# Why is MER important?



## MrSmith (Mar 12, 2012)

I've read a lot of discussions that says mutual funds are bad vs index funds and ETFs because the MER is higher. But, does MER really matter if a mutual fund performs the same or better?

Example: 
TD Dividend Growth (2.03% MER) -> 1yr = -2.9, 3yr = 18.7, 10yr = 7.9

TD Canadian Index (.88% MER) -> 1yr = -8.9, 3yr = 18.1, 10yr = 6.9

Can someone tell me why the Index fund is better? If you put $1000 in each of these funds, which one of these will give you higher return in 1yr, 3yr, or 10yr time?


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## andrewf (Mar 1, 2010)

You're not comparing comparable funds. If the MF and ETF are invested in the same investments, and the MF charges 2% a year more than the ETF, the ETF investment would be worth 1.02^10 more after 10 years, or 21.9% more. After 30 years, the ETF investment would be worth 81.1% more. Fees matter.


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## MoneyGal (Apr 24, 2009)

BY THE POWER OF MATH, WE SHALL BE SAVED!


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## Soils4Peace (Mar 14, 2010)

By the Power of Math, the Rule of 72, your early career investments can lose one Magic Doubling if you pay 2% higher fees. You want to pay between 0 and 0.5% MER.


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## GoldStone (Mar 6, 2011)

It's easy to identify high-MER active funds that outperformed the index in the *past* 10 years. The question is, which high-MER active funds will outperform the index in the *next* 10 years? I'm sure you heard the disclaimer... past performance does not guarantee future returns. Are you willing to pay more than 1% extra in fees each and every year, only to find out at the end of 10 years that you bet on a wrong active manager?

I recommend that you review this classic paper:

The Arithmetic of Active Management


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## Potato (Apr 3, 2009)

To expand on what's already been said: you can think of the index as like the average of all the various funds out there, but with lower fees. You can't control investment return, but you can control fees, so if you try to minimize fees you'll come out ahead in the end. Now that's not to say that _all _mutual funds will do worse than the index, just that net of fees _most _will. So you'll always be able to find a few funds that do a bit better than the index, the question remains: can you pick which ~10-20% of funds will be the ones to outperform for the _next _10 years, in advance?

To go back to your example:



MrSmith said:


> Example:
> TD Dividend Growth (2.03% MER) -> 1yr = -2.9, 3yr = 18.7, 10yr = 7.9
> 
> TD Canadian Index (.88% MER) -> 1yr = -8.9, 3yr = 18.1, 10yr = 6.9


What if you also added the TD Canadian Value fund?
TD Canadian Value (2.18% MER) -> 1yr = -12.9, 3yr = 19.1, 10yr = 5.1

If 10 years ago you weren't sure which fund would out-perform and so put half your money in the Dividend Growth fund, and half in the Canadian Value fund, you'd have made about 6.5% on average, less than if you had just gone with the index fund.

_Both _the Blue Chip and Small Cap funds under-performed, so if you had added those to your mix you'd be even worse off.

So if you're not sure which sector is going to out-perform, you've got much better odds just taking the gimme that is the lower fees and going with the average. If you _are _able to pick the winners of the future, why are you messing around with mutual funds and not buying those stocks or sector ETFs directly? Either way, there isn't much of a reason to pay high MERs.

Now as a footnote, there may be the gunslinger exception: maybe you can't identify hot sectors, but you do believe you can identify _talent_, and want to invest your money with the next Francis Chou (or perhaps the current one). Then your hotshot gunslingin' fund manager will produce enough returns to cover his or her fee and still leave some excess over the index for you. But even then, you're not going to find said manager running a fund for a big bank.

It's better to be lucky than good, but counting on luck doesn't make for much of a plan.


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## MrSmith (Mar 12, 2012)

Thanks for all the replies. I think I'm beginning to understand this a bit better now. It's all about trying to get an average return while minimizing risk. So, while it's possible for a MF with high MER to beat the market, there's a higher chance that it won't.

