe (Stanford University professor of finance) illustrates the impact of transaction costs by using Altamira Equity Fund in 1993 and 1994. The fund's 1993 MER was 2.37% and the 1994 figure was 2.32%. The authors uncovered 1993 transaction costs of 2.22% pushing the total costs to 4.59% as a percentage of the fund for 1993 and transaction costs of 1.30% for total costs to 3.62% for 1994.
Not surprisingly, the authorsconcluded that "MERs do not tell the whole story...Brokerage costs can have a significant effect on a fund's performance". They further concluded that "Funds with higher portfolio turnover rates had lower levels of performance, other things being equal."
Turnover rates vary widely. At one company, the Canadian stock fund reported a 45.5% turnover rate for 1998 while its aggressive small companies fund had a turnover rate of 494%!! Portfolio turnover rates are often difficult to uncover although some companies report turnover in their annual reports.
Dan Hallett, fund analyst with FundMonitor.Com, advises investors to seek out fund companies that emphasize a buy-and-hold philosophy. In the Globe & Mail's Report on Business, Sept. 14, Mr. Hallett suggested AIC, Templeton and Trimark fit this description. Important information about these fund are contained in their Simplified Prospectus. Before investing, obtain a copy from your Financial Consultant and read it carefully. Past performance is not indicative of future performance.
Your financial consultant can provide you with solid advice on mutual fund portfolio turnover and how this might affect the bottom line return on any mutual fund you may consider investing in.
Gerry Leduc, resident of Old Ottawa South, is a Vice-President & Retirement Specialist with Wood Gundy Private Client Investments. He can be reached at 783-7830 (Internet: leducg@cibc.ca). Views expressed are not necessarily those of CIBC World Markets Inc. This article is for information only and does not constitute an offer to sell or a solicitation to buy the securities referred to herein.