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Making Sense Of Load Funds

10/27/00 03:05:44 PM PST
by Sean Moore

What's a load fund? What's a no-load fund? This should help you figure it out.

When you look through a mutual fund prospectus or profile, you'll notice that funds have a few expenses associated with them. Two that are tossed around without any explanation are load or no-load, both of which can have a considerable influence on your decision to buy a fund.

Load funds are distributed through financial planners, banks, and brokerage firms. The "load" in question can be considered the charge you pay to the intermediary who sold you the fund in the first place. This cost is usually used to help pay for the services or advice you receive from the institution that sold you the fund. In essence, it is a service charge for putting your money into a mutual fund.

A no-load mutual fund, in contrast, doesn't involve a service fee. This doesn't mean there are none; you still have other fees such as annual expense ratios, deferred sales charges, and 12(b)-1 fees. No-load funds have attracted a greater following than load funds, but current trends show that mutual fund companies are starting to add load funds into their array of choices. Unfortunately, there is no evidence that load funds outperform no-load funds, so you may ask (and rightfully so): Why even consider a load fund?

Load benefits
Load funds do provide some advantages; for one, a specific load fund may have had a historical record of stellar performance due to a great fund manager, and the services and advice you receive may make the extra fee worth it. If a fund returns 60-80% in any given year, the extra fee is definitely worth it. However, if the fund loses money, then it's another story.

Investors who don't have the time to monitor their portfolios may find that the extra fee for the professional advice is worth their while. Nor are services limited to mutual fund choices; the services offered can include financial planning, saving for education, and retirement planning, all of which can make that fee feasible. Plan on making full use of these services if you decide to pay the extra load.

Not only that, studies have shown that the benefit of load funds over no-load funds is not based on performance but on psychological issues. Investors of load funds usually have better portfolios than those who invest in no-load funds, mainly because they do get professional assistance. This helps those load-fund investors avoid making rash buy and sell decisions.

Even if you do not wish to utilize the services of an advisor, it is still worth investigating the performance of the fund versus its expenses before becoming a shareholder. When you're looking at returns of load funds, make sure you look at load-adjusted returns and not the typical net asset value (Nav) returns. A rate of return that appears to be superb may not be nearly as impressive once all of the costs are factored in. This is true for all funds, load and no-load.

Load strategies over time
Let's look at some examples to illustrate how the different load strategies will affect your investment over time. You can use a fairly simple equation to do the comparisons:

A = P(1 + i)n


P = The principal amount invested
i = (Rate of return - expense ratio)
n = The number of years to forecast

The resulting value of A would be the amount of money you could expect to have after n years if the rate of return and expense ratio remained constant. Of course, the rate of return and expense ratio is likely to change each year, but you can use an approximate figure to calculate a logical value for comparison purposes.

Let's check out a no-load fund. For this example, I'll look at an initial investment of $10,000 (P = 10,000). I'll assume that the average annual rate of return will be 10% and the expense ratio will be 1.5%, or $1.50 for every $100 invested. Therefore, the value of i (rate of return - expense ratio) will be 0.085 (0.10 - 0.015). Calculating the value of A after one year, I find that:

Different loads
To further complicate matters, there are several different load types that can be applied to mutual funds. The first and easiest to quantify is the front-end load. This type of load -- which is a certain percentage of the total amount invested (5% is a common amount) -- is taken off the top at the beginning before any money is invested into the fund. So with a 5% front-end load, a $10,000 investment immediately shrinks to $9,500. This type of load-fund strategy is commonly referred to as buying "A" shares of the fund. "A" shares are usually purchased directly from a broker, with the load being used to pay for the broker's services.

The second type of mutual fund load is the back-end load, or contingent deferred sales charge (Cdsc). With the back-end load, the fee involved diminishes over time; it is paid to the broker or fund company when you sell your stake in the mutual fund, as opposed to when you first buy into the fund. In a back-end load, there is a greater penalty for selling your shares within the first year than there would be if you were to retain your shares a while longer. And if you were to hold onto the shares long enough -- say, six years -- the fee would be eliminated altogether.

Buying shares with a back-end load is also known as buying "B" shares. This load, or redemption fee, is paid only when you try to redeem your shares within a certain period. In addition, "B" shares typically have some higher costs associated with them, one of which is the 12(b)-1 fee that is used for advertising and marketing. You might be able to eliminate the back-end load if you hold onto the shares long enough, but each year you are likely to be paying 1% of the total amount invested in 12(b)-1 fees.

