Load Mutual Funds – Hazardous to Your Wealth
by Rick Miller
Updated: September 1, 2015
Broadly speaking, you can invest in two kinds of mutual funds1:
No-load funds (also “direct-sold” or “direct channel” funds)
An investor buys a no-load fund directly from the mutual fund company, or through a fee-only advisor. The company pays no compensation (or very little compensation) to the advisor, if there is one.
Load funds (also “broker-sold” or “broker channel” funds)
An investor buys a load fund through a broker or other advisor. The fund company charges a load (an extra fee2) to the investor, sharing it as a commission with the broker or advisor. The buyer cannot recover the load, even when selling the fund.
In recent work3, Daniel Bergstresser, John Chalmers, and Peter Tufano compare these two kinds of mutual funds, focusing on costs and performance. They conclude that even without considering distribution costs, that load funds underperform no-load funds significantly:
“The bulk of our evidence fails to identify tangible advantages of the broker channel. In the broker channel, consumers pay extra distribution fees to buy funds with higher non-distribution expenses. The funds they buy underperform those in the direct channel even before deductions of any distribution related expenses. Even before accounting for distribution expenses, the underperformance of broker channel funds (relative to funds sold through the direct channel) costs investors approximately $9 billion per year.”4
But there are lots of investors – millions of them. If you divide $9 billion by millions, maybe the extra cost isn’t really so bad. Let’s make it personal. How much could load funds cost you? There are two answers, and both are important:
a) Too little for the casual observer to notice
b) Too much for you to ignore
Too little for the casual observer to notice
Depending on how you calculate, the average load equity fund underperforms the average no load fund by between about 8 and 135 basis points per year, or .08% to 1.35%. For bonds, the disadvantage ranges between .7% and 2.0% per year. Due to the variability in fund performance, in any given year, many load funds will outperform many no load funds. Look at your favorite financial publication, and you’ll see annual differences in fund performance of 10%, 15%, even 20%. The casual observer will see some load funds near or even at the top, and some no load funds at or near the bottom. It takes careful analysis (the authors of the paper are university professors, after all!) to sift the data and determine the impact.
The tables (one for equities, one for bonds) show their findings. First, distribution expenses [12(b)1 fees] are a big problem for load funds. Including them increases the disadvantage of load funds at least 50 basis points or .5%. Secondly, for equities, more careful analysis5 shows the load fund disadvantage to be bigger (as adjustment increases toward the bottom of the table, the advantage grows by 70 to 85 basis points). For bonds, more careful adjustment6 has less clear impact, but the load fund disadvantage is larger.
Too much for you to ignore
These differences sound small – 2% per year at the most for bond funds, even less for stock funds. What difference would they make to you? Suppose you have $100,000 to invest in a 60/40 mix of equity and bond funds. Consider the dollar impact after distribution expenses (you can’t get a load fund without paying them). Investing in load funds rather than no-load funds is likely to cost you a bundle. After 10 years, you’re likely to be between almost $12,000 and nearly $25,000 behind. After 30 years, the difference is $100,000 to $200,000 – you’ll have paid once or twice your entire initial investment for your advisor’s counsel. And that’s before considering the cost of the load itself!
Why are the differences in dollar returns so large, when the differences in expenses sound so small? Those differences turn out to be large relative to the investment returns you can expect. Stocks, over the long haul, might return 7% per year after inflation, on average7. Bonds might return 4%. The cost differential between load and no load funds is as much as 15 to 20% of your potential return, year in and year out. Buying a load fund is equivalent to signing up for extra taxes – if you are in the 15% Federal bracket for investment returns, you might as well increase your rate to 30% to 35%.
How to identify a load fund
The easiest way to tell if your broker or advisor is offering you a load fund is to ask. They must tell you, and they are likely to tell you that the load is the mechanism you use to pay them. They may be less likely to tell you about the ongoing higher distribution costs [the 12(b)1 fees of 45 basis points or so], and they may even be unaware of the higher expenses of other sorts, and the lower returns on average.
You can also identify the companies that offer the mutual funds that the paper classifies as ‘broker channel’. Some of the largest providers include8:
On the other hand, there are fewer relatively large no-load fund families9:
It’s important to note that the research we are summarizing here does not imply that every no load fund will always outperform every load fund. It does mean that load fund purchasers are making a choice that they are likely to regret, and that the regret is likely to grow deeper over time.
As with many aspects of investing, in deciding what kind of mutual fund to buy there are no guarantees, just strong tendencies. You have to decide whether to harness those tendencies to your advantage, or ignore them, hoping against long odds to come up a winner.