But I still think MER is meaningless because if there's an actively manage MF with the same MER as an index fund, would you still choose the index fund over the MF? Is the inherent risk still the same? 

Do fund managers by the very nature of their job description have more info (and thus insight) into the market so that they can react to market forces quicker? If they can see from their charts that oil and gold is rising, can they not allocate more of their portfolio into those sectors? You can't do that with a index fund.


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## MrSmith (Mar 12, 2012)

Thanks for all the replies. I think I'm beginning to understand this a bit better now. It's all about trying to get an average return while minimizing risk. So, while it's possible for a MF with high MER to beat the market, there's a higher chance that it won't.

But I still think MER is meaningless because if there's an actively manage MF with the same MER as an index fund, would you still choose the index fund over the MF? Is the inherent risk not still the same? If you say you would pick the index fund no matter what, then MER doesn't matter.

Do fund managers by the very nature of their job description have more info (and thus insight) into the market so that they can react to market forces quicker? If they see from their charts that oil and gold is rising, can they not allocate more of their portfolio into those sectors? If they see one of their stocks is falling, couldn't they cut their losses before it hits bottom? You can't do that with a index fund.


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## Lephturn (Aug 31, 2009)

MrSmith said:


> Thanks for all the replies. I think I'm beginning to understand this a bit better now. It's all about trying to get an average return while minimizing risk. So, while it's possible for a MF with high MER to beat the market, there's a higher chance that it won't.
> 
> But I still think MER is meaningless because if there's an actively manage MF with the same MER as an index fund, would you still choose the index fund over the MF? Is the inherent risk not still the same?


No the risks are not the same. With the actively managed fund you are always exposed to the additional risk that the manager makes the wrong choices. With a passive index based ETF there are no choices to be made and you know it will track the index very closely. The same cannot be said of any actively managed fund. You also have the issue where an active fund will trade more - so there will be additional expenses for buying and selling securities plus slippage and this is all in ON TOP of the MER. So there are additional risks and additional expenses that you don't see in the MER.



MrSmith said:


> Do fund managers by the very nature of their job description have more info (and thus insight) into the market so that they can react to market forces quicker? If they see from their charts that oil and gold is rising, can they not allocate more of their portfolio into those sectors? If they see one of their stocks is falling, couldn't they cut their losses before it hits bottom? You can't do that with a index fund.


You need to start reading the prospectuses of these funds. Mutual funds have a great deal of restrictions around what they can and can't invest in and how much. Especially with very large bank sponsored funds with a particular mandate such as "TD Dividend Growth" can only buy certain types of securities - in this case dividend paying stocks of a certain size and meeting certain criteria (dividend growth). If it's a multi billion dollar fund it will also have rules such as "no more than X% in any one security" and that X% is single digits. The end result is that the manager cannot do anything like what you suggest - they can't shift asset classes, buy gold, go to cash, etc. They can't use options to hedge. It's even very difficult for them buy and sell as they are often so large they cannot just jump in and out without moving the security. Mutual fund managers are so restricted in what they can and can't do that it is highly unlikely they will out perform the market. It's possible but it's highly improbable for any fund to out perform after expenses over a sustained period of time.


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## Zeeshan Hamid (Feb 28, 2012)

Here's a simple rule that almost always works :- Higher return almost always requires taking higher risk. Actively managed mutual funds typically measure their performance against an index fund. Fund managers actually don't want their performance to fall much below the index, so they dont actually take a much higher risk to get their fund to perform much higher either. History also shows that almost all actively managed funds almost always underperform the market (aka, whatever index they're tracking) in the long run. Lepthurn gives some other reasons why actively managed mutual funds don't outperform the larger market over a sustained period of time. 

IF I had to buy into an active fund, I'd put my money in pension funds (if I had access to them) because many pension funds have access to private investments that I (or ETFs) otherwise don't. But with good old vanilla mutual funds, ETF is almost always a better choice. 

Zeeshan


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## GoldStone (Mar 6, 2011)

MrSmith said:


> It's all about trying to get an average return while minimizing risk.


