When initially choosing which investment option to go with, many people don’t realize the impact investment costs have on their investments. The more your investments cost you, the less you have to invest.
Your net return can increase by either improving your return, lowering your cost of investing, or a combination of both. Over time, this can have a significant impact to your bottom line due to the power of compounding growth.
Exploring the costs associated with different investment options
To illustrate, we will use Mrs. Smith, a 60-year-old investor who recently sold her home and has $1,000,000 in the bank in a non-registered account and a fully funded Tax-Free Savings Account (TFSA). She is in the 30 per cent income tax bracket. Mrs. Smith is not interested in managing her own investments and is curious about four different investment options she has heard of from talking with her neighbours, former colleagues and friends.
We met with Mrs. Smith and assisted her in exploring these four investment options, looking at the transaction costs to initially get investing, ongoing costs, and the tax deductibility of these costs.
Option one: Exchange Traded Fund (ETF) approach
Investing through Exchange Traded Funds (ETFs) is often referred to as “couch potato” investing. Exchange Traded Funds are a pooled investment security that trade on an exchange. ETFs will track a certain index, sector, commodity, etc.
This approach is passive as it holds the investments that are in the respective index and these holdings are not actively managed. When investing in ETFs, your returns will only ever be as good as those of the index it tracks, less the embedded cost.
To purchase ETFs, there are upfront costs to initially buy the holdings in the first year, as well as ongoing embedded costs annually thereafter — neither of which can be deducted for income tax purposes.
To illustrate the initial transaction costs, we will assume that Mrs. Smith buys 11 different ETFs at $90,900 each. The equity commission schedule for trades at this amount is 1.75 per cent. This commission cost must be factored into how much of each ETF Mrs. Smith can buy.
Each trade will cost Mrs. Smith $1,591 ($90,900 x 1.75 per cent). Multiply that over the 11 total trades and on day one this option costs Mrs. Smith $17,498. After factoring in the cost of the initial trades, this then leaves Mrs. Smith with an initial investment of $982,502.
There will also be subsequent costs if Mrs. Smith sells and buys ETFs going forward. On top of the initial commission charges, the annual embedded cost of investing for this option can be around 0.5 per cent, or $4,913 in the first year ($982,502 x 0.5 per cent = $4,913). This brings the total cost to investing in the first year up to $22,411.
Option two: Direct holdings in a fee-based account
Another option is to work with a Wealth Advisor or Portfolio Manager and purchase direct holdings in a fee-based account.
The cost for the option of holding direct holdings in a fee-based account can fluctuate depending on the Wealth Advisor or Portfolio Manager you are working with, and the amount you have invested. The fee charged often decreases as the account value increases. The benefit of this option is that an advisor can assist you with strategic adjustments with no additional costs.
Option two is the most transparent with respect to fee disclosure of all options. If Mrs. Smith put the $1,000,000 into a fee-based account, we would price this at 1.00 per cent.
For our example, the 1.00 per cent fee would equal $10,000 in the first year ($1,000,000 x 1.00 per cent = $10,000). This $10,000 is all inclusive and there are no other embedded fees or transaction costs. There are no up-front costs associated, and fees are billed quarterly, at the end of each quarter.
These fees are also considered investment counsel fees for income tax purposes and can be deducted on her income tax return. As Mrs. Smith is in the 30 per cent income tax bracket, this brings her after-tax fee down to 0.7 per cent.
Mrs. Smith’s after-tax cost of investing is brought down to $7,000 with the $3,000 tax savings from being able to deduct our fee ($10,000 x 30 per cent) with this option. The total cost in the first year is $7,000.
Option three: Holding a basket of mutual funds
Mutual funds are actively managed and have embedded annual fees called a Management Expense Ratio (MER) and trading costs referred to as Trading Expense Ratio (TER).
In addition to the MER and TER, mutual funds may be sold on either a no-load or a front-end basis with additional fees of up to five per cent initially. Neither the embedded fees or additional fees are deductible for income tax purposes.
Previously, funds could also be sold on a back-end basis where you would typically not be charged an initial fee, but would be charged a fee if you sold the fund within the applicable Deferred Sales Charge (DSC) period. Effective June 1, 2022, DSC mutual funds are no longer allowed, and for good reason in my opinion. If Mrs. Smith was sold DSC mutual funds and was not happy with her performance, or wanted to make a change within the DSC period, she may have to pay up to six per cent to sell the mutual fund.
For purposes of the illustration, let’s see what the upfront and ongoing costs would be to Mrs. Smith if she purchases $1,000,000 of front-end mutual funds with a three per cent initial sales charge (ISC).
