Mutual Funds - Sales Charges, The Bad News Gets Even Worse

In the first two articles in this series we covered index funds versus actively managed funds and then we learned about the major types of the high fees associated with actively managed funds. And since fees are just another chunk of your money going into someone else’s pocket, we saw that taking that money out of your investment instead of letting it grow and work for you makes it very hard -- and therefore very unlikely – for most actively managed funds to beat the market.

Unfortunately, it gets even worse if you invest through a broker…

Next time you think about your broker, think about your local car dealership. Why? Because it’s easy to understand what’s going on at your broker’s offices if you understand what’s happening at the dealership.

Dealerships generally work on commission. Of course, salespeople don’t focus much on this when they’re trying to sell you a car, since it makes it pretty obvious that saving you money isn’t in their best interest. Who pays for those commissions? I think we all know they’re built right into the cost of the car -- we pay.

With mutual funds it’s not a lot different. We pay commissions when we invest through a broker and every time we invest in anything other than a no-load fund. (Now some of you may have “fee-based” brokers that don’t charge commissions, but there are plenty of things to dislike about that group as well – starting with the “fees” part of “fee-based.” More on that later.)

Going back to our car dealership analogy, as you know, the commission is built right into the retail cost of the car that you pay (even after you negotiate) – above and beyond whatever the dealership paid wholesale to the manufacturer. And as you’d expect, the dealership also needs to make money so there’s also a built-in cost to you that has to go to the dealership. Consider the combined dealership profit along with the commission paid to the salespeople your total sales charges.

Meanwhile, when you buy a mutual fund, the cost of what you’re buying is the amount you’ve decided to invest. And this is where the investment industry got clever. There are many different types of “share classes” out there, but the three big ones are A, B and C share classes. All of these are called “load” share classes – just another word to obscure that these are sales charges plain and simple:

1. A shares = “front-end loads” = sales charges you pay up front at the time you invest
2. B shares = “back-end loads” = sales charges you pay when you redeem your investment (where the amount is contingent on when you redeem – in the industry this is called a Contingent Deferred Sales Charge, or CDSC)
3. C shares = “level-loads” = sales charges (and then “service fees”) you pay throughout the entire time you hold your investment.

Note that the key phrase above is always “sales charges you pay.” It doesn’t matter when you pay those sales charges – up front, when you redeem or throughout the entire time you hold the investment -- you’re still getting the same underlying mutual fund product. These “loads” or sales charges are in addition to the ongoing fees you pay for management and distribution of the funds.

So now we’ve got management fees, distribution fees and then a bunch of flavors of sales charges( whether up front or in the form of CDSCs). Is it any wonder that “loaded” actively managed mutual funds have a hard time beating the market?