This article was originally published on The Dividend Pig, as part of the Financial Literacy Day campaign, in Why You Should Avoid Mutual Funds .

According to Andrew Hallam, from Millionaire Teacher, Canadians are in the last spot at 18 out of 18, paying the highest mutual fund fees in the entire world! (Millionaire Teacher, pg.54)

Back in November, as part of the Financial Literacy Day campaign, I wrote about why you should start investing now . My point was to show how easily a nominal $25 per week invested, can grow into a sizable portfolio of over $17,168 in only ten years. For that figure I assumed a very conservative annual total return of only 5%!

I also showed how Canadian investors can take advantage of four TD e-Series Index Funds to build a portfolio for only $100 per month, with a purchase of a fund each week at $25. I also showed readers why the TD e-Series funds are such a great deal! There are no commissions to purchase or sell, and the MER (Management Expense Ratio) is less than 0.33%. Unfortunately, these funds are not well known to most Canadians. It’s a different story for Canadian investors who purchase actively managed mutual funds. and who are paying a premium in fees and being rewarded with under-performance.

What the Fund?

Back in July 2011, I chopped through all the complexities of mutual funds, index funds, and ETFs (Exchange Traded Funds) in Would The Real “Fund” Please Stand Up! If you aren’t up on the terminology, nor understand the difference between index funds, ETFs, or mutual funds, then be sure to check out this post. It’s a back to basics post for any investor.

Most people have a basic understanding of what Mutual Funds are, since they have invested in them at some point.  A mutual fund is basically a pool of funds collected from many investors for the purpose of investing in securities such as stocks and bonds. Most mutual funds are actively managed. in other words an investment manager decides on the securities to purchase, and manages the portfolio.

Most people start off with mutual funds, because it was what they know best through advertising, or by talking with their bank rep or directly through a mutual fund dealer. Mutual funds have long claimed to provide investors with professional management, above market performance, and a solid long-term investment strategy. Yet actively-managed mutual funds rarely deliver on any of these promises, and cost investors a small fortune in ongoing fees.

The main three reasons are:

• Upfront Fees: Commissions to Buy and Sell
• Hidden Fees: MER with included Trailer Fees
• Under-Performance

1. Upfront Fees

First, mutual funds are expensive in terms of the fees and commissions they charge upfront. What most people don’t realize is that many financial advisors are not financial planners, they are mutual fund dealers. Many mutual fund dealers charge hefty front-end and back-end commissions. These are usually laid out as front-end, back-end, and deferred-sales-charges depending on the length of time the funds are held. Here in Canada, these fees can vary anywhere from 2% to 6% of your capital, and are paid directly to the mutual fund company and dealer. That’s money out of your pocket!

2. Hidden Fees

Second, mutual funds are also expensive with the hidden fees that are not so obvious to investors. These fees are termed the MER (Management Expense Ratio). which also includes the Trailer Fee. In Canada, mutual fund fees are much higher than they are in the U.S. and Canadian investors are simply getting burned.

The Trailer Fee (which is part of the MER) is paid directly to the broker as a kick-back for selling the fund. Additionally trailer fees are also paid as an ongoing benefit to mutual fund dealers, depending on the value of a fund’s holding across the dealer’s client base. These are a small percentage, nonetheless add up over time. Essentially, the longer you hold your mutual fund, the more trailer fees you are paying to your advisor.

The MER. called the Management Expense Ratio, is an annual and ongoing fee that is charged from the fund’s income and profits. It pays for the fund’s management and administration, trailer fees, and also includes all the costs of marketing and promotion for the fund.

According to an article in the Globe and Mail back in March 2011 by Rob Carrick, The average Canadian equity mutual fund had a whopping annual MER of 2.43%! When you combine the MER with the included trailer fee, the average Canadian investor is likely paying around 2.5% to 3.0% annual fees to own a mutual fund. These fees are paid on top of any other front-end or back-end commissions. These fees are paid regardless how well or how poorly the fund performs.

The real irony is that investors pay all these fees, compounding year after year, whether the fund does well or performs poorly. 

3. Under-Performance

While mutual funds are a win for the companies who manage them and the brokers who sell them, most Canadian investors are paying a premium for under-performance. According to the 2011 ETF Landscape Review. only 15.1% of actively managed mutual funds in the Canadian Equity category were able to outperform the S&P/TSX Composite Index according to S&P.  Further study would be warranted to see how many of those funds were able to continue beating the benchmarks. When you consider the large annual MER fees, trailer fees, front-end or back-end commissions mutual fund companies charge, there is simply no excuse for paying for under-performance.

A great book covering the overwhelming evidence from the under-performance delivered by U.S. mutual funds, is Rick Ferris new book, The Power of Passive Investing . In his post for Financial Literacy Day, Avrex Money dove into the issue of under-performance and the high fees associated with actively managed mutual funds. One of my favourite bloggers, MoneyCone, also examined the under-performance issue of U.S. mutual funds in The Fund That Beat The Market 9 Times Since 1999 .

Award winning author Andrew Hallam, also covered the pitfalls of the mutual fund industry in depth, in his bestselling book Millionaire Teacher . According to his research, Canadians are at the last spot at 18 out of 18, paying the highest mutual fund fees in the entire world! (Millionaire Teacher, pg.54) Andrew quotes the fund fees that Canadians are paying around 3.0%, compared to U.S. mutual fund fees around 1.5%. I interviewed Andrew back in June 2011, before his book was officially published across North America, in The Millionaire Teacher .

If you are currently investing in mutual funds, and think you are doing fine, then I urge you to get a copy of Andrew’s book, and Rick Ferris recent book as well. You will be glad you did.

Conclusion

In this day and age of low-cost ETFs (Exchange Traded Funds) and low cost Index Funds, paying a premium for under-performance with actively managed mutual funds just doesn’t make for good returns.  Actively managed mutual funds in Canada not only under-perform and under-deliver, they cost a lot too!  Although U.S. investors pay at least half of what Canadians do, actively managed mutual funds still diminish your returns through ongoing fees, commissions, and under-performance. You can do much better with low-cost ETFs, low-cost Index Funds, and dividend paying stocks.

Readers, what’s your take? Are you still investing in actively-managed mutual funds? Have you considered the alternatives?