Until recently, buying mutual funds was an "either or" business. You either bought them through a salesperson-a stockbroker, financial planner, or sometimes a dually-licensed life insurance agent-or you bought them direct from the mutual fund company. If you bought through a salesperson, you paid a sales charge or "load," a fee that compensates the salesperson for selling you the fund. If you bought directly from the fund company, there was no salesperson, so the fund was purchased "no load," without that fee.
In essence, the load and no-load arrangements represented two ways to distribute funds, and most fund companies followed one or the other. Companies such as Alliance Capital, Franklin, Putnam, and Templeton are load fund groups, and sell through brokers, sometimes called "broker-dealer" funds. (These funds also include the brokers' in-house proprietary products, such as Merrill Lynch Mutual Funds.) Janus, T. Rowe Price, Scudder, and Vanguard are no-load groups, sold without the presence of an intermediary. Instead, they are sold through the mail, toll-free telephone lines, and, in some cases, walk-in investor centers. A few, like Fidelity and Dreyfus, though mainly no-load, developed and sold load funds as well.
Now, new ways to invest in mutual funds are emerging, which are neither load nor no-load. One model is the mutual-fund network, the oldest, biggest, and best-known of which is Charles Schwab & Co.'s Mutual Fund Marketplace. The network addresses one of the drawbacks of investing in multiple funds of several no-load companies: You must maintain relationships with numerous fund companies, and keep track of paperwork for every company with which you deal. Plus, the network makes moving money from, say, a Janus to a Scudder fund as easy as moving from one Janus fund to another. Of course, those who run these networks are in it for the money, and with no-load funds, who's going to pay the firm that runs the network? Some fund groups, such as Invesco, Janus, Strong, and Twentieth Century find this distribution arm so compelling that they pay the networks a small annual fee, about 0.25 percent of assets under management, for bringing them customers.
The networks made simple what was previously difficult-managing diverse portfolios of no-load funds. The networks also made it possible for many brokers to leave the major brokerage firms and set up shops on their own. Instead of selling Franklin and Putnam funds with loads attached, they switched to the no-load networks. Instead of collecting a commission for selling a particular fund, they manage a portfolio of commissionless funds, assessing an annual "management fee." Many load-fund companies, not wanting to miss out on this business, now make their funds available no-load to investors who buy through advisers who charge fees. And the big brokerage firms, seeing the popularity of fee-based mutual fund investing, are changing their ways as well. In 1996, expect to see major brokerage firms like Merrill Lynch, Smith Barney, and Prudential Securities offering large numbers of funds, load and no-load, on a fee-only basis.
A little confusing? First, let's take a few steps back.
What You Need toKnow About Loads
For most of their history, mutual funds were sold by salespeople working for the fund companies, brokerage firms, and insurance companies. And for most of that time, the funds came with a stiff "load," or commission. Today, most funds sold by brokers are commonly known as "load" funds.
For many years the load was an 8.5 percent up-front sales charge that lobbed a big chunk of money right off the top of an investment. That meant that out of a $1000 investment, $85 would go toward commissions and only $915 into investments. The 8.5 percent charge usually applied to investments of less than $10,000. For large amounts the sales charge would start to scale back and might even disappear after, say, $1 million. A few fund groups even levied a load on the reinvested dividends and capital gains, though the regulators kept it a tad lower than the initial front-end load. True, the commission seemed high, but salespeople would remind investors that, unlike stocks and bonds, it was only paid on purchase-not again when the investor sold the fund.
There are many more load than no-load funds. That's because many funds need brokers to bring them to investors. Some no-loads with excellent track records never really attracted investors-until they added loads. That allowed them to pay brokers to sell their funds. The first year AIM Weingarten was a load fund, assets under management increased by about $98 million, or 58 percent. For instance, the Pasadena Growth Fund switched from no load to a 3 percent load to encourage brokers to sell the fund. But, says Roger Engemann, the portfolio manager, the 3 percent load proved too small to get the brokers excited about the fund. Then, on the advice of a major brokerage firm, the fund boosted the load to 5.5 percent-and sales took off. The fund more than doubled its assets in less than a year.
