Believe it or not, there are good arguments on both sides of the load funds vs no-load funds debate. One or the other type may be best for you, but before you build a portfolio of mutual funds you need to learn the basics of loads and understand the purposes and differences between the various share classes of mutual funds. You will then be able to determine which type is best for you.
A load is a fee charged for the purchase or sale of a mutual fund. Loads charged upon purchase of fund shares are called front-end loads and loads charged upon the sale of a mutual fund are called back-end loads or a contingent deferred sales charge (CDSC). Funds that charge loads are generally referred to as "load funds" and funds that do not charge loads are called "no-load funds."
This is the first question to ask in the no-load vs. load fund debate. Since the load goes to pay for advice and/or service in making mutual fund transactions, you must first decide if you want to do all of the research and trading yourself or if you want an advisor or broker to do it for you. Skill and knowledge matter less than good judgment. Some investment advisors and brokers are just as susceptible to damaging emotions and poor judgment as the average do-it-yourselfer. However, a good adviser will look at your money logically and help lay out an objective road map to follow so you can reach your future financial goals while living your present life more fully. How much might this be worth to you?
At first you may think that no-load funds are the best way to go for investors but this is not always the case. The reason for buying loaded funds is the same as the reasons loads exist in the first place -- to pay the advisor or broker who did the fund research, made the recommendation, sold you the fund, and then placed the trade for the purchase. However, there is no good reason to pay anyone unless there is something of value exchanged, other than the mutual fund itself.
Some advisors and brokers get paid through commissions and this source of payment is meant to follow advice to the investor customer or client. Although it is possible to buy load funds without a formal client-broker relationship, there is no good reason for it.
The bottom line: In general, any investor who is doing their own research, making their own investment decisions, and making their own purchases or sales of mutual fund shares should not buy load funds.
You already know that you should generally buy no-load funds if you are not using an advisor. But what are other reasons for buying no-load mutual funds? Perhaps the best reason is to boost returns by minimizing expenses.
In most cases, no-load funds have lower average expense ratios than load funds and lower expenses generally translate into higher returns. This is because the expenses to manage the mutual fund portfolio come directly out of the gross returns of the fund.
For example if a mutual fund has a total return of 10.00% before fees and expenses and the total expense ratio of the fund is 1.00%, the investor's actual return is 9.00%. Now imagine you bought an average large-cap stock fund, which might have an expense ratio of 1.25%. An investor can easily find a no-load fund with an expense ratio of 0.75% or less. This is essentially a 0.50% return-per-year advantage over the load fund. Over time, this can mean a difference of thousands of dollars of savings and compound interest to the investor using a no-load fund.
A 12b-1 fee is a fee collected by mutual funds that is typically used to pay marketing, distribution, and service costs, and is paid to the broker. The Financial Industry Regulation Authority (FINRA) allows funds to charge as much as 1.00% annually as a 12b-1 fee.
A true no-load fund will not charge a 12b-1 fee while the most typical share classes of mutual funds charging such fees include Class B Shares (back load funds) and Class C Shares ("level load" funds).
This is a bit of an apples and oranges comparison. However no-load funds generally have lower average expense ratios than load-waived funds. Lower expenses often translate into higher returns to the investor, especially over the long-term. Therefore no-loads are generally better than load-waived funds, at least in terms of lower expenses, which can lead to higher returns.
A true no-load fund does not charge any load and it does not have any fees, such as 12b-1 fees, that may seem hidden to an investor. However, load-waived funds often do charge 12b-1 fees. This way an advisor or broker who gets paid by commission can still make money without getting paid the load. How do they do this? They remove (waive) the load but keep the 12b-1 fee. Therefore load-waived funds may sound like you are getting a good deal but you need to do your research and be sure you are not buying a fund with a high 12b-1 fee.
Load-waived mutual funds are identified by an "LW" at the end of the fund name. In contrast, no-load funds do not have any letter or letters, such as A, B, C, D, R, or LW, at the end of the fund name indicating a share class.
Which share class type is best for you? Sometimes you will find a particular mutual fund that suits your needs but may not be a no-load or load-waived fund. There are several different types of mutual fund share classes, each with its own advantages and disadvantages, most of which center upon expenses. For a direct comparison of share classes, you may want to look at the article, Which Mutual Fund Share Class Is Best? But for now, here are some basic points about the basics of share class types.
