Last week I proposed a few ways for investors to save on fees without firing their adviser. Many Canadians are not able to manage their own portfolios or financial plans, but that doesn't mean we have to give up on lowering costs. It may not sound like it, but 0.5 per cent is a big deal.
If you've ever had a financial projection run for a few decades you'll know that an extra 0.5 per cent in compounding rate of return can translate into tens if not hundreds of thousands of dollars more in your pocket. Unfortunately, you can't just arbitrarily ask for an extra 0.5-per-cent return every year without taking on more risk. And if you do take on more risk, there is no guarantee it will translate into higher returns, you only get the potential for higher returns.
That is, unless you ask for that 0.5-per-cent extra return in the form of lowered costs.
But when we talk about annual investment fees of 2.5 per cent and savings of 0.5 per cent, most people don't understand that while those sound like small numbers they really do have a big impact.
As it stands now, fund companies are required to disclose the ongoing fees in a small section of a large document known as a simplified prospectus. Under the section titled "Fees indirectly borne by the investor," a typical sample calculation is provided over one-, three-, five- and 10-year periods, which demonstrates the approximate amount of fees paid on $1,000 and assuming a return of 5 per cent per year.
Here's a sample taken from an actual prospectus for a fund with a management expense ratio (MER) of 2.36 per cent:
Fees and expenses paid:
But $300 cumulatively over 10 years doesn't seem like a big enough of an amount to make you stand up and take notice, part of the reason is that it's based on a $1,000 investment. Most people would like to ideally have more socked away than that.
Michael J. Wiener, a cryptographer by day and author of the blog Michael James on Money proposed a new metric that would provide a better way of explaining the impact of investment fees to investors: the Management Expense Ratio per Quarter century (MERQ).
He explains it simply using a fund with a 2-per-cent MER as an example, "When an MER consumes 2 per cent of your money after a year, then you have 98 per cent of it left. After two years when another 2 per cent is gone, you have 98 per cent x 98 per cent = 96.04 per cent left. After 25 years you are left with 60.35 per cent. This means that 39.65 per cent of your money is gone."
Using the fund from the table above with an MER of 2.36 per cent, we would have an MERQ of 44.96 per cent. In other words, instead of framing it as "Would you give up 2.36 per cent per year?" we could ask "Would you give up 44.96 per cent over 25 years?" Chances are, people would start paying more attention.
And again, instead of $300 on $1,000 over 10 years, this translates into $84,884.54 on $100,000 over 25 years.
For those math aficionados interested in calculating the number yourself, Mr. Wiener provides the formula: "A minor technicality with the way that reported MER figures are calculated is that they are continuously (daily) compounded. Since MERs are negative percentages, this continuous compounding actually very slightly benefits the investor. So, the actual calculation for an MER of m (expressed as a fraction) to get the amount you have left is e^(-25*m). To get the amount that is gone we have MERQ = 1 - e^(-25*m)." [with e being a constant; ^ denoting "raised to the power of;" and * meaning multiply]
For those of you who just want a quick answer without having to do any math, you can download a spreadsheet I created on my blog which allows you to additionally change the investment amount, factor in annual contributions, and then create a side by side comparison to investment funds with different costs.
Try it out and see the effect of saving just 0.5 per cent in fees per year, a number which many investors could manage while retaining the use of a professional financial adviser. You'll see just how big of a deal it is.
Editor's note: The paragraph referring to the fees and expenses table differs from the original online publication. It has been edited for clarity.