In 1992, mutual fund regulators on the U.S. Securities & Exchange Commission staff proposed negotiated loads-allowing fund companies, brokers, and investors to dicker over price. After all, stock commissions have been negotiable since 1975-why not funds? The fund industry howled, and the SEC commissioners didn't press it. The matter died.
NO-LOAD FUNDS
In the early 1970s, the stock market plummeted, and so did mutual fund sales. To shake off the slump, some companies started to sell their funds direct to investors without a sales charge-"no load." No-load funds weren't brand new then, either. But the early no-loads were started by investment counseling firms like T. Rowe Price for accounts deemed too small for individual management, and were not widely marketed.
But along with the no-loads came liberalized rules on mutual fund advertising. Then fund management companies like Dreyfus and Fidelity began dropping the loads from some funds, and when new funds were launched they came without loads. Money-market funds, which drew millions of new investors into mutual funds in the 1970s, were also sold no-load. Their popularity also worked to the advantage of the no-load fund families.
Until the mid-1980s the mutual fund universe was split between the "loads," which stuck with their 8.5 percent sales charges, and the no-loads. Then the load funds, feeling investor resistance to the stiff fees, started lowering their sales charges. Now, there are only a handful of funds with 8.5 percent loads. Most of the load funds have dropped their fees to the 4 to 6 percent range. Increasingly, they have also offered funds with different methods to pay the sales charge, the "back-end load" and the "level load."
BACK-END LOADS
They call it a back-end load, "redemption fee," "exit fee," or, technically, the "contingent deferred sales charge." The fee starts at 4 or 5 percent of the value of the funds you're selling, depending on the fund. If you sell your shares in the first year, you pay the full charge. In the second year, your exit fee drops by 1 percentage point, and so on. By the fifth or sixth year the redemption fees are usually gone, so if you're truly a long-term investor, you may never pay that fee.
Back-end loads were first introduced about a decade ago. But this alternative didn't really take off until the late 1980s, when Merrill Lynch introduced "dual pricing." Dual pricing creates two classes of shares for each fund: "A" shares, which carry a one-time up-front load, and "B" shares, which carry the back-end load. Now dual pricing is widespread among brokerage house proprietary funds, and even among the independent fund managers that sell through brokers. While many use the A and B share method, a few, such as Eaton Vance, offer a separate line-up of funds with back-end loads.
During the 1980s, as the load funds lowered up-front sales charges and introduced back-end loads, some no-load companies were going the opposite way. Fidelity Investments, for instance, slapped "low-loads"-2 or 3 percent sales charges-on funds that were previously sold no-load. Fidelity didn't use the load to pay brokers, but to pay for its extensive advertising.
But by the 1990s, even though the mutual fund industry enjoyed record sales, investors were resisting loads. Strong Funds, which had low-loads on its equity funds, dropped them altogether in late 1992. Fidelity now waives its low-loads on most funds purchased in retirement accounts (Magellan and Select Portfolios are excluded). In recent years, some load funds with hot performance, such as Oberweis Emerging Growth, switched to no-load, and Heartland Value Fund dropped its front-end load in favor of a back-end load and eventually went no-load. (There are still a few going in the opposite direction. Evergreen Funds switched to loads after the fund management company was acquired by a bank.)
Just because a fund is no-load does not mean there are no fees. For instance, the Vanguard Group levies a 1 percent "transaction fee" on its index funds (0.5 percent for the Vanguard Index Trust Extended Market Portfolio). The difference between this fee and most loads is that the proceeds go to the fund, not to the fund sponsor. The fee is to offset the transaction costs of investing the money. (In most funds, that cost is not explicit but indirect and it is reflected in the price that a fund pays for securities.) At the same time, the Vanguard index funds levy a $2.50 per quarter "maintenance fee" on accounts with less than $10,000 in them. That takes care of reports, statements, and the like. In most funds, that cost ends up on the line itemized as "other expenses."