- Class A shares generally have front-end sales charges (also known as a "load"). The load, which is a charge to pay for the services of an investment advisor or other financial professional, is often 5.00% and can be higher. The load is charged when shares are purchased. For example, if you bought $10,000 of a mutual fund Class A shares, and the "load" is 5.00%, then you pay $500 as a commission and you will have a total of $9,500 invested in the fund. A shares are best for investors who plan to invest larger dollar amounts and will buy shares infrequently. If the purchase amount is high enough, you may qualify for "breakpoint discounts." Be sure to inquire about these discounts on the load if you plan to purchase additional shares of the fund (or mutual funds within the same fund family).
- Class B shares are a share class of mutual funds that do not carry front-end sales charges, but instead charge a contingent deferred sales charge (CDSC) or "back-end load." Class B shares also tend to have higher 12b-1 fees than other mutual fund share classes. For example, if an investor purchases mutual fund Class B shares, they will not be charged a front-end load but will instead pay a back-end load if the investor sells shares prior to a stated period, such as 7 years, and they may be charged up to 6% to redeem their shares. Class B shares can eventually exchange into Class A shares after seven or eight years. Therefore they may be best for investors who do not have enough to invest to qualify for a break level on the A share, but intend to hold the B shares for several years or more.
- Class C shares charge a "level load" annually, which is usually 1.00%, and this expense never goes away, making C share mutual funds the most expensive for investors who are investing for long periods of time. Therefore, in general, use C shares for short-term (less than 3 years) and use A shares for long-term (more than 8 years), especially if you can get a break on the the front-load for making a large purchase. Class B shares can eventually exchange into Class A shares after seven or eight years.
- Class D shares are often similar to no-load funds in that they are a mutual fund share class that was created as an alternative to the traditional and more common A share, B share and C share funds that are either front-load, back-load or level-load, respectively. One of the most widely held D share mutual funds is PIMCO Real Return D. Compared to PIMCO Real Return A, PIMCO Real Return B and PIMCO Real Return C, the D share class is the only one with no load and it has the lowest net expense ratio.
- Advisor shares are only available through an investment advisor, hence the abbreviation "Adv" following the names of funds in this share class. These funds are typically load-waived but can have 12b-1 fees up to 0.50%. If you are working with an investment advisor or other financial professional, the Adv shares can be your best option because the expenses are often lower than B shares or C shares.
- Institutional class funds (aka "Inst", Class I, Class X, or Class Y) are generally only available to institutional investors with minimum investment amounts of $25,000 or more. In some cases where investors pool money together, such as 401(k) plans, breakpoints can be met to use the institutional share class funds, which typically have lower expense ratios than other share classes.
- R share shares do not have a load but they do have 12b-1 fees that typically range from 0.25% to 0.50%. If your 401(k) only provides R share class funds, your expenses may be higher than if the investment choices included the no-load or load-waived version of the same fund. Common R Share funds seen in 401(k) plans are from the American Funds family. For example you may have seen American Funds Growth Fund of America or American Funds Fundamental Investors or American Funds Small Cap World in either R1, R2, R3 or R4 share classes.
Most do-it-yourself types use index funds and no-load funds for the same fundamental reason--to build a portfolio of mutual funds with high quality, low-cost funds. However some investors may not be aware that some index funds also have loads.
It can never be stressed enough that investors should never invest in an index fund with a load! The very purpose of index investing is to passively match the performance of a benchmark index. If there is a load, the expense of the sales charge defeats the purpose of the low-cost approach necessary to succeed in the passive investing strategy.
Are actively-managed funds worth paying a load? The advantages for actively-managed funds are based upon the assumption that the portfolio manager can actively pick securities that will outperform a target benchmark. Because there is no requirement to hold the same securities as the benchmark index, it is assumed that the portfolio manager will buy or hold the securities that can outperform the index and avoid or sell those expected to under-perform.
Therefore, if there is a chance of getting higher returns than a passive investment strategy may achieve, an investor may think paying a load is worthwhile. However, the load will effectively reduce the investor's overall return, which may ironically reduce the odds of beating the target benchmark or index.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.