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There's No Free Fund by Paul A. Merriman Publisher and Editor
We advocate no-load mutual funds, for reasons we’ve stated plenty of times. For details, follow this link to our Web site: http://www.fundadvice.com/FEhtml/InvestingBasics/9504(b).htm.
Sales commissions known as loads do investors no good; they simply divert money away from investments and give it to a salesperson. Savvy investors can choose funds on their own without paying a sales commission.
Many fund salespersons sell load funds without explaining the charges. And in some cases loads are cleverly disguised, as we will spell out in an article we plan for 2001.
While we disagree with many arguments of fund salespeople, this month we’ll agree with one of their points. They often say: “There’s no free lunch.” And they are right.
Every mutual fund has expenses, and the shareholders ultimately pay them. (Some fund families voluntarily “waive” their right to collect expenses in order to boost their reported returns and attract more money to their funds. But the waivers are rarely permanent.)
Understanding fund expenses can be tough. But they fall into three categories.
First, every fund has operating expenses for supporting existing shareholders. These include accountants, lawyers, custodians, transfer agents, an annual meeting, periodic reports to shareholders, taxes and office overhead.
Second, almost every fund pays a fee for portfolio management. This includes the cost of researching, buying and selling securities in the portfolio.
Third, every fund has distribution expenses for advertising, marketing, toll-free phone lines for prospective shareholders and (sometimes) commissions paid to salespersons.
Fund expenses are stated as annual percentages based on assets. They are prorated and charged daily. Shareholders in a fund with expenses of 1.5 percent of assets are charged 0.0041 percent per day they own the fund.
When you try to breakout these components in an individual fund, the waters can get murky. In some no-load funds, the distribution costs are paid by the management company and thus are part of the management fee. In other no-load funds and in most load funds, a separate charge, called a 12b-1 fee, covers distribution costs. This fee is typically 0.25 percent to 1 percent.
In other load funds, a front-end sales charge includes the costs of advertising as well as the sales commission.
These fees are spelled out in a fund’s prospectus, and fund expenses are also listed at Morningstar’s Internet site, www.Morningstar.com.
Here is an example. Morningstar says the Safeco Equity Fund’s no-load shares have an expense ratio of 0.83 percent, including a management fee of 0.61 percent and a 12b-1 fee of zero. This implies that the remaining 0.22 percent must be the operating expense.
Often, though not always, load funds have higher operating and management expense ratios than no-load funds. The Safeco Equity Fund also has front-end load shares with a total expense ratio of 1.12 percent (and a load of 5.75 percent). The management fee for these shares is 0.58 percent and the 12b-1 fee is 0.25 percent. The remaining 0.29 percent is presumably operating expenses.
The expense ratio of a fund always represents a drag on performance. Last year, the Safeco Equity Fund’s no-load shares had a total return of 9.4 percent. The front-end-load shares had a total return of only 9.1 percent.
An investor who put $10,000 into the no-load shares wound up with $10,940 at the end of last year. But an investor who put $10,000 into this fund’s front-end-load shares at the start of 1999 wound up with only $10,283. Most of that $657 difference was because of the sales commission. But about $28 of it was attributable to the load fund’s higher expenses.
It’s true that there’s no free lunch. But there’s also no reason to let a sales commission eat your lunch.
Source: http://www.fundadvice.com
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