Just as life is split between the plant kingdom and animal kingdom, the mutual fund world is divided between load and no-load products, depending on whether you pay a sales commission or not. No-load advocates say loads are money down the drain, a drip, drip, drip that undermines returns over time. Those who believe in loads say you get what you pay for — that loads support the professional guidance many investors need.
It’s an eternal conflict that may never have a clear winner, an issue to be decided by each investor. So what are the various fees investors pay?
Loads are sales commissions, often 1 percent to 5 percent, charged at the front end when the fund shares are purchased, or at the back end when they are sold. The fee goes to the broker or advisor as payment for effort and expertise in picking a fund.
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Many brokers and financial advisors are paid in other ways, of course. “Asset-based” arrangements charge a percentage of the assets in the customer’s account, such as 1 percent per year. “Fee-only” advisors charge an asset-based fee or a flat rate for setting up a master plan, which many customers then implement by themselves by dealing directly with fund companies.
If you do choose a load fund be sure you’re getting the service you’re paying for, says Chris Kim, chief investment officer at Tompkins Financial Advisors in Ithaca, New York.
“Investors should expect transparency with respect to holdings, strategy consistency, market commentary, adherence to an established process, portfolio commentary, professional active management and a track record of (beating) the strategy’s benchmark,” Kim says.
Obviously, if you’re paying for advice in some other way, it doesn’t make sense pay a load as well.
Whether paying a load makes sense also boils down to math and the investor’s expectations. A 5 percent front-end load means the fund must gain 5.26 percent for the investor to break even. If you think the fund can do that, and that no comparable no-load fund will do as well, then paying the load may make sense. The longer you’ll hold the fund, the better the chance gains will offset the load. It’s the same with a back-end load, where 5 percent can cost more if the fund has had healthy gains.
But many experts argue that almost every load fund has a good no-load alternative
“These days, at least 98 percent of mutual funds that carry an upfront load have a reasonably similar no-load counterpart among the 3,700-plus funds in the no-load universe,” says Timothy G. Weidman, business professor at Doane University in Crete, Nebraska.
“So regardless of the investment objectives and/or sectors of the economy that one has in mind when looking for a particular type of fund, it is a very good bet that there are one or more no-load mutual funds that should be among the alternatives under consideration,” Weidman says.
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Ryan McGuinness, president of CTR Financial in Lincolnshire, Illinois, says there’s no reason to pay a load given the wealth of funds that do not charge them.
“Unfortunately, there are still many brokers out there who sell funds on a commission basis, so these fees are how they get paid.” McGuinness says. “This means there is a huge conflict of interest when it comes to accepting their investing advice.”
In fact, many no-load advocates like McGuinness say index-style funds are the way to go. Not only are they free of loads, they have extremely low annual fees, or expense ratios, which pay for the fund managers, paperwork and employees who take investors’ calls. Instead of seeking hot stocks and bonds, index fund managers simply buy and hold the securities in an underlying index like the Standard & Poor’s 500 index.
Avoiding the cost of stock pickers and analysts keeps the fees very low, and lots of research shows that this helps index funds beat managed funds over time, since few fund managers can out-perform the market year after year, and those annual fees add up.
“Don’t buy into that bunk about active management being worth it,” says Scott Tucker, president of Scott Tucker Solutions in Chicago. “All the research shows that active management can’t outperform the market.”
But Daniel L. Grote, a planner with Latitude Financial Group in Denver, says, “We believe there is a time and a place for active management in portfolios,” especially when investing in emerging market, small company growth stocks. “In the case of the latter, I’d feel a lot more comfortable knowing someone has boots on the ground overseas and has met with management, surveyed the local market and understands the hurdles these companies face.”
To make the fee issue more complex, many funds come in various flavors, or “share classes.” In some cases, a fund company charges a lower annual expense ratio for investors with large accounts — a kind of volume discount. In others, the investor can avoid an upfront load by selecting a class with a larger expense ratio. Again, the choice boils down to math, expectations for the fund, and the investor’s time horizon. If you expect to hold the shares for decades, a one-time load might be cheaper in the long run than a larger expense ratio that will continue every year.
Generally, Class A shares require a front-end load, though it may be reduced for subsequent purchases after the account reaches a given size.
Class B shares have a back-end load. These can suit investors who want all of their money put to work rather than using some to pay a load. Often, the load shrinks if the shares are held long enough. Class B shares often have higher expense ratios than Class A or C.
Class C shares usually have a level load that stays the same over time, though it may be discounted if the shares are held long enough. Expense ratios are usually between those of the other classes, and there may be a small back-end load that is waived for shares held longer than a year. Class C can be the best choice for investors expecting to sell quickly.
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Many funds have variations on these themes, so it pays to study the fund documents. An online calculator can help figure which class will work best.
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How to Decide Which Mutual Fund Share Class to Buy originally appeared on usnews.com
