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On this week’s Mullooly Asset Management podcast, Tom and Brendan discuss why load mutual funds don’t make sense. To explain what’s wrong with load mutual funds, we must first make sure that everybody understands the difference between load and no-load funds.
For starters, a load is the equivalent of a sales charge or commission.
Load Mutual Funds
These are mutual fund shares sold with some form of a front end load, back end load, and/or low level load. These funds are typically sold at brokerage firms by their employees (brokers, financial advisors, financial consultants, or whatever else they call themselves these days).
– A front end load charges the buyer upon purchase. These charges typically range from 3 to 5.75%.
– A back end load charges the buyer when they sell the fund. These charges decrease as the years go by. For example, a fund may have a back end charge of 5% in year one, 4% in year two, 3% in year three, and so on.
– A low level load charges the buyer each year. These fees are also known as 12b-1 fees and are typically in the range of 1% for load funds.
Where do all these sales loads go, you ask? Mostly to the broker who sold you the fund and their firm.
No Load Mutual Funds
– These are mutual fund shares sold without a commission or sales charge.
– No load funds can have 12b-1 fees, like load funds. However, no load funds are only allowed to have a 12b-1 fee of up to 0.25%.
One thing to note: All funds have expense ratios, which go towards the expenses associated with running the fund. Whether you’re buying an index fund ETF or actively managed mutual fund, there will be some type of expense associated with its operations.
Burton Malkiel is the author of a classic investment book titled, “A Random Walk Down Wall Street”. He states in the book that:
“In no event should you ever buy a load fund. There’s no point in paying for something if you can get it for free”.
Another good analogy we read from Rick Miller of Sensible Financial Planning is:
“Buying a load fund is the equivalent of signing up for extra taxes”.
Both of these quotes highlight the main reason we believe load mutual funds don’t make sense: you’re paying extra money to receive no additional benefit.
A great research article by Daniel Bergstresser, John Chalmers, and Peter Tufano titled, “Assessing the Costs and Benefits of Brokers in the Mutual Funds Industry”, looked into whether load funds offered any benefit (outperformance) over their no load peers.
To do so they measured performance on a pre-distribution fee basis, meaning they didn’t take front end loads or back end loads into account. They also subtracted 12b-1 fees from the annual expense ratios of the funds. They did this in order to level the playing field and assess the funds purely on their performance. Their findings found that:
“The brokerage channel sells funds with inferior pre-distribtion fee returns”, and also that “more sales are directed to funds whose distribution fees are richer”.
Their results don’t even take sales loads into account! Considering these additional (and unnecessary) costs, there is no real reason for investors to consider load mutual funds. In most instances, you’re paying more for underperformance.
In light of these findings, it’s worth wondering why/how load mutual funds continue to find their way into investors’ portfolios?
It really comes down to an abuse of client trust and a flawed business model in our opinion. We’ve discussed the brokerage industry’s suitability standard and our fiduciary obligation as investment advisors before on the podcast. Brokers have the ability to put their own interests ahead of their clients. The research article discussed above shows a prime example of that inherent conflict of interest: the brokerage industry directing more money to funds with higher distribution fees. Sure, that broker could have recommended a no load fund, but why not recommend a similar fund with a front end sales charge of 5%? It’s right for them and their firm, but not for their client. This is a flawed business model that will hopefully change. In the mean time, it’s important for investors to know what they’re investing in, the costs associated with it, and how it will work to accomplish their goals. We’d be willing to bet unnecessary costs and underperformance aren’t on many investor’s wish lists.
Make sure to listen to the podcast to hear more on this topic!
Sources:
http://www.bloomberg.com/news/2012-04-30/the-worst-deal-in-mutual-funds-faces-a-reckoning.html
http://www.sensiblefinancial.com/media-and-resources/sensible-thinking/load-mutual-funds.php
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=616981
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