The Worst Deal in Mutual Funds Faces a Reckoning

The Worst Deal in Mutual Funds Faces a Reckoning
Illustration by Dennis Pacheco

Imagine an investment that is guaranteed -- at least initially -- to lose you money. Such an investment was once quite common and still exists: the front-loaded mutual fund.

To buy into such funds, investors pay as much as 5.75 percent of their initial investment in a load charge. That $40,000 you wanted to invest? It instantly shrinks by $2,300.

Plenty of investors still pay loads. According to fund research firm Strategic Insight, 5 percent of mutual fund shares were bought with a load of 4 percent or more in 2010. Mutual funds charge the fee, but almost all of its proceeds are sent to the broker or adviser recommending the fund. However, the percentage of funds sold with front-end loads is dropping rapidly, and excessive loads could disappear almost entirely under new regulations.

Worst offenders

Front-end loads are hardly the only way brokers are compensated for recommending funds. Less visible annual 12b-1 "distribution" charges in a fund's expense ratio also flow through to brokers. According to the Investment Company Institute, or ICI, investors paid $10.5 billion in 12b-1 fees in 2010, typically through 0.25 percent charges on front-end funds or annual 1 percent fees on so-called "level load" funds. Even no-load funds can have 12b-1 charges, though they must be less than 0.25 percent.

Still, front-end loads are the worst offenders. That's because while the funds can make financial sense for those who hold them for a long time, Dalbar data shows that investors hold on to equity mutual funds an average of 3.3 years and bond funds for 3.1 years. For these investors, paying a front-end load is a bit like paying a lifetime's rent for a place you might live for only a few years.

The cost of advice

Defenders of load funds say they’re a way to cover the costs of advice. For those who pay a maximum 5.75 percent load, American Funds's $130 billion Growth Fund of America, the largest equity load fund, charges a 0.68 percent expense ratio. That's much lower than the 1.46 percent expense ratio on its no-load version. Yet, the load version pays off only after eight years, and it's pricier than more than 1,500 mutual funds in the U.S. The largest equity fund, the no-load Vanguard Total Stock Market Index fund, has an expense ratio of 0.17 percent.

That's why so many investing experts warn against front-loaded funds. “In no event should you ever buy a load fund,” Princeton University professor Burton Malkiel advises in his best-selling investment guide “A Random Walk Down Wall Street,” now in its 10th edition. “There’s no point in paying for something if you can get it free.”

"Suitable" debates

Two trends should hearten long-time critics of loads. In 2011, investors pulled a net $110 billion from front-loaded funds, while putting a net $24 billion in all mutual funds, according to the ICI. And Strategic Insight estimates that 48 percent of shares bought in 2010 went into no-load funds, up 14 points from 2007.

By contrast, 12b-1 fee payments are holding steady. The $10.5 billion paid in 2010 matches the annual average for the previous decade.

There's another reason paying load fees can hurt investors: Broker-dealers and other advisers paid via loads, 12b-1 fees and other commissions need only recommend “suitable” products for clients. They don’t need to meet the fiduciary standard imposed on other investment advisers, which requires them to give advice in the client's best interest -- much like the ethical code a doctor or lawyer must follow.

That's particularly significant since those paying loads are the poorest and least sophisticated of investors. The top 5.75 percent charge is typically reserved for purchases of $50,000 or less, according to the ICI. These are exactly the sort of investors who need more protection from inappropriate investment products, says Dan Candura, chief executive officer of PennyTree Advisers. “They have less assets to lose and less ability to recover from a mistake.” At front-loaded funds, purchases of $50,000 to $100,000 usually trigger a 4.5 percent load, while purchases of $1,000,000 or more aren’t charged at all.

There is a battle in Washington over whether, and to what extent, all advisers to retail customers should be fiduciaries. “Being a fiduciary means you have your clients’ best interests at heart; it doesn’t mean you can’t get paid,” says Bob Grohowski, senior counsel at ICI.

Yet there’s evidence that brokers -- those who lack a fiduciary standard -- offer worse advice. A 2009 study led by Harvard Business School Professor Daniel Bergstresser looked in detail at funds sold by brokers from 1996 to 2004. He found they lagged other funds, even before taking into account commission costs.

New standards

Merely disclosing conflicts of interest isn't enough, says Boston University law professor Tamar Frankel. Instead, she says, new standards should require that a broker's charges be reasonable. It’s by no means clear that investors will get such rules from regulators. “We do not expect that the new standard will undertake to examine the reasonableness of fees charged by advisers or the commissions charged by brokers,” says Kevin Carroll, managing director and associate general counsel at the Securities Industry and Financial Markets Association, or SIFMA, in a statement to Bloomberg.

The average broker may, in any case, already be preparing for a world without load funds. Wake University law professor Alan Palmiter has noticed how the financial industry often reacts to expected regulations as if they’re already in place. Thus, it’s significant that, from 2007 to 2010, the number of shares sold with loads of 2 percent or more has fallen by half, from 24 to 12 percent. “Brokers are beginning to worry there may be a fiduciary standard and they may get into trouble if they push [load funds] the way that they have in the past,” says Palmiter.