Investing Risk: The Ouch from Management Costs and Taxes

Next in our rundown putting numbers to the magnitude of investing risks comes the combined effect of the management fees (MER), salaries, trading costs, administrative costs, commissions, trading spreads, price premiums over fund Net Asset Value and taxes. Unlike the more sudden and dramatic single events of most other risks, this type of risk mainly happens slowly and often obscurely but the cumulative effects can cause losses that are severe and permanent too.

Recurring Fees and Costs - Annual recurring charges can significantly damage the value of mutual fund, closed-end fund or ETF investments. Whether it be a fund's MER, trading costs or advisor wrap fees, seemingly modest annual costs of even 2% add up over time.

How bad can the effects be? The chart below from Bylo Selhi displays how much an investor is left with after deduction of annual fees. In order to isolate and reveal the fee effect, the chart is before investment returns, i.e. assuming 0% market returns. Market returns must overcome the constant drag of fees if the investor is to make any headway.

Are fees really as high as the worst numbers on the chart? Unfortunately, in many cases the answer is yes. A search in the Globe Investor Fund listing tool selecting funds where the MER, which is usually the main component of total annual costs, is 3% or more, brings up 2621 funds. Morningstar's report Global Fund Investor Experience 2011, linked to by Canadian Capitalist in his blog post Morningstar Grades Canada an F calculates that the median Canadian equity mutual fund charged 2.31%, while median fixed income fund expenses were 1.31% and money market funds were 0.8%. Note that the MER is charged against a fund's total assets, not against profits / returns, so it takes away a chunk of the investment whether or not the fund has made money.

Michael James on Money in MER Drag on Returns in Pictures took the actual returns of the S&P 500 over a 50 year investment period and calculated that a 2.5% annual expense ratio "decimated returns" leaving less than one third the end value of what it would have been with an expense ratio of 0.17% (an expense ratio available amongst the lowest cost index ETFs such as iShares S&P TSX 60 Index Fund, symbol: XIU).

Independent Investor's Cost of Investing (free registration required) shows other examples and studies of the negative impact of too-high fund fees.

Stocks and Salaries - A company's internal cost for management salaries is the individual stock counter-part to fund MER. Just as fund fees can vary, so can the salary burden of a company. It doesn't always follow, despite the oversight role of a company Board in controlling management, that the shareholder owner gets good value for salary. Some companies overpay and all the profit in effect ends up in management hands. At worst, management can bleed a company and leave the shareholder with a bankrupt worthless shell. That risk of loss is one reason for research into a company, including its management's behaviour, before investing.

Taxes - Fees are not the only thorny all-too-present recurring problem. Taxes can drastically reduce returns too. It is quite difficult to generalize about how dire the effects can be since taxes depend heavily on combinations of factors that vary considerably from one investor to another:

• tax bracket of the investor
• tax rates on interest, dividends and capital gains that vary according to the investor's tax bracket
• the proportions of interest, dividends and capital gains created by the investment mix
  
• account type holding the investment - tax-deferred, such as RRSP, LIF, LIRA etc; tax-free TFSA; annually taxable regular account

An example taken from the cited Morningstar report gives an idea of the impact: the effective taxes in Canada consumed 26% (vs only 20% in the USA) of a mutual fund's gains over a 5-year holding period for a couple with $100k income and a $100k initial portfolio composed of 40% fixed income and 60% equities in a taxable account.

Planning and deliberate structuring of investments is the primary way to achieve lower taxes. That can be quite involved and investors may be wise to turn to a professional tax advisor to do it effectively. Amongst those going it alone, a popular planning software is RRIFmetic, which shows how to optimize retirement income flows, factoring in taxes, from different types of accounts during retirement. The Finiki page on Tax-Efficient Investing contains a rundown of practical basic principles to follow.

Some may quibble that costs and taxes are not really a risk at all since there is no uncertainty about them - they always occur. We prefer to include them because, a) their negative effect is considerable and, b) there is great variability in their level. Fortunately, the investor can reduce this risk a lot through advance research by looking at published information on fees and costs and picking investments with lower costs. Costs are a much bigger risk for the unwary, the heedless and the careless.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.