Mutual Fund Concerns: Transaction Costs

On 09/20/2010, in Mutual Funds, by Jordan Wilson

Previously we looked at the perceived advantages of investing in mutual funds.

I believe funds are an excellent way for investors to develop well-diversified portfolios and meet their investment long-term investment objectives.

However, there are potential downsides when investing in funds. Not necessarily negatives, but areas investors need to be aware of and take measures to protect themselves against.

We will look at some of these areas of concern in the next few posts.

Today we review transaction costs incurred when buying and selling open-end mutual funds.

The Importance of Transaction Costs

In discussing compound returns, we discussed how important cost minimization is for investors wishing to maximize their long-term capital appreciation.

Every dollar you pay to someone else is a dollar of extra returns that must be earned just to break-even. And every dollar lost, is a dollar that cannot compound over time. This also creates problems for investors in attempting to achieve long-term portfolio growth.

Transaction costs are a major expense when investing.

Mutual Fund Transaction Costs

Funds may be subject to a sales charge when investors buy or sell shares of the fund. This transaction fee compensates brokers or internal fund salesmen for selling investors the fund.

The fee is known as the load.

You may encounter front-end, back-end, or declining loads. Some funds may offer you more than one option.

Although similar to the broker’s commission when you trade a marketable security, be aware that a load is not a commission.

Front-end Load Funds

A front-end load is paid to the mutual fund company when you purchase units or shares of the fund. Upon sale, there is no load paid.

For example, on January 1, 2010 you invest $1000 in an global equity fund that has a a 5% front-end load and a closing net asset value (NAV) of $50 per share. You will pay $50 as a sales fee (5% of the $1000) and receive 19 shares of the fund with your remaining $950.

Back-end Load Funds

A back-end load is the opposite of a front-end load. Instead of paying a sales fee when you purchase shares of the fund, you pay a fee when you sell.

As you pay the transaction fee only at the end, back-end loads are also known as deferred loads or deferred sales charges.

Using our previous example, let us say that the 5% load is a back-end instead of front-end.

Had you invested $1000 in the global equity fund at $50 per share, you would receive 20 shares as the entire amount would be available for purchase.

Perhaps in 6 months the fund rises to a $60 per share NAV. You decide to sell your 20 shares and will have gross proceeds of $1200. As you now have a deferred load, you must pay the 5% sales fee. But not on the initial capital invested as in the front-end. Rather, you will pay on your gross proceeds. In this case, you will be charged $60.

The trade-off between the front and back-end loads is two-fold.

As you hope to experience appreciation in the value of the fund, you should expect to pay more for a back-end load with the same percentage fee than with a front-end load.

Because of the time value of money, the longer you hold the shares, the better the back-end load will look. If you intend to keep the investment for a long time and have a choice between equal fees, back-end funds should be the better option.

Declining Load Funds

Many back-end loads offer declining sales charges over time.

This is an incentive for investors to stay in the fund for longer time frames.

For example, perhaps the back-end load is structured as follows: 5% sales charge if sold within 3 years; 3% sales charge if sold after 3 years but before 7 years; 0% if sold after 7 years.

If you do not sell for at least 7 years, you will not be charged any fees.

In our example, you consider selling your fund shares on December 31 in the years 2010, 2015, and 2020. The per share NAV on those three dates is respectively $60, $80, $100.

With a declining back-end load, you would pay a sales charge of $60 (2010), $48 (2015), and $0 (2020). The longer you hold, the better the deal. In this example, the dollar value sales charge decreased even though the total assets grew over time.

Often, declining loads appear very reasonable as many investors plan to hold onto funds for extended periods. However, be aware that the best of intentions often go awry. Personal circumstances may change and you may need to divest before the back-end load falls to nil.

No-load Funds

No-load funds do not charge a sales fee.

All else equal, no-load funds are more desirable to investors than any type of load fund.

Every dollar of investor capital goes to acquire shares of the fund. And every dollar of gross proceeds upon sale is due to the investor. None of the investor’s funds go to pay the salesman.

Of course, load fund salesmen will make compelling arguments as to why paying a sales charge to acquire a particular load fund is worth the fee.

While their load funds may be excellent, always keep in mind that the salesman is paid for selling the fund.

Many salesmen may be principled and want to find the you best fund for your needs. But some salesmen may push customers towards funds that provide them with the best sales charge.