Some no-loads charge redemption fees, too, but they're usually meant to discourage short-term trading. Vanguard has a 1 percent redemption charge on its Specialized Portfolio series of funds to discourage short-term trading. The Lindner Fund and the Lindner Dividend Fund take a 2 percent redemption fee on shares sold within 60 days of purchase. The Pennsylvania Mutual Fund levies a 1 percent exit fee on shares redeemed within a year of purchase.
Since the wide variation in loads has so muddled the distinction between load funds and no-loads, the terms don't mean so much anymore. In fact, the Investment Company Institute, the fund industry's trade association, looks at funds by the method used to distribute them, not by the sales charges. There are "sales force" funds-those sold to investors through sales folks-and "direct marketing" funds-those sold by the management companies directly to investors
"HIDDEN LOADS"
If the loads, low-loads, and no-loads aren't confusing enough, consider the "12(b)-1" fee, or what some commentators call the "hidden load." The 12(b)-1 charge, named for the U.S. Securities & Exchange Commission rule which enabled funds to levy it, is, like loads, meant to help defray marketing and distribution costs. Sales force fund companies can use the 12(b)-1 revenues to compensate brokers for their selling efforts. Direct marketing companies, on the other hand, use the money to pay for advertising. At least half of all funds levy some sort of 12(b)-1 fee.
What's very different about this charge is how it is collected from the shareholders. Instead of paying the charge once when investors buy the fund (front-end load), or when they sell it (back-end load), investors pay this fee from the fund's assets. In that sense, the 12(b)-1 charges are treated just like the fees shareholders pay for portfolio management, administration, auditing, printing, postage, and other expenses.
There are limits on 12(b)-1 fees. The fee-which must be disclosed in the prospectus-has a maximum of 0.75 percent of assets per year, or 75 cents per $100 of assets plus a 0.25 percent "service fee," for a total of 1 percent. Many funds, in fact, charge less. Many sales-force companies with front-end loads also offer funds with back-end loads and 12(b)-1 fees. Many no-load funds have 12(b)-1 fees, too, but the charge is usually much smaller than with a sales-force fund. The rules say that a fund that calls itself "no-load" can have a 12(b)-1 fee of no more than 0.25 percent. Funds with 12(b)-1 charges are noted in the Business Week Mutual Fund Scoreboard.
One percent may not sound like much, but think about it this way. On a $10,000 investment, that's $100 in the first year. But you have to pay 1 percent every year you're in the fund. And, providing that the fund is increasing in value, that 1 percent represents more money each year. Rules enacted in 1992 are designed to put a cap on 12(b)-1 fees so that investors don't pay more in such fees than they would have had they paid an 8.5 percent load. But that cap pertains to the entire fund and not to any individual investor. According to experts, the 12(b)-1 fee on a fund that is not growing would eventually hit the cap. But a fund that's taking in new money may never hit its cap. So investors in those funds may end up paying the 12(b)-1 fee indefinitely.
Confusing enough? It's getting worse. Alliance Capital is one of a number of fund companies that have A, B, and C classes of shares for all its stock and bond funds. The A shares carry a 4.5 percent up-front load. The B shares have an ongoing 1 percent annual 12(b)-1 charge and a declining back-end load. For equity funds, the back-end load is 4 percent in the first year, declining 1 percentage point a year, and disappearing in the fifth year. For fixed-income funds, the back-end load starts at 3 percent and disappears in the fourth year.
The C shares charge neither front- nor back-end loads-they just level a 1 percent a year fee. That's perhaps why it's called the "level-load" fund. Like the 12(b)-1 fee, this level load comes out of the fund's assets every year. You might call it the "forever load." Introduced just a few years ago, some fund executives thought they would quickly outpace both front- and back-end shares in new sales, but that hasn't been the case. According to Morningstar, Inc., 60 percent of the level-load funds have less than $5 million in assets, and 25 percent less than $500,000. Perhaps it's because the shares probably are neither the best deal for investors, nor for the commissioned salespeople who sell them.
Although most fund companies call their front-end load shares "A," back-end load shares "B," and level-load shares "C," don't assume all A's, B's, or C's are alike. In some fund groups, for instance, the C shares are for institutional investors, or reserved for investors who come to the fund via an employer-sponsored retirement plan.
