This occasional feature highlights a few of the things you may hear or see about investing that are correct as far as they go. However, they don’t go far enough, so those who “believe” them may end up poorer as a result. In this issue we look at so-called “no load” funds that actually have significant purchase costs that technically are not loads.
A load on a mutual fund is a sales commission that is paid up front and deducted from the amount actually invested. For example, if one makes an initial purchase of $10,000 of a fund with a typical 5.25% load, only $9,475 buys shares of the fund. The remainder is used to compensate the brokerage firm and the registered representative that sold the fund.
Many investors realized that starting off in the hole was not a very good way to invest, and funds offered by many mutual fund companies without loads started taking a considerable amount of business away from traditional “full service” brokerage firms such as Merrill Lynch and Morgan Stanley. They needed a no-load product, but still required high fees to generate the revenue required for their style of business. What they did was create various classes of mutual funds with different cost structures.
The following examples are taken from the Morgan Stanley web site, but other brokerage firms and some mutual fund companies have similar types of share classes. They have four classes for their funds, which are cleverly called A-, B-, C-, and D-class shares. The A- share class is the only one with an up front sales charge or load, which may be 4.25% or 5.25% depending on the fund. Investors buying large enough amounts get lower loads, and the loads disappear if one buys over a million dollars worth. These shares also have a 0.25% annual rate12b?1 “distribution fee” that is really a charge used to compensate those who sell the funds.
The B-share class is the largest gibberish generator by being billed as no-load. Due to its onerous built-in fees, many long-term investors would be better off paying the load up front. What are the not-so-visible “got-yas?” First the 12b-1 fee is 1% a year, an increase of 0.75% over the A-shares. To make sure they get you, there is a back-end sales charge of 5% if the shares are sold within a year that goes down by a percent in most years and disappears after six years. In other words, Morgan Stanley is going to get their load through the higher 12b-1 fee or from a back end sales charge. So much for being “no-load.” Pure gibberish that is technically correct, but highly deceiving.
After six years there is a disadvantage to owning B-shares as compared to A-shares due to the higher 12b-1 fee. Investors have the right to convert to A-shares at that point. In their extreme devotion to the interest of their (not so well informed) clients, Morgan Stanley will automatically convert the shares after ten years (according to their web site)!
Unless one is going to own the fund for at least six years, the C-shares are clearly a better deal than the B-shares, and may be a better deal than the A-shares. They have the same 12b-1 fees as the B-shares, but only a 1% back end sales charge, and it goes away after a year. However, C-shares can’t be converted to the lower 12b-1 fee A-shares. The D-shares are the best deal of all with no sales charge and no 12b-1 fee, but to get those you have to have at least $5 million in Morgan Stanley funds.
How much of a difference do those charges and fees make? Comparing the B-shares of Morgan Stanley’s S&P 500 index fund with those of the Vanguard Index 500 fund that has no loads, no 12b-1 fees, and lower management expenses over the one-, three-, and five-year periods that ended on September 30, we see the Vanguard fund had total returns that were 1.3%, 5.6%, and 5.9% higher, respectively. In up markets the advantage of the Vanguard fund will be greater than in down markets because by taking away some of your investment before the market falls, Morgan Stanley reduces your losses a bit. However, to me that seems like “heads you lose a lot, tails you still lose a lot but not quite as much.” Buying any class of an index fund offered by a full service broker is a costly mistake.
I hope none of you buy any mutual funds from the likes of Merrill Lynch, Morgan Stanley, or other high priced brokerage firms, but if you do, pay very careful attention to the share classes available and their terms.
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