Finally, there's the level-load strategy, also referred to as buying "C" shares. The fee involved will be a smaller service charge (say, 1% of the amount invested as opposed to the 5% in a front-end load) that is paid annually for as long as you own the fund. Since the fee is incurred every year, this type of strategy would be the least appealing for the long-term investor.

Some funds allow you to convert from one class to another. This can help reduce expenses over the long term. Mutual fund prospectuses contain information on all expenses associated with a fund. Trying to determine all of the distributed costs can be a difficult task, but many of the costs are reported as an expense ratio. This factors in management fees, administration expenses, 12(b)-1 fees, and transaction costs. By using this expense ratio along with the load strategies, you can compare different techniques to help gauge which one will best fit your investment criteria.

A = $10,000(1 + 0.085)1 = $10,850
Let's make the same assumptions for a front-end load, except I'll deduct 5% from the initial $10,000 investment, leaving me with $9,500:
A = $9,500(1+0.085)1 = $10,307
For a back-end load, I'll assume that the shares will be redeemed after a year, so a 5% redemption fee will be deducted from the resulting value of A. In addition, there will be a higher expense ratio (2.0%) to account for the higher 12(b)-1 fees. The value of i (rate of return - expense ratio) will be 0.080 (0.10 - 0.020):
A = $10,000(1+0.080)1 = $10,750
Now subtract 5% for the redemption fee:
A = $10,750 - ($10,750*0.05) = $10,260
Now look at the level-load strategy. We'll have to use a larger expense ratio to account for the additional load that is charged to the investment every year. I'll increase the expense ratio to 2.5%, which will correspond to an i (rate of return - expense ratio) value of 0.075 (0.10 - 0.025):
A = $10,000(1 + 0.075)1 = $10,750
You can compute values for A for the different scenarios using a number of different periods. The redemption fee for the back-end load will decrease as the length of time that the load is held increases. In the fifth year, the redemption fee will only be 1%, and if the shares are redeemed after that, the redemption fee drops down to zero, but the higher expense ratio will be used for the life of the investment. Some funds will, however, drop the higher expenses with the redemption fee, converting "B" shares into "A" shares. Figure 1 shows the computed values for the different scenarios; Figure 2 displays the results in a graphical format.

In reality, the rates of return and expense ratios will differ for different funds. But with the use of this equation
A = P(1 + i)n

P = The principal amount invested
i = (Rate of return - expense ratio)
n = The number of years to forecast
you can gain an approximate return to expect from a certain fund, taking many of the costs into account. It's also important to consider the life of the investment; if you are likely to sell your stake in the fund within a few years, then you might do best to avoid a back-end load fund, whereas if you are likely to hang onto the investment for many years, then buying into a level-load fund wouldn't be advisable. --S.M.

SIDEBAR Figure 2: Future Investment Value. Here's the approximate future value of a $10,000 investment, shown in graph form.

Returns vs. expenses
You need to consider several variables when trying to determine whether a fund's returns justify its expense ratio. To make things easier, the Securities and Exchange Commission (Sec) offers a mutual fund calculator on its Website ( to help you determine the expense-return tradeoff of a specific fund. The calculator takes all fees associated with load funds into account. It's a great starting point and also forces you to study the expense section of the prospectus, a task often neglected by many mutual fundholders.

The Sec's calculator will ask you to enter the following information in the following order:

1. Number of years you plan to invest in the fund
2. Initial investment capital
3. The type of fund you want to invest in -- money market, bonds, or stocks
4. Average annual return you expect
5. The percentage sales charge on purchases (load)
6. The percentage-deferred sales charge (back-end load)
7. Does the fund convert from one class to another during your investment time frame? If so, enter the conversion year, and
8. The percentage total annual operating expenses.

Based on the information entered, you will see a display indicating the total cost of holding the specific fund. This cost includes total fees as well as the foregone earnings, which you can think of as the amount you could have invested had it not been deducted in fees. For example, a 5% front-end load on a $10,000 investment means $500 has been foregone. The mutual fund calculator derives foregone earnings based on the investment income you could have earned on that $500. In addition, the amount of your investment at the end of your holding period will also be displayed. This helps determine whether paying the additional fee is justifiable.

You should compare both no-load and load funds to determine which would be the better alternative. Make sure you compare similar funds, though; don't compare stock funds to bond funds, for example.

Factoring in the costs
Even though load funds charge the additional fee, it is still worth your while to determine whether these costs are justifiable for your needs. Factoring these load costs as well as other expenses into your fund research will help you understand exactly how the different funds operate and how you are most likely to achieve the greatest profits. After all, you want to make a responsible investment decision. The more research you do, remember, the better off you are.

Sean Moore Staff Writer.

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