by Marvin Appel, PhD, and Brian Hufford, CPA, CFP
The latest edition of the Mutual Fund Expert database lists almost 15,000 mutual funds. The financial press regularly reports on the performance of the largest mutual funds, or the hottest, or the biggest losers, or on individual managers with interesting stories to tell.
How is a busy professional supposed to make heads or tails of all the available information? This article, and the next several in our series, will help you navigate the sea of information that is readily accessible. The first decision you must make is to invest the effort to make your own investment selections. You will realize that selecting mutual funds yourself — rather than relying on a broker — gives your investment program a significant advantage.
How brokers get paid
Depending on the sales strategy of a fund company, a fund can be "load" or "no-load." Brokers — including financial planners and accountants with the appropriate licenses — sell load funds. (Many financial advisors become brokers strictly to sell mutual funds.) These salespeople receive a commission that consists of a percentage of the assets you invest. You should be alert to the possibility that the investment advice you are offered could be colored by the commission reimbursement your advisor receives.
The fund company itself sells no-load funds. No-load funds pay no, or at most, minimal sales commissions.
As a result, a salesperson on commission generally will not recommend a no-load fund, even if it is an appropriate investment, because he will not get paid to do it.
The distinction between load and no-load funds has nothing to do with investment strategy. In fact, some funds offer both load and no-load shares in the same portfolio. Sales loads are simply commissions for salespeople, and, as with any other commission or mark-up, reduce your return accordingly.
Many load funds sell "class A" shares that impose a 5 percent sales charge upfront. That means for every $10,000 you invest, only $9,500 is working for you. Your investment must grow by more than 5 percent just to break even. If you can find a no-load fund with the same performance, you would have the full $10,000 working for you from the start.
What about funds that do not have a sales charge?
We were recently privileged to share the experience of a former marketing executive looking to roll her company-sponsored 401K plan into a rollover IRA under her own control. One broker tempted her with a proposal to set her up in a portfolio of mutual funds "for no fee."
If getting advice from a broker for free strikes you as too good to be true, you are right. This broker recommended a variety of "B"-class mutual funds. Such shares have no upfront sales charge. However, during the first decade you hold B-class shares, you would be charged an extra percentage per year, on top of the usual expenses that apply to Class A shares. Naturally, if you compare the investment performance of a Class A and Class B share of the same mutual fund, you will find that once purchased, the class B share returns less per year than the Class A share.
If you decide to sell your B-shares and leave the fund family before a specified period of time (usually six years), you will have to pay a percentage of your assets that could be as high as 5 percent. (The sales charge you have to pay depends on how long you were with the fund family before leaving.) Funds you can pick yourself have done at least as well as what a broker can offer you.
In 11 of 16 of stock fund categories examined, the average no-load fund has outperformed the average load fund in the same category even before accounting for the impact of the sales load.= This, of course, does not mean that every no-load fund is superior to every load fund.
Certain load funds may well have their place in your portfolio. But you should be aware that in selecting load vs. no-load funds, the overall odds have favored better performance from no-loads. Of course, the results of any historical investment comparison do not predict future results.
Why would any investor pay more?
As with anything else, people who make their living by offering advice need to get paid for their efforts. If you want a broker's advice, you must pay for it by paying a sales load, either upfront or over time. What is important is to recognize how much you are paying for a broker's advice, so you can better decide whether that advice represents a good value.
Financial care differs from dental care in that, as an investor, you have the opportunity to save money by tending to your own needs if you are willing to muster the effort. The strategies presented in upcoming Practical Investor aarticles can help you do just that.
The study used data from the May 31, 2002, edition of Mutual Fund Expert. Five-year, risk-adjusted performance was compared within equity fund categories for load and no-load funds. The categories tested were all-cap, asset allocation, Asia Pacific, global emerging markets, information technology, international equity, international small cap, real estate, large-cap blend, large-cap value, large-cap growth, mid-cap blend, mid-cap value, mid-cap growth, small-cap value, small-cap blend, and small-cap growth. The average performance is the simple average of the individual fund's performance within each category, not weighted for assets. Only funds with at least five years' performance history were considered. Load fund averages were higher in global emerging markets, international small cap, information technology, mid-cap growth, and mid-cap value fund categories. (That is, the average no-load fund outperformed the average load fund in 11 out of 16 categories.) The data in the Mutual Fund Expert database and the calculations performed for this study are believed reliable but are not audited and cannot be guaranteed.