Is an Expense Ratio of 1% really 1%? What you need to know about Mutual Fund Fees.
The Management Expense Ratio (MER) on Mutual Funds is often misunderstood and its financial impact underestimated. It includes management fees, advertising/sales expenses, reinvestment fees, exchange fees, custodial fees, and administrative fees. Financial advisors will often quote fees of “only” 2 % or “only” 3 %, but what does this really mean? If you invest $100 then a fee of 2.5 % means the fund keeps $2.50. Now say that the fund performs at 6.5% and the interest generated is $6.50. In this case the management fee is actually 38.5% of the returns (i.e. $2.50/$6.50). Therefore, management fees of 1 % are actually closer to 15 % of your returns (i.e. (38.5% / 2.5%) x 100 = 15.4%).
This means that getting a low fee index fund with a MER (management expense ratio) of 0.5% has a significant advantage over a similar mutual fund fees of 2.5% all other things being equal. To understand the impact of fees on a retirement portfolio we looked at investing $100,000 at 6.5% for 25 years at an MER of 2.5% and 0.5%.
Therefore, a major determining factor on the returns of your investment portfolio is management fees. In fact, based on management fees of 2.5% the actual cost to the investor is over 50% of the investment returns in the long-run (due to compound interest). Not surprisingly many sources such as the Center for Retirement Investing have cited fees as the major determent of fund performance. Lastly, it’s also important to understand the load fees on an investment. Front –end loads are charged upon purchase and back-end loads are charged when a fund is sold. For front end loads fees usually decrease with volume and for back end loads fees usually decrease depending on how long you hold the investment. To be an informed investor you need to understand exactly what these are. Note some mutual funds have zero load fees.