The Costs of Passive Fund Investing

There are many options for buying a group of securities in one product. The most popular ones are mutual funds, segregated funds, and exchange-traded funds. They have in common that these products are an easy way to buy a group of securities at once instead of buying each security individually. The fund can also proportion the securities so you, the individual investor, do not have to. There are two main classifications for what type of fund you can purchase in terms of costs. It is important to know how these costs work to avoid paying too much for this convenience. These products differ in how they are administered, access to the products, and their costs.

Active Versus Passive Investing

Before getting into which of the products are suitable for you, some aspects need to be considered to understand what the variations are among the products.

Active investing is when someone (a portfolio manager) picks the stocks in the fund and decides how much of each one to hold (the weighting). This portfolio manager would also monitor the portfolio and decide when a security should be sold off, added to, or have its weighting decreased. Since there are ongoing research, meetings, and analysis that must be done to build and monitor this portfolio, this fund manager would have research analysts and administrative personnel to help run the fund.

Passive investing has the same setup as active investing, but rather than deciding what securities to buy or how much of each one to buy, the portfolio manager would copy a benchmark. A benchmark is a collection of securities against which the fund is compared to see how well it is doing. Since everything in investing is about how much money you can make and how much risk it takes to make that money, every fund out there is trying to compare to all of the other funds of the same type to see who can make the most money. The basis for the comparisons is the benchmark, and then it becomes comparing between peers or funds managed the same way. Comparisons, in general, are done only for returns. The equation’s risk aspect is handled by looking at what type of securities the fund holds or how specialized the fund is.

How Do I Know By the Fund Name If it is Active or Passive?

The short answer is that you have to get to know how the fund manager operates the fund. Some clues to know more quickly if the fund is active or passive are given next. If they are intentionally trying to pick securities according to some beliefs about the market, this is active management. If the fund description talks about “beating the benchmark” or “manager skill,” it is actively managed. Another clue is to look at the return history. If returns vary versus the index by different amounts each year, then the fund is actively managed. Lastly, the fees may be expensive and have sales loads.

If the fund’s name says “Index” or “Index fund,” there is a good chance that the fund is passively managed. If the fund’s name says “ETF,” this could be a passive fund, but you need to make sure of this because some ETFs are actually active funds, but they are managed in a certain way. Most of the passively managed ETFs are provided by BMO, iShares, Claymore, Vanguard, and Horizons in Canada and Powershares, Vanguard and SPDR (or Standard and Poors) and others if the holdings are from the U.S. Most of the other companies would have actively managed funds only. If the fund description states that the fund is trying to “imitate” the performance of an index or benchmark, this implies that it is copying the index and is passively managed. From the return perspective, passively managed funds will be very close to the index they claim to imitate, but slightly less due to fees each year. The amount that the returns are under the index will be close to identical each year unless there are currency conversions or variances in cost, which may come from currency fluctuations or hedging that the fund may do. Passive funds typically do not have sales loads as they are geared toward people who invest for themselves.

Some funds try to mix active and passive management. These funds can be assumed to be actively managed, although their results will be closer to the benchmark than most other funds, so this is something to consider if the index’s variation is a factor.

Types of Costs

Whatever product you buy, there will be a cost associated with buying it, keeping it, and selling it. This will be true whether you have an advisor versus doing it yourself and whatever institution you go to. Even buying your own individual stocks will have trading fees, which you must account for. However, how much you are paying for each product and the advice will make a large difference in what return you will get after everything is made.

There are many types of costs to be aware of when deciding which products to invest in. This article will focus on the passive funds that make up a growing selection of retail investors’ products.

The Management Expense Ratio (MER)

This is the highest cost for most funds and represents the cost of managing the fund. “Managing the fund” means running the investment company, advertising, overhead, and the cost for the advisor or salesperson when it applies. Administrative costs like GST within the fund and accounting for trades and record keeping are also part of this cost. The MER is given as a percentage, which is the percentage of the assets that the fund manages or invests over a year.

If you have $100,000 invested in a fund, and the MER is 0.5% per year, you pay $500 per year to keep this fund. The cost is subtracted from the return and what you see in your investment statement is your return net of fees or after fees. The Management Expense Ratio is the management fee plus the administrative costs. The administrative costs are usually between 0.05% and 0.1% of the assets of the fund. If the information you obtain states a “Management Fee” instead of a “Management Expense Ratio,” you would have to add on the administrative costs to get the true fee. Seek out the prospectus and look up fund operating costs to find exactly how much the number is.