There are a variety of choices in the mutual fund marketplace. When evaluating funds, it's important to carefully consider the load each one charges. There are no-load funds, front and back-loads, and even expiring back-loads.
In this article, we're going to discuss each of the above fund types. We'll explain how these loads can reduce an investment's overall performance, and demonstrate this impact using examples.
The term "mutual fund load" is used to describe the payment an investor makes to the fund's management team, or a broker, when shares are either purchased or sold. The various combinations of these payments include:
In some instances, there can also be an exchange fee. Each of these costs will be explained later on; after a brief discussion of no-load mutual funds.
Most investors realize they don't always get what they pay for in life. Just because a fund charges a load does not mean it's going to outperform a no-load mutual fund. In fact, there are some real advantages to buying no-load funds.
Think about it this way: If a fund charges a front-load of 4.75%, which is not uncommon, there is a lot of ground to make up. An investment of $10,000 means nearly $500 will be used to pay for fees.
Unless that fund outperforms the market on a consistent basis (and remember, that's no guarantee of future returns), a no-load mutual fund is the better investment. In this example, the fund is already starting out with a 4.75% disadvantage. Making up the money lost to the front-end load will be very difficult if shares are held for a short period of time.
Front-end loads and purchase fees are paid by the investor when shares of the mutual fund are acquired. Front-end loads are usually paid to brokers, while purchase fees go to the fund's management team. An investor can expect to see in the marketplace front-loads that range from 2.50% through 5.75%.
Front-loads and purchase fees are subtracted prior to the money being deposited into the account:
Let's say an investor wants to buy shares in a mutual fund and sends the broker $2,500 towards a fund with a 4.50% front-load. This means the money that gets deposited into the account is $2,500 minus 4.50%, or $2,387.50.
The same process happens with purchase fees, but instead of the money going to the broker, the fund's management team gets paid.
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 broker, while redemption fees go to the 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:
Let's say an investor wants to sell all their shares in a mutual fund. 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 minus 5.0%, or $2,850.
Also known as deferred loads, back-loads can sometimes offer the investor an advantage; but it's important to read the fine print in the fund's prospectus to see if this applies to the mutual fund being evaluated.
Back-loads sometimes expire after a given time has passed, 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.
In this example, the mutual fund charges 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. Therefore, no fee is owed if the money is kept in the mutual fund longer than 4 years.
The final fee an investor might encounter is an exchange fee, which is even rarer than back-end loads and redemption fees. An exchange fee is charged by some mutual funds when an investor exchanges shares in one fund for another. This usually happens when the exchange occurs within the same family of funds.
Everything else being equal, an investor should not be concerned if the fund charges a front-end fee or a back-end fee. The return will be exactly the same. Let's look at an example that demonstrates this point.
Let's say Hank has a choice to invest $10,000 in two mutual funds. Both of the 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 6.0% annually for two years. What is the real return on investment for each fund?
Fund A has a front-load, so Hank is paying $475 right away, and his net investment is $9,572. A 6.0% return over the next two years means he will have $10,702.29 at the end of year two. The total net return on investment over the two-year time period is 7.0%, or around 3.5% per year.
Fund B has a back-load, so Hank retains his entire investment until he sells his shares in this mutual fund. With the same 6.0% return, he will have $11,236 at the end of year two. When Hanks sells this mutual fund, he will owe $533.71 in fees, so his net is $10,702.29. Exactly the same as Fund A!
Given the choice of a front-end or back-end load, the investor should be 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 (Last Reviewed on June 1, 2016)