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 When it comes to mutual funds, you've got a lot of choices out there in the marketplace. When you're evaluating mutual funds, you need to carefully consider the loads the mutual fund charges investors. There are no-load mutual funds, front and back-loads and even expiring back-loads. We're going to discuss all of these fund types in turn and explain why investors need to understand how these loads can eat into their investment's overall performance.
What is a Mutual Fund Load?
A mutual fund load can be defined as a payment an investor makes to the mutual fund's management team or a broker when shares in the fund are either purchased and / or sold. The various combinations of mutual fund loads include:
- Front-End Loads
- Purchase Fees
- Back-End Loads
- Redemption Fees
In some instances there can also be an exchange fee. We're going to explain each of these mutual fund loads later on, but first let's talk briefly about no-load mutual funds.
No-Load Mutual Funds
As investors we must understand that you don't always get what you pay for. Just because a mutual fund charges a load does not mean that fund is outperforming a no-load mutual fund. In fact, there are some real advantages to buying no-load mutual funds. Think about it this way - a fund that charges a front-load of 4.75%, which is not uncommon, means you've got a lot of ground to make up. An investment of $10,000 will set you back nearly $500.
Unless that fund has outperformed the market on a consistent basis (and remember, that's no guarantee of future returns) you'd be better off putting your money into a no-load mutual fund. In this example, the fund is already starting out with a 4.75% disadvantage - which is a lot of ground to make up especially if the fund is only held for a short period of time.
Front-Loads and Purchase Fees
Front-loads and purchase fees are paid by the investor when shares of the mutual fund are purchased. Front-loads are usually paid to mutual fund brokers, while purchase fees go to the mutual fund's management team. An investor can expect to see front-loads that typically range from 2.50% through 5.75%.
Front-loads and purchase fees are subtracted from the investor's purchase prior to the money being deposited into the account:
Front-End Load Example
For example, let's say an investor wants to buy shares in a mutual fund and sends the broker $2,500 on a fund with a 4.50% front-load. That means the money that gets deposited into the account is $2,500 - 4.50% or $2,387.50.
The same thing happens with purchase fees but instead of the money going to the broker the mutual fund's management team gets paid.
Back-End Loads and Redemption Fees
Back-end loads and redemption fees are paid by the investor when shares of the mutual fund are sold. Back-end loads are usually paid to the mutual fund broker, while redemption fees go to the mutual fund's management team. Back-end loads and redemption fees are less common than front-end loads and purchase fees.
Back-end loads and redemption fees are subtracted from the account balance before the money is sent to the investor:
Back-End Load Example
For example, let's say an investor wants to sell all their shares in a mutual fund and the value of those shares is $3,000 and the fund carries a back-end load of 5.0%. This means the account holder would receive $3,000 - 5.0% or $2,850.
Expiring Back-Loads
Back-loads or deferred loads can sometimes offer the investor an advantage, but you need to pay attention to the fine print in the fund's prospectus to see if this applies to the mutual fund you're evaluating.
That's because back-loads sometimes expire after a given time has past or after the account reaches a certain funding level. The expiration of this fee can happen at a given point in time or it can slowly decline over time.
Expiring Back-Load Example
For example, the mutual fund might charge a back-load of 4.75% for the first 12 months, 3.75% over the next twelve months, and it expires completely after 48 months - meaning no fee is owed if you keep your money in the mutual fund long enough!
It pays to read the fine print. If you're convinced that buying a mutual fund with a load is in your best interests, make sure you know all the rules that apply.
Exchange Fees
The final fee an investor might encounter with a mutual fund is an exchange fee. This particular fee is even rarer than back-end loads and redemption fees. Basically an exchange fee can be charged by some mutual funds when the shareholder exchanges shares in one mutual fund for another. This usually happens when the fund exchange occurs within the same family of funds.
Front-End versus Back-End Loads
Everything else being equal, you shouldn't care if you're paying a front-end fee or a back-end fee - your return will be exactly the same. Let's look at an example to see why.
Let's say you've got a choice to invested $10,000 in two mutual funds. Both funds charge a 4.75% load, Fund A is front-loaded and Fund B has a back-load. Let's also assume that each fund returns you 6% annually for two years. What is your real return on investment for each fund?
Front End or Back End Load Example
Fund A has a front-load, so you're paying $475 right away, and your net investment is $9,572. A 6% return over the next two years means you'll have $10,702.29 at the end of year two. Your total net return over the two year time period is 7.0% or around 3.5% per year.
Fund B has a back-load, so you retain your entire investment until you sell your shares in this mutual fund. With the same 6% return, you'll have $11,236 at the end of year two. When you go to sell this mutual fund, you'll owe $533.71 in fees. So your net is $10,702.29 - exactly the same as Fund A.
So given the choice of a front-end or back-end load the investor is pretty much indifferent because the outcome is likely to be the same unless the back-end load is one that eventually expires.
About the Author - Mutual Fund Loads
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