We've never made any bones about where we stand in the debate, if there still is one, between load and no-load mutual funds. There's a big difference between these two types of funds. Sometimes it's the difference between whether the investor makes money or whether a salesperson makes money.

It's too simple to say that all no-load funds are superior to all load funds. You're obviously better off in a top load fund than in a crummy no-load. But I don't think those are your real choices. I simply don't see any reason why a well informed, intelligent investor should pay a sales commission to buy a mutual fund. Certainly anyone who is up to reading our newsletter, or a handful of other mutual fund newsletters, is capable of recognizing and finding good funds without paying for that service from a broker whose interests are almost inevitably in conflict with the interests of the investor.

But I am getting ahead of myself. Let's look at 10 reasons to avoid load funds.

1. Load fees do the investor absolutely no good. Any mutual fund is really just a pool of money that's managed to accomplish some particular objective such as income or growth, usually following a particular strategy. A load is simply industry jargon for the commission paid to a salesperson who brings in the money. The commission you pay on a load fund goes only to the salesperson or sales organization, not to the fund's manager or investment adviser. Managers and advisors make their money from fees taken out of the fund's assets. Whether investors pay loads or not, they all pay their share of management costs. The fees are typically 0.5 percent to 1 percent of the fund's assets annually. But sometimes they exceed 1.5 percent.

2. Every study on the subject has concluded that over long periods of time there is virtually no difference in returns between the performance of all load funds and all no-load funds-except for the sales commission. Specific results will vary a little for every time period, but the pattern is the same year after year, decade after decade. Over the past five years*, no-load funds had average total returns of 7.88 percent in bonds and 10.04 percent in equities. Load funds, when you remove the effect of the load, had returns of 8.01 percent in bonds and 9.86 percent in equities.

However, the sales commission has a huge effect. Loads used to be simple, but now they come in many flavors and varieties. A fund's marketing department would say these varieties are designed to give investors more options. A cynic might say these varieties are designed to make the sting of the load less obvious. You choose which you want to believe.

3. The presence or absence of a sales commission has absolutely no effect on how well a fund's investments perform. All it does is decide which fund sells its assets at par value and which one charges a premium price. To make the point even more sharply, think of a horse race. Imagine you can take your pick of two equally capable horses for a particular race. They are ridden by equally capable jockeys. There are only two differences. One horse is stationed on the starting line, and if you want to place a bet on it you have to walk up to a ticket booth, stand in a line, and put down your money. The other horse has to start the race 100 yards behind the starting line. If you want to bet on that horse, you can do it without standing in line. There's a guy who will take your money right where you are, and he'll stand in line for you. Which horse would you bet on?

A load fund is like a horse that has to start a race from far behind. Invest $10,000 in a no-load fund and you have to choose the fund and fill out the form yourself. But your entire $10,000 goes to work for you. Buy a fund with a 5 percent load and somebody else (who will get a big chunk of your money) tells you which fund you should buy and fills out the paperwork for you. And only $9,500 of your money goes to work in that fund.

If these two funds are equally successful in the future, the load fund won't ever catch up. In fact, because of compounding, it will fall farther and farther behind. If the no-load earns a 10 percent return in the first year, the load fund manager would have to earn 17 percent on his portfolio just to get you even with that no-load fund. The irony is that the load fund manager has no incentive to do that. He has no reason to care that you paid a commission. He simply sees you as a $9,500 investor.

4. Paying a load is akin to throwing away most or all of the supposed advantage you get from having a salesman choose a fund for you. If it's true that asset allocation accounts for 95 percent of investment results over long periods of time, then only 5 percent is left over as a reward for having the "right" fund and the "right" manager. But even if a salesman could help you pick that "right" fund, paying him a commission of 5 percent wipes out the benefit.

5. When you pay a 5 percent load you lose the opportunity to invest 5 percent of your money forever. When you buy a load fund, the money that goes to the salesman goes to work for him, not for you. When you invest in a no-load fund, all your money goes to work for you.

And load percentages are always higher than the quoted figures. In our example of a $10,000 investment, $500 went to the sales organization, $9,500 was invested on your behalf. By a mathematical distortion sanctioned by the industry and the government, funds are allowed to call that a 5 percent commission. In fact, you invested only $9,500, and the $500 load amounts to a commission not of 5 percent but of 5.26 percent on your real investment.