Some companies, like Neuberger & Berman and Oppenheimer Management, use the "Y" designation for institutional shares. But not all use "Y" that way. Evergreen Funds, for instance, uses Y to designate shares purchased when the fund was still a no-load fund company. New shares are in A, B, and C classes. Some fund managers create multiple classes of shares and call them institutional or "trust" shares. In most cases, those are shares that are distributed through bank trust departments. "Retail" shares are for individual investors.
And what about "Class II" shares? Franklin Funds announced that plan in early 1995. These shares are an alternative to front-end loads, but have a totally different payment structure: Investors would pay a 1 percent load at time of purchase, and another 1 percent of asset if they sell the fund within 18 months. Class II shareholders would also pay higher 12(b)-1 fees of 0.65 percent for bond funds and 1 percent for equity funds.
And mutual fund companies are always coming up with new ways to sell mutual funds, too. One method that's catching on is the "hub and spoke" or "master and feeder" fund arrangement. It works like this: A fund company sets up and manages, for example, a government bond fund. That's the hub. Since this company distributes directly to individual investors, it opens a no-load government bond fund. But instead of owning government bonds, the fund owns shares in the hub, which is a government bond fund. Next, the fund company thinks banks might want to sell this government bond fund to their customers. So it creates another spoke, perhaps with the bank's name on it, sold with a 4 percent load.
The process can go on and on, creating spokes for sales through different distribution channels-institutional investors, retirement plans, and offshore investors-all feeding into the same hub. The advantage of this arrangement is that it's cheaper to run one large, centralized hub portfolio than several smaller funds. That savings should be passed on to the investors in the form of lower expenses.
Investors, for the most part, may not even realize their fund is the spoke of a hub. And, if they're satisfied with results, they may not care. But suppose you paid a load for a spoke fund, while others bought the same hub for a lesser load, or even no load. Right now, a broker selling you a spoke has no obligation to tell you there's another spoke for the same hub with a different pricing scheme. So you may well ask.
Loads, low-loads, hidden loads. Does this mean you forgo all of them and just concentrate on no-load funds? Not necessarily. What is important is that those who invest in mutual funds understand the sales charges, exit fees, and ongoing distribution fees and how they affect the total return from their investments. The U.S. Securities & Exchange Commission, for the most part, has been fairly vigilant on fee disclosure. Their philosophy has been to provide investors with all the information and let the buyer decide. But that puts the burden of fathoming the fee structure back on the fund buyer.
To Load orNot to Load?
Why would anyone buy a load fund? In most cases you can find a no-load analog of most any load fund. True, there are some excellent load funds, but there are also great no-loads. And portfolio performance has nothing to do with whether you paid a broker to sell you the fund. So if you're going to go to the trouble of researching mutual funds at all, you might as well buy no-loads, right?
Perhaps. That's a question only you can answer for yourself. If you're reading this book, it may be because you want to take these decisions into your own hands. You don't want to use a broker or financial planner. But it's a mistake to dismiss load funds out of hand. If you do, you're cutting yourself off from a large part of the mutual fund universe and many excellent investment opportunities.
When the only alternative to the no-load was an 8.5 percent load, the scales tipped heavily toward the no-load. But today there are former no-load funds that sell with 2 and 3 percent low-loads, and former full-load funds with 4 percent loads. And then there's the back-end load, which many investors never have to pay.
In determining whether to pay a load you have to consider how long you anticipate staying with the fund. Everyone's financial plans are subject to change, of course. And if yours do, most load fund families have a wide range of portfolios to choose from, just like no-loads. And intrafamily switches, such as moving from a Putnam international bond fund to a Putnam government bond fund, can usually be done without paying another load. Increasingly, some load fund groups, like Fortis and Prudential, will let investors switch funds out of other load funds and into theirs without paying a new load. Of course, that's not going to help you if you will end up owing the fund a redemption fee. So if you want to retain the flexibility of moving to other funds of other managers, consider taking the charge up front.
