total-cost-of-investing

What is my total cost of investing? (Part 2)

by Invisor Last updated on December 02, 2014 Tags: Save Well

In a previous post, we covered one of the significant components of total cost of owning a fund – Management Expense Ratio (MER). In this post we will cover the rest of the cost components, including Sales Commissions, which in our opinion, are the most complex of all of the cost components.

Sales Commissions
Sales commission (commonly known as a ‘load’) is a one-time fee paid to an advisor’s firm for selling a mutual fund to the investor. Loads are either front-ended (less common these days, thanks to competition) or back-ended (more common).

A front-end load is a sales commission that generally ranges from 1 to 5% which is deducted from the amount invested and paid to the advisor’s firm. The investor, in this case, ends up investing the net amount after the front-end load.

A back-end load or a deferred sales charge (DSC) is a back-end fee that is charged to an investor in a mutual fund if the units are redeemed before a certain minimum amount of time. This is a charge that is levied to discourage an investor from exiting the fund and to recoup the upfront compensation paid to their sales force (advisors) for placing money in the fund.

A typical DSC could be 5 to 6% in year one, declining to zero by year seven. Therefore it is important to look for these charges before purchasing a fund for your portfolio. We have noted while working with our prospective clients that DSC is a charge that is unknown to many. The cost surfaces only when the investor chooses to redeem the fund.

Why should investors be forced to lock-in to a fund for 6 to 7 years or have to pay an exit fee in the form of DSC charges to compensate for sales commissions paid to the advisor, especially when a fund is performing poorly or no longer fits their overall asset allocation plan? Sounds absurd, doesn’t it? Beware of these charges when you purchase a fund. The good news is that thanks to competition, there are a number of no-load funds available today that do not charge any sales commissions. So look for alternatives where these charges don’t apply.

Trading Expense Ratio (TER)
The TER is a measure of the fund’s total trading costs (commissions, spreads, taxes & fees) as a percentage of the average total assets of the fund. This is a cost that the investor bears indirectly for investing in the fund, which depends on the amount of trading conducted by the manager of the fund (generally known as the turnover) – the higher the turnover inside a fund, the higher the drag on performance. These costs are captured inside the funds and disclosed inside fund prospectuses. Investors should look for funds that have low turnover levels. An annual turnover of 30 or below is generally indicative of a lower levels of trading in the fund resulting in a lower TER.

Currency Conversion Charges
This is an element of cost that is often not understood well by investors, although it results in a significant drag on the portfolio performance over time. Currency conversion charges are incurred when you transact in a fund denominated in a non-Canadian currency (for example US Dollars), inside your account that is based in Canadian dollars. For example, when you purchase or sell a US listed exchange traded fund in your investment account that is denominated in Canadian Dollars, a foreign exchange conversion charge is incurred on the transaction.

Foreign exchange conversion charges for ‘retail’ investors, many a times as high as 2% of the transaction value, are built into the exchange rates applied on the transaction by the brokers. Hence this additional cost is not transparent to investors although exchange rates are disclosed on a transaction confirmation.

Impact of costs of investing
Although the various elements of cost may look small in percentage terms, they all add up over time especially in a low-return environment we are currently experiencing, which is expected to continue in the foreseeable future. For example, a 1% lower cost of investing (per year) on a portfolio of $100,000 over 25 years (ignoring taxes, assuming it earns an average return of 7% per year, and you contribute $5,000 to your savings every year) could enhance your portfolio value by $128,000 over that time period! (see chart below).

calculate

Source: Invisor Investment Management Inc.

Beware of services offered for free
A number of service providers in the investment industry offer various services apparently for ‘free’ or a very low cost (especially trading) to attract attention. But we all know the old adage – “there is no free lunch”. There are a number of ways in which service providers make up a lot more than the costs they incur in providing such services, through ways that are less transparent to the investor (e.g. foreign exchange fees, timing & pricing of the trade, etc.).

In the investment world in particular, a known cost is generally better than a ‘free’ service, especially considering the power of compounding over time shown in the chart above.

Call to Action
• Know your total costs of owning a portfolio – especially the important elements outlined above. These costs may look immaterial individually, but they add up and significantly impact your portfolio over time. If you are unclear about the costs and where to find them, speak to your advisor, broker or the fund company;

• Although costs are an important component of your portfolio, that is not the ‘be all and end all’ of your investing experience. Constructing a well-diversified portfolio aligned with your goals using the most appropriate funds/securities, risk tolerance and time horizon is of primary importance. In doing so, it is important to strike the right balance between the return objectives and the risks & costs associated with the investment products selected;

• Establishing an investment plan and following a disciplined approach takes emotion out of the equation and maximizes your portfolio value over time;

• Consider working with a fee-based advisor who is independent (not employed by or paid by fund companies) and has access to a wide variety of low-cost investment products with a strong track record, including the F-Series Mutual Funds (only available to fee-based advisors) and exchange traded funds. These products are very effective in constructing well-diversified portfolios seeking to maximize returns, while minimizing risks and costs of investing.

Follow Us!