6. Load amounts are higher than they look. The effect of your commission grows over time. If you avoided a $1,000 commission by investing in a no-load fund, over 25 years you would wind up with nearly $11,000 more if your money compounded at 10 percent. In other words, the $1,000 load would, in effect, be an $11,000 load.

7. You might need your money sooner than you think. Load funds are sold based on a long-term commitment. Salespeople convince investors the commission will represent a small cost when amortized over many years. But life is full of surprises. A few years ago an airline pilot became a client, giving us $300,000 to invest for 15 years. We put the money into no-load funds. Three months later, he called to say a divorce court judge had ruled the $300,000 belonged to his wife, not him. If he had bought load funds, paying 5 percent commissions, $15,000 of his money would have been gone the day he wrote the check. Here's another way of looking at it: Paying a 5 percent load is equivalent to knowingly and willingly suffering one of the biggest one-day losses in stock market history. It's the equivalent of the Dow Jones Industrial average dropping over 200 points in a single day.

8. A load may not give you what you think you are buying. Savvy fund pickers pay a lot of attention to the record and abilities of a portfolio manager. Some fund salesmen say they earn their fees by finding the best managers. But what happens if you get into a load fund with a great manager and that manager leaves to run another fund? At best, you have paid for the track record of a manager who's now gone. At worst, if you decide to follow that manager to a new load fund in a new family, you must pay the load a second time. This doesn't happen all the time. But the best managers are the ones who get new job offers. Think about that the next time you consider investing in a load fund because of its manager.

9. The broker who chooses a fund for you may have a reason to prefer that you buy a poorer-performing fund instead of a top-performing one. Studies show that funds operated by brokerage houses (naturally, they are almost exclusively load funds) have poorer average performance than independent load funds. Yet a broker often earns exotic trips and other perks, in addition to a higher percentage of the commission, for selling house funds. So if you buy a load fund from a broker, at least insist on getting one that is not managed by that brokerage house. You'll then get more objective guidance-and hopefully better performance.

10. On average, load funds charge higher expenses than no-load funds. These are the expenses that all funds take out of their assets, whether their investors pay loads or not. In a study that covered thousands of funds, Morningstar found that the average load fund charges its investors significantly more than the average no-load fund. Expense ratios among equity funds averaged 1.1 percent for no-loads and 1.6 percent for load funds. Among bond funds, the average was 0.6 percent for no-load funds and 1.1 percent for load funds. Those differences may seem small. But unlike a load, a fund's expense charge hits you year after year after year. The longer you own a high-expense fund, the deeper it reaches into your pockets.

WHAT IF YOU ALREADY OWN LOAD FUNDS?

Don't necessarily sell that fund. Ironically, most of my advice about avoiding load funds ceases to apply once you already own one. The reason is simple: Once you pay the load, your money is gone. Getting out of the fund won't get it back. Therefore, if you are already in that position, there is no particular advantage to sell that fund just because of the load.

Don't necessarily keep the fund, either. If the fund has a back-end load, that provision may give you an incentive to leave your money in that fund. Sometimes, back-end loads are structured so that the longer you leave your money in the fund, the lower the load. You should study the prospectus to find this out, or have somebody help you with it. Or call the fund and ask about your options.

Don't keep a fund just because of its back-end load. Even if you keep a back-end-load fund long enough to avoid most or all of the load, guess what? The salesperson still got paid the commission. And guess what that means? The fund found some way to extract that money from you to cover its commission cost. This could account for some of the higher expenses that load funds levy on their shareholders. And, of course, you may be hit with annual 12b1 fees to cover marketing costs. If this is the case, then you may get nicked by those fees again and again, every year you own the fund.

The best advice: Figure out if that is really the right fund for you to own. Start with the asset allocation process to determine the best mix of investments for your situation. Then ask yourself: Does this fund fit within the plan I should have? Does it have a good record? Reputable management? Reasonable fees? If your answers are positive, then your best bet is probably to stick with it.

Consider using this as an opportunity to weed out the chaff from your portfolio. If you don't have a clear idea why you invested in that particular fund, consider selling for that reason, not because of the load. If this is a fund you would definitely not invest in again, consider selling it in order to find something more suitable for yourself-among no-load funds, of course.

In summary, the presence of a load is not reason enough to sell or keep a fund. The decision depends on the details of the load, your own circumstances and needs, and the quality of the fund itself.

* This article was originally published in 1995

 

 

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