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Management Expense Ratio (MER)

What is a MER?

A Management Expense Ratio (MER) is an expense passed on to mutual fund investors in order to cover the costs associated with operating a mutual fund. The MER is calculated on an annual basis by dividing the fund’s operating expenses by the average dollar value of its assets under management. Of these operating expenses, the fee paid to the fund manager is the largest component. Recordkeeping, legal, accounting and auditing expenses are other costs that contribute to a final MER. From an investor standpoint, it is important to choose funds with “fair” MERs. Because the operating expenses are drawn from the fund’s assets, ultimately lowering the investor’s rate of return. If the fund underperforms one year and earns a negative return, the expenses are still funded by the assets, making a bad year even worse. 

What is a "fair" MER?

In judging whether a fund’s MER is justified, consider the fund’s investment strategy, the investment manager’s experience, and the fund’s historical returns.
When considering the fund’s investment strategy, the first thing to do is identify whether the fund is passively or actively managed. Active management portfolio managers are typically larger and require a team of research analysts to study individual companies and make buy, sell and hold recommendations. Having a larger team costs more money, and translates to a higher MER. 

Alternatively, passive funds such as the Vanguard S&P 500 ETF, try to mimic an index (in this case, the S&P 500). Replicating an index requires far fewer staff, and therefore charges significantly less. 

Doing research on a portfolio manager’s experience, both academic and professional, is also important. You want a manager who has “been there, done that.” A portfolio manager that has experienced stock market swings is preferred over one that has not.

Looking at historical returns is another piece of the puzzle in judging whether a fund’s MER is justified. When doing so, you want to compare a fund’s return to the return of the benchmark index. The excess (or deficit) return relative to the benchmark is known as alpha. Since alpha represents the performance of a fund relative to benchmark, it represents the value that an investment manager adds (or subtracts) to a fund’s return. This means that alpha is the return on investment not attributable to general market movements. Obviously, a positive alpha is desirable. In addition to generating positive alpha, it is also important that the fund’s alpha exceeds the fund’s MER. Therefore, you are always comparing “net returns.” Consider the example below:

Fund A:

Gross Return: 8.50%

MER: 3.50%

Net Return: 5.00%

Fund B:

Gross Return: 6.00%

MER: 2.00%

Net Return: 4.00%

As you can see from above, Fund A is the better investment. Even though Fund A’s MER is greater (3.50% compared to 2.00%), Fund A investors grow their money at a greater rate than Fund B investors. This is because the gross return of Fund A was much greater than that of Fund B. So, when comparing funds, it is important to compare net returns and not to simply seek the lowest possible MER.

When an Active Manager is Desired

The major benefit of active management is downside protection. Active managers typically outperform the market when it starts moving in a downward direction. This is important considering that investors “feel” downward swings much more than upward swings. Actively managed funds typically have downside capture ratios of less than 100, meaning that a fund loss less than its benchmark. In bull markets, actively managed funds typically perform similar to that of the market.  

Sources
https://www.investopedia.com/terms/e/expenseratio.asp
http://www.morningstar.com/InvGlossary/upside-downside-capture-ratio.aspx

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