Comparing the management fees of two exchange-traded funds (ETFs) without considering their Management Expense Ratios (MERs) is a deceptive practice that can lead to a significant misjudgment of the true cost of an investment. While the management fee is a major component, the MER provides a more comprehensive and accurate picture of the total annual cost to an investor.

This issue is particularly relevant for Canadian investors, who may find that fund providers prominently display the lower management fee on their websites and marketing materials, while the all-encompassing MER is often located within less accessible regulatory documents like the “ETF Facts.” In contrast, the U.S. market tends to give more prominence to the “Expense Ratio,” which is analogous to the Canadian MER.

Deconstructing the Fees: Management Fee vs. MER

The key distinction lies in what each fee includes:

• Management Fee: This is the fee paid to the investment manager for their services in managing the fund’s portfolio. It covers the costs of the portfolio managers and the investment research team.

• Management Expense Ratio (MER): This is the total cost of running the fund, expressed as an annual percentage of the fund’s average net assets. Crucially, the MER includes the management fee and a host of other operating expenses, such as:

  • Administrative and operating costs: These cover the day-to-day expenses of the fund, including accounting, legal, and audit fees, as well as custody and transfer agent fees.
  • Financial Derivatives: Transaction costs for trading futures and options, and the interest rate component of a swap agreement is a direct cost to the fund. When a fund borrows money to invest (a more direct form of leverage), the interest on that loan is also a direct cost.
  • Taxes: In Canada, the MER includes harmonized sales tax (HST) or goods and services tax (GST) on the management fee.
  • Other miscellaneous expenses: This can include costs associated with the independent review committee and other regulatory compliance requirements.
    
    

Why a Lower Management Fee Can Be Misleading

A fund may advertise a very low management fee to attract investors, but have a significantly higher MER due to substantial operating costs. For example:

• ETF A might have a management fee of 0.20%, but an MER of 0.65%.
• ETF B might have a seemingly higher management fee of 0.30% but a lower MER of 0.50%.

An investor solely focused on the management fee would incorrectly perceive ETF A as the cheaper option. However, in reality, ETF B would be the more cost-effective investment, as it consumes a smaller portion of the investor’s assets in total fees each year. Over the long term, this seemingly small difference in MER can have a substantial impact on investment returns due to the power of compounding.

It is important to note that many leveraged income funds in Canada have an MER well above 2.0% while their websites show Management Fees of 0.65% or less. HDIV from Hamilton is a good example - with an MER of 2.67% which is high. Delving deeper we see that the high MER is due to the 25% extra leverage and the complexity of this fund of funds to manage. HDIV is a very good and popular fund, investors hope that the 25% extra leverage causing higher yield, will more than recover the extra fees.

The Bottom Line for Investors

Always look at and compare total returns of funds over a significant period before you invest. Total Return is the great equalizer because the MER is already deducted. Total Return (which includes price appreciation and distributions) is the net actual return that was received.

To make an informed decision when comparing ETFs, it is imperative to look beyond the prominently advertised management fee and seek out the MER. In Canada, this information is readily available in the mandatory “ETF Facts” document for each fund, which can typically be found on the ETF provider’s website. By comparing the MERs of different funds, investors can get a true “apples-to-apples” comparison of their annual costs and make choices that better align with their long-term financial goals.

Smart investors recognize that MER costs are a direct drag on a fund’s performance!