The #1 thing to pay attention to when picking a fund are the fees. In my experience, with good funds, the fees are very upfront and easy to determine. Often, the sketchier funds tend to bury (or even omit) any mention of fees, focusing instead on cherry-picked performance data. For a guide to choosing specific funds, please see this page. Here, I’m going to give an overview of the different types of fees we’re looking to minimize and avoid.
Expense Ratio (ER) / Management Expense Ratio (MER) / Basis Points
The expense ratio (ER), which is typically called management expense ratio (MER) in Canada, is the percentage of your investment in a given fund that you have to pay each year towards operating expenses. You want this number to be as low as possible, because it will be collected every year, regardless of whether the investment gains or loses value for that year.
Expense ratios are often expressed as a percentage. For some reason, they are also sometimes referred to as basis points, and in this format they are NOT expressed as a percentage. So you might find a fund with an expense ratio of .25%. This could also be expressed as 25 basis points. .50% would be 50 basis points, and 1.25% would be 125 basis points. I have no idea why and I refuse to Google it because it irritates me.
How low do you want your expense ratios to be? Very low. The average expense ratio across all of our funds is .09%, and it’s only that high because we have some investments through a previous employer that are around .25%. If you’re investing (for some reason) in a very specialized index (like a emerging market dividend fund) you might pay a bit more than that (like in the .4% or .5% range) but I personally don’t bother with indices that are so specialized.
In an employer account like a 403(b) or a group RSP, you may have a poor selection of funds available to you. The typical MER of index funds offered by the brokerage used by my Canadian employer is ~1.3%. This is terrible. Thus, I invest only up to my employer match in this account, and use the remainder of my RSP room elsewhere.
If you’re really looking to minimize fees, ETFs are typically a bit cheaper than their mutual fund counterpart. For example, VTIAX (the mutual fund version) has an ER of .11%, while VXUS (the ETF version) is just .08%. The flip side is that, depending on your brokerage, some of this difference may be eaten up in trading commissions that could be charged when buying and selling ETFs. For more on choosing a brokerage, please see this page.
Ultimately, though, my advice is to do your best with fees but don’t drive yourself crazy. Sometimes you might be constrained by the fund selection offered by your employer. Do the best you can, and keep your fees as low as possible. Index funds are the way to do that.
Loads (Front-End and Back-End)
Some mutual funds have loads. A load is a sales charge that you either pay when you initially invest in the fund (a front-end load) or when you sell your shares of the fund (a back-end load). Funds without loads are called no-load funds.
I don’t want to spend any more time on loads than that. There is never any reason to invest in a fund with loads. When people are recommending them, it is because part of the load is going to them as a commission. Do not trust advisors who recommend funds with loads.
Now that we know the basics of determining fund costs, let’s look at a few prospectuses to see how we can use this knowledge to choose our funds.