Avoid load funds, a study suggests

Your Funds

Your Money

August 07, 2005|By CHARLES JAFFE

NEARLY $1 out of every $5 that went into mutual funds last year flowed into funds that charge a sales load, compensating a broker or planner for making the sale.

But a new study from the University of Michigan indicates that investors who pay for financial help might want to avoid load funds altogether, because they carry a surprising cost beyond the sales fees.

The Michigan study showed that when a mutual fund adds additional share classes -- coming up with new ways for brokers and planners to pitch the product to customers -- performance tends to suffer.

Unspoken in the research is the idea that investors want to reconsider precisely how they pay for financial guidance.

Mutual funds sold through brokers use different share classes to give investors options in paying for counsel. Each class carries some form of cost that goes to pay for the help of an adviser.

Class A shares carry the traditional front-end load, so that a percentage of the purchase goes straight to pay for the broker or planner selling the fund. Class A shares have the lowest expense ratio, and are the only shares to have "breakpoints," where commissions get cut if you invest big chunks of money.

Most experts consider the upfront sales charge the best option for long-term investors who are buying a fund and plan to hang on for five or more years.

B shares, by comparison, have no upfront load, but levy a 12b-1 fee -- for sales and marketing -- that jacks up costs and pays for the adviser's services.

There also is a back-end load, paid for selling within a few years of investing. Typically, this charge shrinks over time; when it evaporates, most B shares convert into A shares to take advantage of the lower cost structure.

B shares have become less popular in recent years, largely because they offer no breakpoints and because a long-term holder gets a better deal in Class A shares while a short-timer is better off in Class C. The Investment Company Institute actually shows that total assets in B shares have been shrinking for more than three years.

Class C shares have no front-end load, but carry a high 12b-1 fee -- often the maximum 1 percent -- in perpetuity. Some carry a back-end load for up to two years, but most don't; this lack of a big fee when buying or selling a fund makes C shares the pick for someone making short-term moves, as they tend to be the least-expensive option when the holding period is just a year or two.

According to Lu Zheng, the Michigan professor who authored the study with Vikram Nanda and Z. Jay Wang, that trading in C shares is part of the problem.

When a fund company adds share classes, the advisory community goes out and pushes the fund, noting the choices an investor has when it comes to paying for advice. That brings in additional money, which can help the fund in the short term.

But with the trading inherent in C shares and the fact that larger funds typically have a tough time outperforming its benchmark index, the change tends to show up as a drag on performance.

"When a firm creates B and C shares, it is imposing liquidity costs on the portfolio," says Zheng, who noted that the study examined all diversified domestic equity funds from 1993 to 2000, by which time nearly half of all loaded funds had more than one share class.

"The additional money that comes in at first is good, but after two years, we found that multiple-class funds under perform no-load counterparts by about 1.5 percent annually. ... That's a big price to pay."

Zheng's advice was for investors to switch to no-load funds, but that is not a realistic choice for many load-fund investors. After all, they paid for financial advice, in large measure because they were not comfortable building a portfolio on their own.

But for investors who are looking to hire a financial adviser, the implication is that fee-only advice -- where the customer pays a flat fee, typically about 1 percent of assets under management -- might be a better alternative than paying sales charges.

The adviser gets compensated, but puts the investor into no-load funds.

The investor should calculate the overall cost of owning the funds -- once the advisory fee is factored in, it is possible that no-load plus adviser will be more expensive -- but Zheng said the cost of buying a fund with multiple-share classes should not be ignored.

"The positives of adding share classes are more options to choose from, and that you get the advice you pay for," Zheng says, "but the downside is an impact on overall performance, so people need to be sure they are comfortable with the cost of owning funds this way."

Charles Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or at Box 70, Cohasset, MA 02025-0070.

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