We previously reviewed the perceived advantages of investing via mutual funds. Funds are a great way for investors to build well-diversified portfolios and meet long-term investment objectives.
However, there are potential downsides. Not necessarily negatives, but areas investors need to be aware of and take measures to protect themselves against.
This is why we diverted to the concept of compound returns over the last few posts. How time horizon, cost structure, and rate of return can greatly impact long term wealth accumulation. Even 1% here or there can alter asset growth.
We will consider how mutual funds (or any investment) may negatively impact your annual net returns and thereby significantly impair wealth accumulation. Today, transaction costs incurred when buying and selling open-end mutual funds.
The Importance of Transaction Costs
As we saw in compound returns, every dollar you pay to someone else is a dollar of extra returns that must be earned just to break-even. And every dollar lost, is a dollar that cannot compound over time. A significant problem for investors attempting to achieve long-term portfolio growth.
Transaction costs can be a major expense when investing. Less so now that most investors use online brokerage accounts. $10 per trade is easier to handle than in the days of full service brokers.
As well, the introduction and proliferation of exchange traded funds has worked to reduce loads (and, as we will review later, expense ratios) in mutual funds.
Mutual Fund Transaction Costs
Funds may be subject to a sales charge when investors buy or sell shares or units of the fund. This transaction fee compensates brokers or internal fund salesmen for selling investors the fund.
The fee is known as the load or sales commission.
You may encounter front-end, back-end, or declining loads. Some funds may offer more than one option.
Note that different load options may result in other different terms or conditions. For example, a no-load fund may charge higher annual fees than the exact same fund with an upfront sales commission. Clearly understand the total fee structure, including ongoing costs, before choosing a load option.
Although similar to the broker’s commission when you trade a marketable security, be aware that a load is not a commission in that sense. If investing directly via the mutual fund company, there should be no broker’s transaction cost. Two different concepts.
Front-end Load Funds
A front-end load is paid to the mutual fund company when you purchase units or shares of the fund. In future, when you sell the investment, there is no load paid.
For example, on January 1, 2018 you invest $1000 in an global equity fund that has a a 5% front-end load and a closing net asset value (NAV) of $50 per share. You will pay $50 as a sales fee (5% of the $1000) and receive 19 shares of the fund with your remaining $950.
And yes, your fund has a lot of work just to recover the compound returns you will lose over time on that initial 5% load.
Back-end Load Funds
A back-end load is the opposite of a front-end load. Instead of paying a sales fee when you purchase shares of the fund, you pay a fee when you sell.
As you pay the transaction fee only at the end, back-end loads are also known as deferred loads or deferred sales charges.
Using our previous example, let us say that the 5% load is a back-end instead of front-end.
Had you invested $1000 in the global equity fund at $50 per share, you would receive 20 shares as the entire amount would be available for purchase.
Perhaps in 6 months the fund rises to a $60 per share NAV. You decide to sell your 20 shares and will have gross proceeds of $1200. As you now have a deferred load, you must pay the 5% sales fee. But not on the initial capital invested as in the front-end. Rather, you will pay on your gross proceeds. In this case, you will be charged $60.
The trade-off between the front and back-end loads is two-fold.
As you hope to experience appreciation in the value of the fund, you should expect to pay more for a back-end load with the same percentage fee than with a front-end load.
Because of the time value of money, the longer you hold the shares, the better the back-end load will look. If you intend to keep the investment for a long time and have a choice between equal fees, back-end funds should be the better option.
Declining Load Funds
Many back-end loads offer declining sales charges over time.
This is an incentive for investors to stay in the fund for longer time frames.
For example, perhaps the back-end load is structured as follows: 5% sales charge if sold within 3 years; 3% sales charge if sold after 3 years but before 7 years; 0% if sold after 7 years.
If you do not sell for at least 7 years, you will not be charged any fees.
In our example above, you consider selling your fund shares on December 31 in the years 2018, 2022, and 2027. The per share NAV on those three dates is respectively $60, $80, $100.
With a declining back-end load, you would pay a sales charge of $60 (2018), $48 (2022), and $0 (2027). The longer you hold, the better the deal. In this example, the dollar value sales charge decreased even though the total assets grew over time.
Often, declining loads appear very reasonable as many investors plan to hold onto funds for extended periods. However, be aware that the best of intentions often go awry. Personal circumstances may change and you may need to divest before the back-end load falls to nil.
As mentioned above, check to see how a back or deferred load may result in other charges or expenses. If you save money on the commission, you may just be paying for it under another guise.
No-load Funds
No-load funds do not charge a sales fee.
