Pay less, get more

It hurts me a little to admit this, but the last time I wrote about mutual fund fees in this column, I received several spirited letters informing me I was dead wrong in arguing that high fees can damage your returns.

My big mistake, several readers told me, was not realizing that fees are subtracted before fund returns are posted. Thus an 18%-a-year superstar fund really did earn you that magnificent 18% a year, even after the fees were paid. If that’s the case, who cares how high the fees were?

Well, I do. And so should you. I admit that the letter writers make a plausible-sounding point. But they should think about what they’re saying.

Is it really a winner?

For starters, you can’t project the past into the future. A fund that makes you 18% this year might lose you 2% next year. Past performance is a lousy predictor of future performance.

Burton Malkiel, a Princeton economics professor, shows in his classic book A Random Walk Down Wall Street that the best funds in the 1970s lagged behind in the ’80s, just as the best funds of the 1980s failed to keep up in the ’90s. In fact, Malkiel finds that the top funds from any long period usually end up underperforming in the next. John Bogle, founder of The Vanguard Group, came to the same conclusion when he looked at the top 10 funds leading up to the dot-com boom. Between 1996 and 1999 the funds produced an average annual return of 55%. Over the next three years, they lost 34% a year.

Fees still matter

You can’t rely on past performance to predict a fund’s future returns, but how much it charges in fees can provide you with an important clue. Expensive funds perform worse over the long term than funds with lower fees. As strange as it seems, the less you pay, the more you get.

Surprised? Most people think that funds with higher fees (called Management Expense Ratios or MERs) have more money to spend on research and managers, so they should perform better. But that’s not the case.

Bogle showed this by splitting U.S. funds into four groups ranging from the cheapest to the most expensive. He found that the gross returns before fees were actually pretty even across all four groups — the pricey funds didn’t perform any better than the cheap ones. So the net return that investors got depended on how much they lost to fees. The more money that went to the managers, the less there was left for investors.

Study after study has confirmed this effect, including a Canadian survey done by Gene Hochachka, a former quantitative analyst for the Vancouver mutual fund company Phillips, Hager & North. He found a straight one-for-one correlation between fees and returns. For every percentage point your fund company charges you in fees, your return goes down by one percentage point.

If that doesn’t convince you, try this little experiment. Go to an online fund screener such as Globefund.com and run two reports. In the first report, include the top 100 funds by 15-year annualized return with an MER of less than 2.5%. Those are your cheap funds. Then run the same report for the expensive funds, which are those with an MER of more than 2.5%. You’ll find that the cheap funds come out swinging with an average annual return of 12% — which is three full percentage points better than the pricey ones.

So how do you pick a winner?

The lesson here is that even though fees are subtracted before returns are posted, those fees are still quietly dragging down your results. That wouldn’t matter if expensive funds performed a lot better than cheaper ones, but they don’t.

Given that, your best bet is to reduce your fees by investing in a low-cost portfolio of index funds, such as our Couch Potato Portfolio. Its fees are about 0.5%, which is one fifth of the 2.5% charged by your average mutual fund.

If you’re more comfortable with prepackaged investments, you might prefer a low-cost balanced fund. Suzane Abboud, our mutual fund specialist, recommends the CIBC Monthly Income Fund, TD Monthly Income Fund or the RBC Monthly Income Fund as decent choices. Nothing is guaranteed, but by reducing your fees you’re improving your odds — and that’s what smart investing is all about.