When dealing with people selling load funds, always be cautious as to their intentions.

Commissions on Mutual Funds

As I wrote above, a sales charge is not a broker’s commission. It is compensation from the mutual fund to the salesperson.

Open-end mutual funds are bought and sold directly from the mutual fund company. They do not trade on exchanges and you do not require a broker to transact trades on your behalf.

That said, to improve investor accessibility to mutual funds, many fund families allow investors to buy and sell funds through the investor’s brokerage account.

So if you purchase open-end funds (load or no-load) through your broker, you may be required to also pay a commission to the broker.

Note that not all funds are available through all brokerage firms. Some funds can only be purchased or sold directly through the fund company. Other funds may only be bought or sold through specific brokerage houses.

The number of funds sold can vary substantially between brokers. If you plan to invest in mutual funds, select a broker that offers access to a wide variety of funds.

As an aside, remember that we are discussing open-end mutual funds here. There are also closed-end funds. Closed-end funds do trade on exchanges and you do need to trade them through a broker. You do not buy or sell closed-end funds via the fund itself.

Closed-end funds do not charge any load. But they will always have a broker’s commission. And, as we shall see later, the same is true for exchange-traded funds.

No-Transaction Fee Funds

If you can buy a no-load mutual fund directly from the mutual fund company and not have to pay any broker’s commission, why would you ever buy a no-load fund through your broker?

Good question.

Outside of wanting to keep your investment portfolio all in one place (without having to set up accounts for your stocks and bonds at E*Trade and your mutual funds in additional accounts at Fidelity and Vanguard), I do not have an answer for you.

I guess many other investors could not come up with reasons either.

Which leads to no-transaction fee funds.

Most brokers have arrangements with certain mutual fund companies to sell funds without charging a brokerage commission. This levels the playing field between fund companies and brokers and allows investors to access a variety of funds without incurring brokers’ fees.

For example, with online or automated telephone trades, Charles Schwab currently charges $49.95 per mutual fund trade. However, if the fund is part of their Mutual Fund OneSource® service, there is no commission charged by Charles Schwab.

At E*TRADE, mutual funds are charged an online commission of $19.99. But if the funds are part of E*TRADE’s no-load, no-transaction fee program, the broker’s commission is waived.

There may be differences between brokers as to which fund families they will waive their commissions on. So check ahead before making investment decisions (or even choosing a broker to deal with).

The brokers give up their commissions to incent customers to buy funds through them. However, no-transaction fee program fund participants typically pay a fee to the broker each time a no-transaction fund is traded. This remuneration from the mutual fund company to the broker is a cost to the fund. And that cost is passed on to fund shareholders, thereby negatively impacting fund performance.

So even though you are not paying commission on the transaction, you will pay indirectly.

Load, No-Load or No-Transaction Fee?

With very few exceptions, I would not generally recommend load funds to investors.

There are so many no-load options available that you have ample selection for all your portfolio needs.

Exceptions might relate to niche funds that specialize in small market segments where there are no suitable no-load alternatives. For investors starting out or simply wanting to create a well-rounded investment portfolio, I likely would not recommend niche funds anyway.

Exceptions might also relate to load funds with superior net long-term performance.

That is not to say that load funds outperform no-load funds. In fact, studies indicate that there is no correlation between loads and fund performance. But in assessing individual funds, a specific load fund might have superior returns over a similar no-load fund.

Rather, I do believe that you will pay for a fund’s costs in one form or another. Just because you are not paying a sales charge does not mean you are not paying a fee. It is just buried amongst the other expenses. That is why I am always highly focussed on a fund’s costs and its management expense ratio. And you should be too.

In comparing funds, total annual expenses are my main comparative on the cost side of the equation. Then I would consider the load versus no-load charges.

I am a little more relaxed about no-transaction fee funds.

While I firmly believe that you need to always minimize transaction costs, a $19.99 commission on a $10,000 transaction is tolerable. Especially if it allows me access to a much wider variety of funds.

For example, E*TRADE offers access to over 7,600 mutual funds, but only approximately 1,100 no-transaction fee funds. TD AMERITRADE offers over 13,000 mutual funds for sale, but only “hundreds” of no-transaction fee funds.

Okay, enough on mutual fund transaction costs.

We will take a further look at fund costs later.

Specifically, annual fund operating costs and the management expense ratio.

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