With this option, the ISC eats into her original investment. Mrs. Smith would pay $30,000 ($1,000,000 x 3.0 per cent) in ISC, leaving $970,000 ($1,000,000 - $30,000) to be invested. On top of the ISC, there is also embedded MER and TER which totals 2.3 per cent annually.
Mrs. Smith will be paying annual embedded MER of $22,310 in the first year ($970,000 x 2.3 per cent). The total cost to Mrs. Smith in the first year is $52,310 ($30,000 ISC + $22,310 MER).
Option four: Holding a basket of segregated funds
Mrs. Smith has heard about some guaranteed insurance products called segregated funds.
The primary difference between mutual funds and segregated funds is that the latter is an insurance product. Being an insurance product, the investments can be set up with different maturity and death benefit guarantees.
Another feature is segregated funds have the ability to name beneficiaries to bypass probate and public record. Similar to mutual funds, segregated funds can also be sold as no-load or ISC, and have embedded MER and TER, neither of which are tax deductible. Effective June 1, 2022, DSC segregated funds are also no longer permitted.
To illustrate, we will see the total and ongoing costs to Mrs. Smith if she purchases $1,000,000 of segregated funds with a three per cent ISC.
Similar to the mutual fund example above, Mrs. Smith is left with a smaller investment after paying the ISC. Mrs. Smith would pay $30,000 ($1,000,000 x 3.0 per cent) in ISC, leaving $970,000 ($1,000,000 - $30,000) invested. On top of the ISC, there is also embedded MER and TER which totals 3.5 per cent annually. Mrs. Smith will be paying an annual embedded MER of
$33,950 in the first year ($970,000 x 3.50 per cent). The total cost to Mrs. Smith in the first year is $63,950 ($30,000 ISC + $33,950 MER).
The power of compounded growth
The long-term effect on accumulated savings can be quite shocking when different net returns are explored over a 10-year period. To help with the illustration, we will assume that investment returns over the next 10 years will be six per cent for all four options.
Running the numbers
Option one: Exchange Traded Fund (ETF) approach
The net return is 5.5 per cent (6.0 per cent less the 0.5 per cent embedded ETF fee). A net return of 5.5 per cent compounded over 10 years would have grown Mrs. Smith’s $982,502 (amount invested after factoring in the initial commission charges) to $1,678,255.
These numbers assume that no changes were made to the basket of ETFs. Costs are low with this option; however, performance is an important component. There is much debate about the performance of ETFs as you will only ever do as well as the index you are tracking, less the embedded costs of the ETF.
With this option, costs can only be kept low with inactivity as there are costs to buy, sell or switch the ETFs held, as illustrated by the initial costs of $17,498. Having a Portfolio Manager making strategic adjustments to your portfolio will result in greater performance than the ETF approach in our opinion.
Option two: Direct holdings in a fee-based account
The net return is 5.3 per cent (6.0 per cent less the 0.7 per cent after-tax fee).
A net return of 5.3 per cent compounded over 10 years would have grown Mrs. Smith’s $1,000,000 to $1,676,037. In the first year, option two is by far the cheapest ($7,000 with option one compared to $22,411 with option two). On an ongoing basis, the cost differential of option two over option one is approximately 0.2 per cent, after tax (5.5 per cent - 5.3 per cent).
This cost would more than likely be offset by higher returns achieved with a good Portfolio Manager who is able to actively manage your portfolio and make strategic changes. A Portfolio Manager is also able to manage the day-to-day investment decisions and administration of your accounts, while also providing Total Wealth Planning and holistic service.
Mrs. Smith does not want to manage her investments, so by working with a trusted and knowledgeable Portfolio Manager she can focus on what truly matters most to her.
Option three: Holding a basket of mutual funds
Option three has a sizeable increase in fees compared with options one and two. When compounded over 10 years, the difference is significant.
With this option, the net return is 3.7 per cent (6.0 per cent less the 2.3 per cent fee). A net return of 3.7 per cent compounded over ten years would have grown Mrs. Smith’s $970,000 (amount to initially invest after factoring in the $30,000 ISC) into $1,394,952.
This equates to a $281,085 difference over only 10 years when compared to option two ($1,676,037 - $1,394,952).
Option four: Holding a basket of segregated funds
With the segregated funds option, the net return is 2.5 per cent (6.0 per cent less 3.5 per cent fee). A net return of 2.5 per cent compounded over ten years would have grown Mrs. Smith’s $970,000 to $1,241,682.
The difference between option four and option two is a whopping $434,355 ($1,676,037 - $1,241,682)!
We encourage all investors to find out what their cost of investing is and to determine both the initial and ongoing costs. Small differences can have a material impact on your long-term financial success.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email greenard.group@scotiawealth.com, or visit greenardgroup.com.