If your investment is for your retirement nest egg or your toddler's college education, a load should not stand between you and the best possible fund. After all, even an 8.5 percent load-and there are very few of them left-over a 10-year holding period works out to less than 1 percent per year. That kind of sales burden can be easily overcome in the performance of an exceptional load fund versus a mediocre no-load.
But most investors are not faced with a choice of 8.5 percent versus no charge. What about choosing between A and B shares? Suppose you're interested in the MFS Emerging Growth Fund. The A shares have an up-front 5.75 percent load, which is fairly stiff in today's market. The B shares, on the other hand, have no up-front load. But there are 12(b)-1 fees amounting to 1 percent a year, and a back-end load that's 4 percent in the first and second year, but then declines 1 percentage point a year until it disappears in the seventh year. What's the best buy?
Depends on your assumptions for your holding period and the rate of return on your investment. If you assume a $10,000 investment and an average annual return of 10 percent a year, the B shares provide better returns up until year 8, even if you redeem and trigger the back-end load. According to Multiple Class Calculator, a software program developed by Money Marketing Inc., the B shares earn more money until year 8, when the A shares nudge them out by $9. After that, the advantage goes to the A shares, but not by much. In year 10, the A shares only beat the B shares by $14. And the higher the assumed return, the longer the B shares retain their edge.
What if you have three choices, as is the case with MFS Emerging Growth's sister fund, MFS OTC Fund. That fund has A, B, and C shares. The C share has neither an up-front nor back-end charge, but levies 1 percent a year forever. Suppose you go with the same $10,000 investment and assume a 10 percent average annual return. In the early years, the C shares work out best. That's because there is neither a big bite up front, nor one on the back end. For instance, in year 2, the C shares are worth $11,586 versus $11,124 for the A shares and $11,571 for the B shares before redemption, $11,171 after.
But the A shares have a much lower expense ratio than the B or C shares. And over time, that gives the advantage to A-share holders. In year 7 and beyond, the advantage swings to the A-share owners; they have a $169 advantage over B-share holders, and a $93 advantage over C-share holders. By year 10, the A-share holders are $427 ahead of the B-share holders, and $706 over the C-share holders. Obviously, the C shares, which are the cheapest in the earlier years, could end up costing the most if the investment is truly a long-term one. Perhaps the C shares are appropriate if, at the start, you believe the investment will be redeemed in the first few years. Still, many people have a hard time swallowing that chunky up-front sales load. If that's the case, B shares may make the best choice under certain conditions. MFS, for instance, will automatically convert B shares into A shares after the customer has passed the period in which a back-end charge might be levied, usually six years. That way, the investor is also relieved of the heavier 12(b)-1 burden that's in the B shares.
In weighing a load versus a no-load fund, you should also consider the fund's investment parameters. For instance, equity funds generally have broad charters and often disparate results. So even if both funds are growth funds, the differences in returns of growth funds are great and having the "right" fund is important. Paying a modest load for an equity fund that's demonstrated superior results may be better than buying just any no-load.
At the other extreme, short-term bond funds all maintain a fairly similar portfolio, and the differences in returns from one fund to the next are small. So it doesn't make sense to pay a load for a short-term bond fund when there's little likelihood that it will show any better performance than a no-load fund.
There is at least one reason to pay a load-to compensate a broker or financial planner for the time he or she spends meeting with you and monitoring your investments. Perhaps a recommendation for one equity fund does not merit paying a 5.75 percent load. But if a financial planner takes the time to tailor a portfolio of funds for you, he or she has to be paid. The load is one way to do it.
There are other ways as well. Some financial planners, for instance, put their clients' money into no-load funds and then levy an annual fee for the entire portfolio, perhaps 1 or 2 percent. That's not necessarily a better deal for investors, either. If you are investing for more than a few years, you might be better off paying your planner by investing in load funds-providing the planner still delivers good service long after being paid. Six percent off the top of the initial investment may sound steep, but if the fund managers have sliced off 1 percent a year for 10 years, you've paid a whole lot more.
