An interesting scenario arises when you look at regular day-to-day investor’s investments. You find they’re hugely invested in mutual funds (which, likely isn’t that bad of a decision) and they don’t understand how M.E.R. - the management expense ratio - works.

As with any business, running a mutual fund is a costly endeavor; revenue is an absolute operating requirement. If nothing else, the mutual fund managers and marketeers must feel they’re being adequately compensated for the time they’re spending. On top of that, there’s expenses and transaction costs, brokerage fees, and legal costs for a mutual fund to be established - clearly, profit needs to be seen.

Mutual funds are tricky though - since it’s already dealing with your money, rather than taking the required expenses and profit in the form of a fee or posted transaction on your account, they’re generally funded out of the fund’s assets. That is, it’s taken right out of what you believe is invested money. Taking expenses out of investors’ assets means that you are paying for them; you’re just less aware, and it’s much more difficult to figure out where the money is going.

Enter the Management Expense Ratio. This number defines the actual cost to investors, expressed as a percentage of assets. Some mutual funds see M.E.R.s of up to 3 per cent - this sounds low, but for a fund which is returning the market average 5 to 10 per cent per annum, that takes between 30 and 60 per cent of the return. Factor in taxes, inflation and everything else involved and you see that the fund has a real return to you of close to zero.

Not all funds are this ridiculous - some of the more passively managed funds, such as index funds, see M.E.R.s of less than half a per cent; looking to Vanguard’s index funds and you’ll find many funds which have less than a tenth of a per cent in expense fees - that’s more reasonable. But some funds, especially those with higher M.E.R.s, and “conglomerate” funds, go even further - buying up shares of funds that they also manage in order to compound and make more transparent the effects and costs of the M.E.R.

Khorana (Georgia Institute of Technology), Servaes (CEPR) and Tufano (NBER) in 2007 published a paper entitled “Mutual Funds Fees Around the World,” with their primary finding being that Canadians paid on average a 2.56 per cent expense ratio in 2002 - the highest in the world. The international average asset-weighted expense ratio for equity funds was 1.29 per cent, according to the study which analyzed 46,580 mutual funds with assets totaling $10 trillion U.S. Belgium, with an average M.E.R. of 1.05 per cent, was the most affordable country in the world to buy mutual funds in.

The reason - the study suggests - that the Canadian marketplace is so heavily gouged by the mutual fund fees market, is that the government enforces a natural oligopoly. Through legislation and thoughtless monetary and fiscal law, Canada has prohibited investors from purchasing funds domiciled in other countries¹ - this force drives up the ability for suppliers of mutual funds to charge more, and gain higher profits. Another study, by K. Ruckman in 2003, called “Expense ratios in North American mutual funds,” compares fees between the U.S. and Canada, concluding that despite sharing similar market-locking forces, American funds are considerably cheaper - a variable which this editor suggests is simply due to population scale.

What is to be learned here? Simply that the M.E.R. is a very, very important variable in picking a mutual fund, and for a fund in which you trust it’s decisions, its possible that the losses you see even on good years are a fault of the expenses, rather than the choices. Perhaps a self-directed R.R.S.P. is the way to go - if not, be careful where you park your money, it may just dwindle away.

1. Since the time of publication of that study, Canadian economic forces have opened the borders significantly in terms of allowing investment in foreign funds. [↩]

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