7.3.3 Fees and return on investment

From: Financial Consumer Agency of Canada

When you invest, you must pay certain fees and costs, which will decrease the value of your investments. The amount of fees and expenses you pay will partly depend on the type of investment strategy you choose. With an active investing strategy, you trade frequently in order to outperform a benchmark index and maximize returns. On the other hand, passively managed funds such as an index fund will invest in assets in the same proportion as the products that the index tracks.

An active investing strategy – that is, trading frequently in response to changing information – is more costly. For example, actively managed mutual funds will select investments with the goal of outperforming a benchmark index and maximizing returns.

On the other hand, passively managed funds are investments that do not need close management and trading, such as a fund that simply matches the proportion of stocks on a stock exchange or other index. They just need the mix to be adjusted a few times a year.

Active management will lead to high management expenses (that is, a high management expense ratio or MER) and high trading commissions (that is, a high trading expense ratio or TER) as a result of the research and trading used to maximize portfolio returns. In contrast, since passive funds are traded less often, fees should be lower.

The graph below shows how an active fund and a passive fund compare to a benchmark (a standard reference for comparison):

  • The benchmark is the Standard and Poor's Toronto Stock Exchange Composite Index (S&P/TSX), a list of stocks that represents the value of shares on the Toronto Stock Exchange. Over 10 years, it shows a return of 7.03 percent per year.
  • The passive fund is an investment fund that simply matches the mix of shares listed in the S&P/TSX, and adjusts its holdings a few times a year to reflect changes in the index. After adjusting for management expenses of 0.26 percent per year, it shows a net return of 6.71 percent per year, a little less than the benchmark index.
  • The active fund is a typical Canadian equity mutual fund. Although it uses a trading strategy to try to earn a better return than the index, it has management expenses of 2.56 percent per year. Over 10 years, it shows a net return of 4.95 percent per year.

The passive fund in this example produced better returns than the active fund, and tracked the market quite well. Of course, there is no guarantee that a passive fund will always outperform an active fund; over time, however, high fees tend to limit the net returns on actively traded funds.
 

Investment performance of shares and effect of costs. Description below.
Text version: Investment performance of shares and effect of costs

All investment types start at a price of around $10,000 then dip slightly for a few months before a continuous rise in price until fall 2008. Stock prices then fall again for a few months before climbing back to a high of near $22,000 in March 2011.

Investment type Net percentage return over 10-years Price of shares over 10-years
Benchmark
[Standard and Poor's Toronto Stock Exchange Composite Index (S&P/TSX)]
7.03% $19,813.62
Passive fund 6.71% $19,222.33
Active fund 4.95% $12,652.87


You can read more about Fees and Costs in the section on Investment advisors.

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