High management fees can eat away at returns: over time, the impact of high fund fees can be staggering - Exchange Traded Funds

In our inaugural ETF article last month, we touched upon the main advantages that have led to the explosive growth of ETF assets in recent years. This month let's take a closer look at the number one advantage of ETFs, namely lower management fees or expense ratios (MERs), and what this can mean for your ultimate investment results. The MER is the amount you pay your fund manager for services, usually a percentage of assets.

It's often said you get what you pay for. As it turns out, when it comes to hiring professional money managers, the less you pay, the more you get. This inverse relationship means that lower MERs tend to lead to higher returns. In fact, a U.S. study by Morningstar found that "... the most important determinant of performance is fund expenses" *. Most exchange traded funds have MERs that range between 10 and 65 basis points (0.1%-to-0.65%). By contrast, mutual fund MERs typically weigh in from 200 to 300 basis points (2%-to-3%). Compound this difference out over most investors' time horizons and the end result is staggering. The accompanying Mutual Fund Fee Impact Calculator result found on the Ontario Securities Commission Web site illustrates this point quite well.

In both "investment pies" the investment is held for 25 years and the market earns a 10% annual rate of return. Both the mutual fund and ETF earn the market rate of return, before typical fees have been deducted. Each pie can be thought of as the total return that would be generated by the original investment if no fees were charged. Since there are fees associated with investing, each pie is sliced into three pieces. The "total load and fees" piece is the portion that was actually paid out due to the respective MERs. The "foregone earnings" slice represents the portion of returns that could have been earned if the fees had been invested on your behalf instead of paid out. The "return to the investor" is your piece of the pie to keep.

Look at the difference. The higher MER eats up a sizable chunk of your return pie. The lower MER allows you to retain over 90% of the returns and dish out diet-size cost pieces. On an original $10,000 investment, the difference in the final value of your investment pie goes from $59,235.14 to $102,064.93! That extra $42,829.79 retained will buy you plenty of your favourite fruit pies.

Costs Matter: Distribution of Returns and Costs

25 Year Holding Period 10% Annual Return

                    Mutual Fund  Exchange Traded
                    (1.5% MER)   Fund (0.25% MER)

Foregone Earnings     12.46%           3.86%
Total Load & Fees     20.89%           2.52%
Return to Investor    66.65%          93.61%

Source: Ontario Securities Commission; www.osc.gov.on.ca

Note: Table made from pie chart

RELATED ARTICLE: RRSP Investment Ideas Maximize Foreign Content Exposure Cost Effectively

* There are currently 16 Canadian-based ETFs, all 100% RSP eligible. But unlike mutual funds, you are not limited to only Canadian choices. There are currently in excess of 100 U.S. based. ETFs that slice U.S. and international markets by capitalization, style, industry Sector and regions. They trade on U.S. stock exchanges, typically the AMEX, and qualify as foreign content. You can research the complete list at www.amex.com or www.indexfunds.com.

* If 30% foreign exposure is too restrictive for your RSP, Barday's Global Investors Canada offers two fully-RSP eligible foreign equity ETFs: the iUnits[TM] S&P[R] 500 Index RSP Fund (iS500R; TSE: XSP) and the iUnits[TM] MSCI[R] International Equity Index RSP Fund (iIntR Fund; TSE: XIN). MERs are 0.30% and 0.35% respectively.

* The i500R and iIntR are the world's first synthetic ETFs. They use index futures and currency forwards to replicate, to the extent possible, an investment in the constituent companies of the S&P 500 and MSCI Provisional EAFE[R] indices, while remaining Canadian property for the purpose of the foreign content rules for RSP funds.

* Source: "Quarterly Mutual Funds Review", The Wall Street Journal, July 6, 1999

Howard Atkinson, CFA, CIMA, is author (with D. Green) of The New Investment Frontier: A Guide to Exchange Traded Funds for Canadians. He is also the National iUnits Marketing Manager at Barclays Gobal Investors Canada, Ltd. Phone 416-594-4404.

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