Above average return, actually. The majority of actively managed funds under-perform comparable index funds, once fees are deducted.



MrSmith said:


> So, while it's possible for a MF with high MER to beat the market, there's a higher chance that it won't.


Precisely.



MrSmith said:


> But I still think MER is meaningless because if there's an actively manage MF with the same MER as an index fund, would you still choose the index fund over the MF?


Your question is purely hypothetical. At the retail level, there is no such thing as _"an actively managed MF with the same MER as an index fund"_ (unless you intentionally pick some seriously overpriced index funds... they do exist). I can construct a well-diversified, all-ETF portfolio with a MER between 0.1% and 0.2%. Good luck building a comparable portfolio of active funds for less than 1.7% - 2.0%.



MrSmith said:


> Do fund managers by the very nature of their job description have more info (and thus insight) into the market so that they can react to market forces quicker? If they can see from their charts that oil and gold is rising, can they not allocate more of their portfolio into those sectors?


Once again, I refer you to the classic paper that I linked upthread. Nobel Prize winning economist Bill Sharpe wrote:



> If "active" and "passive" management styles are defined in sensible ways, it must be the case that
> 
> (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
> 
> (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar


It's a matter of simple *arithmetic*.


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## Potato (Apr 3, 2009)

MrSmith said:


> But I still think MER is meaningless because if there's an actively manage MF with the same MER as an index fund, would you still choose the index fund over the MF? Is the inherent risk not still the same?


Others have already put up great answers, but I'll put a slightly different spin on this part.

If you don't have the headwinds of higher costs, then the active fund should have about the same expected return as the index, but would have a higher volatility/wider range of outcomes than the index (the index is diversified enough that it will never blow itself up, nor rocket to the moon, whereas some of the actively managed funds will). Most people have strong loss aversion, so will prefer the index's relatively sedate average over swinging for the fences, even at the same MER. And of course, the MERs of most index funds (e-series, ETFs) is so low that it's nigh impossible to find this type of situation in the first place.



> Do fund managers by the very nature of their job description have more info (and thus insight) into the market so that they can react to market forces quicker?


To a rough approximation, the sum of all fund managers *is* the market/index. So some will do better, some will do worse, and with the higher fees their investors will do worse in aggregate. Picking the winners in advance is hard. 

So you've got to work with the information and probabilities you have. *With a high degree of certainty, you know the markets as a whole generally go up over the long term*. Index funds let you invest on that knowledge: you get the market return, less a small fee, and can hold on for the long term. Any other investment you or your fund manager makes is not going to be as certain as that. Some (such as going into cash or shorting the market) actively go against that long-term wisdom.


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## Eclectic12 (Oct 20, 2010)

Zeeshan Hamid said:


> [ ... ]
> 
> IF I had to buy into an active fund, I'd put my money in pension funds (if I had access to them) because many pension funds have access to private investments that I (or ETFs) otherwise don't. But with good old vanilla mutual funds, ETF is almost always a better choice.
> 
> Zeeshan


Another place that IMO, an active fund can make sense is a developing market. 

The fund is likely to have better sources of information than the individual investor. Then too, a new index may also have junk in it to fill out the index.


I'd also put a caveat on the "ETF is almost always a better choice" to make sure the appropriate due diligence has been done. I haven't checked in a while but at one point, I did see an ETF that tracked the Canadian Index that had a MER of 1.75% which made no sense. 


Cheers


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## gibor365 (Apr 1, 2011)

This is why MF investments are not so good


> Saturday, March 17, 12:00 PM Random number generation? A striking report from S&P tips off that not only did 84% of actively managed funds fail to beat their benchmarks in 2011's tricky market, but less than 50% of portfolio managers outperformed even over a five year tracking period. Even the best of the lot struggle, with only 12.2% of the large-cap funds ranked in the top quartile five years ago managing to maintain a spot in the upper 25% five years later. "There's no evidence of persistence of performance beyond what would be randomly expected," says Buckingham Asset's Larry Swedroe.


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