Personal Business: Investing
THE HIDDEN HITS IN MUTUAL-FUND FEES
It is getting harder to figure out how much a mutual fund costs. The assortment of sales charges and expenses has multiplied, making some investors feel as if the industry has a hand in every pocket, while others mistakenly believe they are getting their mutual funds for free. New rules will go into effect on July 7 that are aimed at preventing fund companies from overcharging, but they won't clear away the confusion.
The mutual-fund industry has enjoyed enormous profits in the past decade as the number of investors has grown exponentially. But instead of lowering expenses by spreading out fixed costs among many more shareholders, fund companies have raised expenses. Instead of honoring investors' demands for lower sales commissions, many companies that distribute their funds through brokers have resorted to pricing structures that hide the sales charge by combining it with the fund expenses. "They've gotten credit for bringing sales charges down," says Don Phillips, a vice-president at Morningstar, a mutual-fund rating service. "But expenses have gone up. It's just a giant reshuffling."
SHORTCUT. Mutual-fund costs are divided between sales charges, or loads, and expenses. Almost all load funds are bought through brokers or financial planners, and the sales charge pays their fee. No-load companies market directly to consumers, without a broker, so the sales charge isn't necessary. Some companies that market their funds directly, such as giant Fidelity, charge an entrance fee of 2% or 3% of your initial investment for popular or specialized funds.
A fund's expense ratio, which is found in the prospectus, is made up of management, service, and, increasingly, 12b-1 fees, which are used to finance distribution costs. Originally intended to pay for the advertising costs of no-load funds, 12b-1 fees come into play far more often today with load funds, where they go toward paying an ongoing commission to the broker as well as providing additional expense income to the fund company.
The 12b-1 fee, which was first used in 1988, has allowed load-fund companies to adopt an increasingly wide array of pricing structures. With roughly a third of the load funds sold today, investors must now choose among pricing classes usually termed A, B, C, and D (table).
AROUND THE BEND. As a rule, an A share has the traditional one-time, up-front sales charge, in which the fund company takes an initial cut that averages 4% to 6% of your money and then invests the rest. There may also be a 12b-1 fee of about 0.25% of assets per year. B shares have a "back-end" load, or a sales charge that is assessed for five to eight years through a yearly 12b-1 charge. Investors who purchase B shares are also subject to a contingent deferred sales charge (CDSC) that tapers off from 5% to zero over five to eight years. The main advantage of B shares is that investors get to see all their money go to work right away, though they pay more in the long run.
Currently offered by only a handful of brokerage houses and fund companies, including PaineWebber and the Thomson Fund Group, "level loads," sometimes called C or D shares, charge a 12b-1 fee plus a 0.25% service fee for the length of time the fund is held. Investors also may be assessed a 1% penalty if they redeem their shares in the first year.
This primer of pricing options is only a rough guide, however. Fund companies can give their share classes whatever name they want. Thomson, for example, calls its level load B shares.
"LABORIOUS." Although level loads looked like the wave of the future last fall, some fund companies have balked recently at moving to C shares. "There was real concern about confronting the investor with so many choices," says Stephen Gibson, national director of marketing for Putnam Investments, which put C shares on hold. "Three different structures gets to be fairly laborious." While each fund has its own set of fees, in general, if you know you are going to hold the fund for more than six years, it's better to pay up front and get the sales charge over with. However, most investors don't know how long they are going to hold the fund, Gibson says.
Fortunately, fickle investors don't pay a very high price for choosing the wrong class of shares. Investors who hold a fund for just a year will pay much less for a C share, but individuals who stick with a typical multiclass fund for 5 or 10 years will pay about the same in sales charges whether they choose A, B, or C shares. For example, the five-year total return for a $10,000 investment in a fund that averages a 10% annual gain will be $15,713 for A shares, $15,694 for B shares, and $15,657 for C shares, says Chicago's Financial Research Corp.
