Understanding Mutual Fund Loads and Share Classes
by Austin Pryor for Sound Mind Investing
What does it cost to buy mutual funds? That depends on how you buy them…whether you go to them or they come to you. Mutual funds earn their profits by the management fees they charge, which are based on the amount of money they are responsible for investing. The more investors’ money they manage, the more they make. Naturally, they want to attract as many customers as possible.
So-called “load” funds get new customers by having a sales force of stockbrokers, financial planners, and insurance professionals sell their funds for them. These funds charge a sales fee, which is added on top of the fund’s net asset value. This markup cost can run as high as 8.5 percent on every dollar you invest. The load applies to all purchases you make in the fund, not just the first time; some load funds even charge to reinvest your dividends for you (which I think is going a bit far). In return, the salesperson comes up with recommendations as to which funds might be best suited for your goals and completes all the paperwork to get your account opened. The load is the way the salesperson is rewarded for opening and servicing new accounts. If you would never get around to doing the research needed to select funds that are right for you, the salesperson provides an important service by doing this work for you and motivating you to action.
“No-load” funds, on the other hand, have chosen to deal directly with investors. They don’t have a sales force to represent them—they believe plenty of investors are willing to do their own research and paperwork in order to save on the sales load. They don’t come to you; you go to them. Of course, they make it as easy as possible through their advertising, 800 numbers, and customer service departments. Since they don’t have salespeople to pay, they don’t charge the load (thus the name “no-load”). By showing some initiative, you can save the 5–8.5 percent load that is commonly charged. That means all the money you put into your fund account goes to work for you. I recommend you limit your investment shopping to no-load funds. You can learn all you need to know in the SMI newsletter to select the funds that are right for you, and you’ll save thousands of dollars in loads over the years.
THE ON-GOING COSTS
In addition to the sales commissions involved when investing in load funds, there are also the ongoing operating expenses that are charged by all mutual funds, whether load or no-load. These are the costs of owning mutual funds over the long haul.
1. First, there are the costs associated with making the investing decisions. This means paying for an experienced portfolio manager as well as a staff of financial analysts to help with all the research, and is by far the largest of the operating expenses.
2. Second, there’s a lot of administrative overhead involved in having a large office, staff, and equipment.
3. Third, there’s the cost of having a bank maintain the shareholder accounts and safeguard all the money and securities which are constantly coming and going.
4. Fourth, there are the costs of presenting regular reports to shareholders, as well as for legal and auditing services.
In addition to all the operating expenses, over 70 percent of all stock funds also charge some of their marketing expenses to shareholders. These expenses are referred to as “12b-1” fees because of the SEC ruling that permits them, and the money from them can only be used to advertise and sell the fund to prospective investors.
Collectively, operating and marketing expenses cost shareholders in the average stock fund around $15 annually for every $1,000 of account value. The way this is commonly stated is that the average fund’s “expense ratio” is 1.5 percent. These operating and marketing expenses are not taken out of your account all at once. Rather, in a manner that is invisible to the shareholder, they are charged daily against the fund’s net asset value. The price you see in the newspaper has already had that day’s share of the costs deducted.
When you see fund rankings in financial newspapers and magazines, these expenses have already been deducted; that is, the effects of each fund’s annual expenses have been taken into account. That is not usually the case, however, with respect to any sales commissions a fund might charge. Unless the article specifically states to the contrary, sales loads are typically not taken into account when fund performance rankings are compiled. Therefore, the return you would actually receive would need to be adjusted downward by the amount of the sales load.
DON’T LET CLASS CONFUSION FOOL YOU
To keep track of the mountain of data generated by the mutual fund industry, I subscribe to a pretty neat service offered by Morningstar, the leader among organizations that monitor the investment performance of mutual funds. For $1,125 a year, I receive a computer CD each month that is packed with the equivalent of several thousand pages of data. The current one has information on 6,053 mutual funds (or 15,986 if you count different classes of shares of the same fund!).
Much of this dramatic growth is attributable to a feeding frenzy on the part of investors. The public’s appetite for investing has been huge, and fund organizations have responded in fine capitalistic fashion by meeting the demands of the marketplace. A considerable number of the new funds, however, aren’t really “new” at all. They’re old load funds trying to look more like no-loads by creating new “classes” of shares. If you study the offerings of load fund organizations these days, you’ll often find they offer three primary ways of investing in the same fund.
* Class “A” shares. This is the traditional load fund arrangement where you pay a sales charge to the broker or financial planner who introduced you to the fund, and this charge is deducted from your investment at the time you make it. Whereas this used to run 8.5 percent, competitive pressures from the no-loads have taken their toll. The most common front-end load is now 5.75 percent, and some stock fund loads are as low as 3 percent. In addition to this one-time sales charge, you also pay the on-going annual operating expenses which are common to all mutual funds.
* Class “B” shares. These shares move the load from the front-end to the back-end, where it gradually diminishes the longer you hold your shares. A typical arrangement might call for you to pay a 5 percent load if you sell your shares during the first year, a 4 percent load if you sell during the second year, and so on until you pay no load at all if you hold on for five years or more. Your broker still receives a sales commission, but it comes from the fund organization rather than immediately from your account. How does the fund recoup this money? By adding it to the fund’s annual expenses, which makes them higher than they otherwise would be. So (surprise!) you’re the one who ultimately pays; you just do it a little every day rather than all at once up front. After six to ten years, some fund organizations will automatically convert your Class “B” shares to Class “A” shares (which pay lower—that is, normal—annual expenses) on the basis that by then you’ll have “paid your dues.” Other organizations aren’t so fair-minded and continue to gouge you indefinitely. I would not recommend you buy Class “B” shares.
* Class “C” shares. At first glance, these seem the most like no-load funds. They usually have no front-end loads (although some charge 1 percent up front), and the deferred load, a relatively small 1 percent, usually applies only to redemptions made during the first year you own your shares. The selling broker typically gets a 1 percent up-front commission for selling Class “C” fund shares as well as an on-going quarterly payment which is built into the fund’s expense charge and continues for as long as you own your shares.
If you must buy load funds, those following our Upgrading strategy should only consider Class “C” shares. You can see that, under similar market conditions, they maintain a profit lead over Class “A” shares for the first nine years. This is due to the front load paid at the time of purchase; it takes many years to overcome this initial cost. If you hold them long enough (10 years or more), Class “A” shares eventually catch up due to their lower annual expenses, but Upgraders will never hold their stock funds for a decade.
Two kinds of no-load funds are also included for comparison purposes. One group charges 12b-1 fees. The other group, for competitive reasons, elects not to charge 12b-1 fees in order to keep the expenses to shareholders down. (Note that 12b-1 fees are already included in a fund’s expense ratio and its published performance results—and therefore also reflected in SMI’s momentum score calculation for each fund. In other words, you don’t need to worry about 12b-1 marketing fees on top of the regular operating expenses because the expense ratio includes them all.) As the table makes clear, no-load fund investors enjoy the best of both worlds—no sales charges going in or coming out, and low annual expenses for as long as you stay.
SMI’s monthly Fund Performance Rankings show whether a fund is no-load, charges a front load, or charges a back load. The information is the latest available from Morningstar, and refers to the fees charged when funds are bought directly from the fund organization. Different fees, or no fees at all, may apply when a fund is purchased through a discount broker’s fund supermarket or a 401(k) plan.
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Originally posted 2/20/2011