Keep in mind, too, that while it's common practice to refer to a fund as a "4 percent load" or a "6 percent load," not everyone pays the full freight. If the fund carries a sales charge, there are ways to minimize the costs. Most load fund groups have fee schedules that slide downward for progressively larger investments. Typically, purchases up to $10,000 carry the maximum load. Before making a large investment in a load fund, ask the broker about the next "breakpoint," the dollar amount necessary to qualify for a lower load. In some cases, it might be worth making an extra $1000 or $2000 investment to qualify for the lower sales charge. At the high end, the sales fee often drops to 1 percent-or even totally disappears on major investments of $1 million or more.
Suppose you plan to invest $15,000, but you won't be able to put the money in all at once. Check with your broker to see if the fund management company will let you sign a letter of intent. In such an agreement you pledge to invest over a 13-month period a specified amount which, if invested at one time, would qualify for a reduced sales charge. If you fail to fulfill the letter of intent, you'll owe the fund the difference between the sales charges you've paid and what you should have paid. The company can take the money from your account.
If you're spreading your investments over several funds in the same load fund group, many funds will give you the same break as if the investment were made in one fund. And all the funds don't have to be for the same account. If you're investing for your personal funds, your IRA, a spousal IRA, and some custodial accounts for the kids, you can probably get a discount that takes in the total investment. But you have to ask.
Mutual FundNetworks
If you opened a stock brokerage account and invested in, say, 10 stocks, you could buy, sell, and keep track of them through one account. It used to be nearly impossible to do the same with mutual funds, except if you kept your investments to one fund family. You could mix and match multiple funds in one account using a commissioned broker or financial planner, but you would still be limiting yourself to a little more than half the fund universe. You would not be able to include, say, T. Rowe Price or Vanguard offerings, since they don't pay commissions to brokers.
Mutual funds are not as interchangeable as stocks, but thanks to the emerging mutual fund networks, they're heading that way. You can think of the networks as sort of a family of fund families. The discount brokerage firm of Charles Schwab & Company originated the network concept more than a decade ago in a program called Mutual Fund Marketplace (MFM), and it now has more than $50 billion in fund assets. MFM has 900 funds, most of which would be recognizable to investors as no-load funds. But for most of them you have to pay a small transaction charge. Within MFM, there's also a program called One Source, through which investors can buy some 370 funds with no fee. The broker is paid by the fund company, often through a 12(b)-1 charge.
For the other no-load funds, you pay a fee to the broker. For trades up to $15,000 in size, the fee is 0.7 percent of the investment. The fee is 0.2 percent on the next $15,001 to $100,000, and 0.08 percent on everything over $100,000. A $10,000 trade costs $45 and a $25,000 trade, $75. Schwab officials say that, on average, clients in the Mutual Fund Marketplace program end up paying commissions of about 0.3 percent of the amount invested. Investors can get a 10 percent discount by conducting their trades by an automated phone line or by computer link.
So why would anyone pay Schwab to invest in a fund that doesn't charge commissions? If all you ever planned to do was to buy that one fund, there's no good reason. And the commission structure makes the purchasing of no-load funds uneconomical for small trades or monthly investing programs. The transaction fee is 0.7 percent for sums up to $5000, which is $35. But it will cost you $39 anyway. That's because Schwab, like most stockbrokers, has a minimum transaction charge-and in Schwab's case, it's $39. If you're stashing away a couple of hundred dollars a month in a fund, you would do better to deal directly with the fund. You don't want to spend $39 to invest $200.
Many investors like the convenience of the Schwab program even if they have to pay the fees. Rather than a statement and an account with every fund, Schwab delivers a consolidated statement. At tax time there's one Form 1099. If you want to sell one fund and redistribute the proceeds into three other funds, you can effect the change with one phone call instead of several. If you're switching funds, there's a $15 fee for the fund you're switching out of and the regular commission for the one you're going into. In OneSource, investors are permitted 15 free trades a year, as long as the funds have been held more than 90 days.
There's another advantage, too. There are some excellent funds with high minimum investments. Two highly regarded bond funds, PIMCO Low Duration and PIMCO Total Return, require minimum investments of at least $500,000 to open an account. But invest through Schwab and you can buy in for as little as $1000. Schwab lowers thresholds because it maintains an "omnibus" account with each no-load fund. That means that PIMCO treats all Schwab customers as one account. Schwab, in turn, keeps track of how many shares of that account belong to each customer. So Schwab can offer lower minimum investments because it is pooling funds from a large number of clients.