Why, then, does the fund industry create all this confusion? It's essentially a marketing ploy. Because the 12b-1 charge is added to the expense ratio, back-end and level-load funds are proving to be easier to sell to investors who believe it's dumb to pay an up-front load if they don't have to. Of funds that have multiple share classes, 65% of sales in the first quarter of 1993 went into B and C shares, according to Financial Research Corp.
Gibson says clients are going to brokers demanding to buy a "no-load" fund, thereby proving they don't understand that the load goes to pay the broker's fee. Critics charge that some brokers are taking advantage of that confusion, selling back-end or level-load funds to clients as "no loads" and neglecting to mention the ongoing sales charges and redemption penalties. In fact, brokers are not obligated to explain all the different pricing options and may choose for you--opting for the method of payment they prefer.
Figuring out how much you are paying for a mutual fund has gotten so complicated that the National Association of Securities Dealers, with the approval of the Securities & Exchange Commission, will soon begin enforcing new regulations that are meant to ensure that most investors will end up paying no more than the maximum 8.5% load regardless of the pricing structure they choose. Starting on July 7, funds cannot charge more than a 1% 12b-1 fee or a 0.75% 12b-1 fee plus a 0.25% service fee in a single year. They may also be forced to reduce the sales charge in years that post lower sales, since fund companies would then have less need to compensate brokers. Also as of July 7, only those funds that charge less than 0.25% a year in 12b-1 fees will be able to call themselves no-load.
Expenses can make a real difference to a fund's overall performance. In the roaring bull market of the 1980s, when the S&P 500 returned an average 17.5% a year for the decade, expenses took approximately a 7% nick out of fund returns. But if the market gains 10% in the 1990s-- slightly below its historical average--15% of profits will be eaten away by expenses. If the market grows only 6% a year in the 1990s, as some bearish analysts predict, expenses would gouge a punishing 25% out of returns.
"This scenario for equities is already the reality for money-market-fund holders," says Phillips. A 3.5% return on those funds loses 21% of its value with the .75% average expense cut. "Investors are going to have to spend more time looking at these costs," he advises. "No service has infinite value. At some point, the costs can and will outweigh the benefits."
EASE OF USE. For now, Phillips recommends picking funds that stick fairly close to the average expense ratio for their category. Small funds typically have larger expense ratios because they have fewer investors to absorb fixed costs. Bond funds tend to have lower expense ratios because the funds are easier to manage, while specialized equity-sector funds that place more demands on a manager assess higher fees (table).
As with any fund choice, the sales charge and expenses should not be the primary consideration. "The emphasis on expenses can get investors pointing at the wrong end of the elephant," says Charles Dornbush, Fidelity's chief financial officer. "No amount of understanding the expense ratio really helps if they didn't understand the basic investment risks of the fund or if they're unhappy with the investment performance."
Some very successful funds have high loads, and some equally dynamic funds have huge expense ratios. The Kaufmann Fund averaged returns of 30.5% for the past five years despite an expense ratio of more than 3%. And the United Income Fund averaged more than 17% returns over the past 10 years, making its 8.5% up-front load seem insignificant to long-term investors.
So, the first step is deciding whether you want to choose a no-load yourself or buy a load fund with the help of a financial adviser. Narrow down the list of funds to a handful of quality choices that meet your investment objectives. Then, consider the impact of fees and expenses on total return before you make your final choice.AIM FOR
Fund type Average expense ratios
U.S. diversified equity 1.37
(asset allocation, balanced)
Taxable bond 1.03
Municipal bond 0.76
DATA: MORNINGSTAR INC.
THE ABCs OF LOAD-FUND INVESTING
Share Structure Sales charge Special charge
class for cashing out
A Front-end load Average 4%-6% initial N/A
B Back-end load 0.75% 12b-1 fee for Declines from 5%
about 6 years to 0 over 5 to 8
0.25% perpetual years
C or D Level load 1% perpetual 1% in first 12
12b-1 fee months
N/A=Not applicable DATA: BUSINESS WEEK
Amey Stone Edited by Amy Dunkin