Tuesday, 20 August 2013

Always check the Management Expense Ratio (MER)

A lot of people who do not want to invest in the stock market directly (that is, by buying and selling individual shares themselves) access the market indirectly - that is through managed funds and there are a variety of these including index funds and actively managed funds which cover a variety of sectors, stock types and commodities.

However, in the capital markets, there is no such things as a free lunch so you will always have to pay a fee to the investment manager for providing this service - this is how they make money.  This fee is also called the Management Expense Ratio (MER).

Before investing in a financial product you need to check this MER and decide whether you are willing to pay this amount for the service that is being offered.  You also need to distinguish between flat fees and performance fees as well and consider how much the manager will need to outperform the relevant benchmark for you to be ahead by using them.

What is the MER and how does it affect your returns?

As described above the MER is the amount you pay your fund manager for managing your money.  It is normally stated as a % of funds under management (FUM) which essentially means that you are paying a percentage of the money you give your fund manager to manage (regardless of whether the fund value goes up or down).

There may also be a performance component to your MER.  This is intended to provide incentives for the fund manager to perform better.  You pay a % to the fund manager as a base fee and then an extra amount if they exceed the benchmark they are tracking (presumably by a certain amount).

An example of how it works

  • Assume you invest $100,000 with Fund Manager A.  The fund manager charges 1.5% as the base fee with an extra 0.5% if they exceed the benchmark by 1% after fees
    • Assume the benchmark increases by 5% over the year but your fund manager does really well and increases the value of the fund by 10%
    • Your investment is now worth $110,000
    • The fees are calculated as follows
      • The base fee expressed above is an annual fee (although it normally accrues monthly) and it is 1.5% of the funds under management which comes to $110,000 * 1.5% = $1,650
      • After the base fee is paid your funds are worth 108,350 which is an 8.35% return (which is 2.35% more than the benchmark rate of 5%) so the manager is entitled to their performance fee is is another 0.5% of FUM.  0.5% * $110,000 = $550
      • The total fees you have paid therefore are $2,200
  • Your investment return therefore is not 10% but rather ($110,000 - $2,200) / $100,000 = 7.8%
In the example above, even after fees this fund manager significantly outperformed their benchmark and delivered value to their investors however you can see how fees can affect returns.

Where it becomes much more contentious is when the fund manager makes less than the benchmark rate or when they make close to the benchmark rate.  In those situations the investor is still paying the fund manager the base fee even though they added no value.

Assume for example the fund does ok and makes exactly the same amount as the index (note that index funds cost you much less) then at the end of the year your investment would be worth $105,000 but you would still need to pay the base management fee of 1.5% = $1,575 which means after fees your return would be ($105,000 - $1,575) / $100,000 = 3.425%

Fees always affect returns negatively.  They make both positive and negative returns smaller.  There is no situation when you are better off with fees.  It is the base fee that does this.  Arguably the performance fee is better because you only pay this when you are 'winning'.

Fees are not necessarily bad...but you need to watch out for them

Although paying fees will always reduce your return, you may invest with a fund manager who consistently does well and so you are doing better than the comparative index fund (note that you still pay fees with this but they are more like 0.1% for a listed broad based ETF).

However finding such a fund manager is hard.  Every manager has up years and down years and you hope that the fees you pay mean that over the long run you do better by investing through them.  

What you need to do is make sure that the fees are not too high

Big MERs are a problem especially when they are big base fees. You may not mind paying these when the fund is performing well but I can assure you that they bite when the fund is doing poorly.  What you want is a fund that charges a reasonable MER - there are many active funds out there now that charge less than 1% MER.

Although the MER is less important than the fund and fund manager themselves, you are paying a certain fee for an uncertain return so you want to minimise this fee and maximise the expected return.  Low fees are also not a guarantee that you will win comparatively - certainty does not exist in the stock market however you are trying to make sure that the tables are not tilted too far away from you.

Make sure, therefore that you always check the MER when you are thinking about investing in a managed product.

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