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For many years Paul Merriman has been telling investors to “just say no” to buying load funds. Predictably, this message is quite unpopular among people who earn commissions selling such funds. In this article, Paul responds to an unhappy financial planner.
In August, the Wall Street Journal featured Explode Loads!, one of the most popular tools on FundAdvice.com, describing how investors can use it to find no-load alternatives to the 100 largest load funds. A few days later I received the following email:
DEAR PAUL: I am a financial planner who finds your views on mutual funds to be misleading and unfair. You seem to have an almost religious zeal when you write over and over again that investors should steer clear of load funds in favor of no-loads.
I have been selling load funds for almost 20 years, and my clients have achieved excellent results from their investments. I have many clients who own the Federated Capital Appreciation Fund, and they are very happy with it.
Sure, they paid a commission when they bought their shares. But they are certainly glad they had my help in picking this fund, which according to the Wall Street Journal achieved a load-adjusted return of 10.73 percent over the past 10 years, compared with only 9.91 percent for the Vanguard 500 Index Fund which your Web site, FundAdvice.com, says is better.
I just wish you would tell investors that some load funds are truly superior and that some advisors are well worth the fees they charge.
-- Matt
I sent the following response:
DEAR MATT: I’m happy to grant your wishes. For the record, some load funds are truly superior. And many advisors are well worth the fees they charge. Finding and working with a good advisor is one of the most important things that separate successful investors from unsuccessful ones. And if you are doing a good job for your clients, I salute you.
It’s true, as the Wall Street Journal reported, that Explode Loads! recommends Vanguard 500 Index Fund (VFINX) as a no-load alternative to Federated Capital Appreciation (FEDEX) – and nine other large-cap blend funds that charge sales commissions.
It’s also true that the 10-year load-adjusted return of the Federated fund is higher than that of the Vanguard index fund. (The figures you cited are for the 10-year period ending July 31). I’m sure the people who invested in that Federated fund 10 years ago are glad today that they chose it instead of the Vanguard index fund.
However, I wonder if you are still putting clients into that fund. According to Morningstar Inc., over the past three years Federated Capital Appreciation lagged 89 percent of its peers and was trounced by the S&P 500 Index.
Since you mentioned the Wall Street Journal article, I’ll point out something that you didn’t: The other nine of the 10 large-blend load funds listed on our Web site underperformed the S&P 500 Index over 10 years. Federated Capital Appreciation was the only one with a load-adjusted (real-life) return higher than the Vanguard index fund.
(On average, the 10 load funds on this list underperformed the S&P 500 Index by 1.99 percent annually for the 10 years ending July 31. For the trailing three-year period, every one underperformed the index, by an average of 4.01 percent annually.)
It’s always easy to identify the best investments of the past and concentrate on them. But nobody can invest retroactively. And there is no risk in the past, because we already know how it turned out.
A decade ago, neither you nor your clients had any way to know which would be the largest large-cap blend funds in mid-2005. And even if you had had that knowledge, there certainly was no way to know that Federated Capital Appreciation would be the lone member of this group that would beat the S&P 500 Index from mid-1995 to mid-2005.
For you to cite this fund as an example of superior advice is like taking personal credit for having good luck.
Load funds stack the odds against investors -- like betting on a horse that must start far back in the pack. To understand why, let’s look at a concept you know but that your clients may not fully understand: the load-adjusted return.
Here’s a simple example. Assume that you invest $10,000 each in two funds on the same day and that over the next year their portfolios have identical 10-percent performance gains. The only difference is that one fund charges a 5.75 percent sales commission up front while the other is a no-load fund.
On the first day of your investment, $10,000 goes into the portfolio of the no-load fund, but only $9,425 goes into the portfolio of the load fund. The other $575 pays sales costs. One year later, after 10 percent appreciation in each fund, your no-load fund account is worth $11,000, but your account in the load fund is worth only $10,368 (110 percent of $9,425). Same cash outlay, exact same portfolio performance. But a difference of $632 in value after one year.
Your return of the no-load fund was 10 percent, representing your $1,000 gain. But your comparable return in the other fund was only 3.68 percent, representing your $368 gain on the $10,000 initial outlay. I don't believe many advisors make such real-life comparisons when they are trying to sell load funds.
Now let's look at this from another point of view. This time we'll look through the eyes of a portfolio manager instead of an investor.
Imagine for a moment that you and I are portfolio managers – you at the load fund and I at the no-load fund. Suppose you know I will achieve a 10 percent return that first year and you’re trying to compete with me. To do that, your performance will have to be enough to turn $9,425 into $11,000 in one year. That means you need a portfolio return of 16.7 percent. The only way you can hope to achieve that is by taking significantly more risk than if you were targeting a return of 10 percent.
This puts you in a pretty awkward position. Because of the load, you as portfolio manager must either settle for a much lower real-life return to your shareholders or you must take higher risks with your shareholders’ money.
In your real life as a financial advisor who sells load funds, that is exactly the awkward position you are in with respect to your clients.
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