All else equal, no-load funds are more desirable to investors than any type of load fund.
Every dollar of investor capital goes to acquire shares of the fund. And every dollar of gross proceeds upon sale is due to the investor. None of the investor’s funds go to pay the salesman.
Of course, load fund salesmen will make compelling arguments as to why paying a sales charge to acquire a particular load fund is worth the fee.
While their load funds may be excellent, always keep in mind that the salesman is paid for selling the fund. I would add that “excellent” is a relative term. You need to assess whether the expected performance of the fund over time justifies paying someone for the privilege of owning it.
Many salesmen may be principled and want to find the you best fund for your needs. But some salesmen may push customers towards funds that provide them with the best sales charge. When dealing with people selling load funds, always be cautious as to their intentions.
Of course, the same caveat as with deferred loads is true for no-loads. You need to examine the other fund costs to see if you are paying a hidden commission.
Commissions on Mutual Funds
As I wrote above, a sales charge is not a broker’s commission. It is compensation from the mutual fund to the salesperson.
Open-end mutual funds are bought and sold directly from the mutual fund company. They do not trade on exchanges and you do not require a broker to transact trades on your behalf.
That said, to improve investor accessibility to mutual funds, many fund families allow investors to buy and sell funds through the investor’s brokerage account.
So if you purchase open-end funds (load or no-load) through your broker, you may be required to also pay a commission to the broker.
Not all funds are available through all brokerage firms. Some can only be purchased or sold directly through the fund company. Other funds may only be bought or sold through specific brokerage houses.
The number of funds sold can vary substantially between brokers. If you plan to invest in mutual funds, select a broker that offers access to a wide variety of funds.
As an aside, remember that we are discussing open-end mutual funds here. There are also closed-end funds. Closed-end funds do trade on exchanges and you do need to trade them through a broker. You do not buy or sell closed-end funds via the fund itself.
Closed-end funds do not charge any load. But they will always have a broker’s commission. And, as we shall see later, the same is true for exchange-traded funds.
No-Transaction Fee Funds
If you can buy a no-load mutual fund directly from the mutual fund company and not have to pay any broker’s commission, why would you ever buy a no-load fund through your broker?
Good question.
Outside of wanting to keep your investment portfolio all in one place (without having to set up accounts for your stocks and bonds at TD and your mutual funds in additional accounts at Fidelity and Vanguard), I do not have an answer for you.
I guess many other investors could not come up with reasons either.
Which leads to no-transaction fee funds.
Most brokers have arrangements with certain mutual fund companies to sell funds without charging a brokerage commission. This levels the playing field between fund companies and brokers and allows investors to access a variety of funds without incurring brokers’ fees.
There may be differences between brokers as to which fund families they will waive their commissions on. So check ahead before making investment decisions (or even choosing a broker to deal with).
The brokers give up their commissions to incent customers to buy funds through them. However, no-transaction fee program fund participants typically pay a fee to the broker each time a no-transaction fund is traded. This remuneration from the mutual fund company to the broker is a cost to the fund. And that cost is passed on to fund shareholders, thereby negatively impacting fund performance.
So even though you are not paying commission on the transaction, you will pay indirectly.
Load, No-Load or No-Transaction Fee?
I take a “best of breed” approach to investment recommendations. That is, I try to find the fund that best meets the needs and objectives of a client. My business model excludes my receiving commissions, etc. I have no vested interest in any funds. You pay my fee, you get what is best for you.
That said, with a few exceptions, I do not generally recommend load funds to investors. There are so many no-load options available that you have ample selection for all your portfolio needs.
Exceptions might relate to niche funds that specialize in small market segments where there are no suitable no-load alternatives. For investors starting out or simply wanting to create a well-rounded investment portfolio, I likely would not recommend niche funds anyway.
Exceptions might also relate to load funds with superior net long-term performance. Though this tends not to be the case. Research indicates there is no correlation between loads and fund performance. However, in assessing individual funds, a specific load fund might have superior returns over a similar no-load fund.
You will pay for a fund’s costs in one form or another. Just because you are not paying a sales charge does not mean you are not paying any fees. They may just be buried amongst other expenses. Always focus on a fund’s overall costs and its management expense ratio when deciding on the right fund.
One final comment. Sales commissions may be negotiable. It often depends on the fund company and the level of assets you intend to purchase or bring in. But if you do not ask, you will never get. And every dollar saved, is worth a lot more over time in your portfolio.
Okay, enough on mutual fund transaction costs.
We will take a further look at fund costs later.
Specifically, annual fund operating costs and the management expense ratio.