Schwab has even extended the Mutual Fund Marketplace program to load funds like American, Colonial, Franklin, Pioneer, Putnam, and Templeton. But the regulations bar brokers from discounting the loads. Still, buying load funds through Schwab or one of its competitors may appeal to investors who want the funds but do not want to deal with the full-service brokers who usually sell them.
Fidelity Investments' FundsNetwork program is similar to Schwab's, offering 2000 no-load and load funds, 350 of them without a transaction fee. Transaction charges are two-part, a base fee plus a variable fee depending on the size of the transaction. For investments of up to $5000, the fee is $17.50 plus 0.8 percent of the principal. For a $3000 purchase, that works out to $41.50. Following the commission schedule, the fee on a $1000 investment would work out to $25.50, except there's a $28 minimum. Several other discount brokers run broad-based mutual fund programs like Schwab's. Jack White & Company has some 4200 no-load and low-load funds. The minimum charge is $27 per trade on trades of up to $5000, $35 for trades of $5001 to $25,000, and $50 for trades in excess of $25,000. Jack White also has a no-fee service with, at last count, 762 funds. That's by far the largest no-fee network.
Load-fund investors may also check out Jack White's CONNECT System. It allows investors to buy load funds without paying loads. Instead, there's a flat $200 fee, no matter how large the purchase.
Suppose an investor would like to place $25,000 in a fund with a 4.5 percent front-end load. That would take $1125 off the top of the investment. The CONNECT charge for the sale would be a flat $200. CONNECT places the buyer's offer on an electronic bulletin board and looks for a seller. CONNECT pays half the fee, or $100, to the seller as an incentive to sell through the Jack White system instead of cashing out through the fund company. And CONNECT can't guarantee that it can match up willing buyers and sellers on the spot, or even on the day that the order is placed. But the system is expected to become part of a securities dealer's electronic bulletin board, which will enable Jack White to attract fund buyers and fund sellers.
Advisers and"Wraps"
The emerging mutual fund networks are doing more than changing the way many individuals buy and sell funds. They're changing the way brokers and investment advisers conduct their businesses as well. Over the last few years, thousands of brokers have left brokerage firms, where they got paid for their advice through commissions, and have opened up their own firms where, instead of charging commissions, they levy a fee based on the client's assets under management.
Instead of selling traditional load funds from companies like Alliance Capital, Franklin, and Putnam, they channel their clients' money into no-load funds through the networks. They're putting so much in, in fact, that some load-fund groups-not wanting to miss this burgeoning market-make their funds available no-load through the networks to the advisers' clients. According to Cerulli Associates, Inc., total assets under the control of fee-based advisers amounted to some $282 billion at year-end 1995, a near tripling since 1992. The portion of those assets in mutual funds was an estimated $45 billion, versus $7.5 billion in 1992. And those figures will swell even more in coming years. In 1996, Merrill Lynch & Co. and Smith Barney, Inc., the nation's two largest brokerage firms, will be introducing fee-based programs that will mix both load and no-load funds, a radical departure from past practice.
Fee-based advisers don't get paid for selling any particular fund-only for their advice. Of course, in theory, a traditional load fund performs the same function. The difference is that instead paying the salesperson at the time of sale, the client pays the salesperson over time. Perhaps more important, in a traditional load fund, the salesperson is paid the same no matter how the investment performs, and you may never hear from him or her again.
With an asset-based fee arrangement, the salesperson is, in effect, on the "same side of the table" and you're in a long-term relationship. If the advice is good, the assets under management grow, and so does the adviser's annual fee. Conversely, if the client loses money, so does the adviser. Paying an adviser through asset-based fees is not necessarily cheaper than traditional loads, and indeed, could wind up being more expensive. But it should only be more if the fund performs well. Most people don't mind paying for good advice.
Keep in mind, too, that fee-based arrangements only work out well if the fee is kept under control. Many independent advisers charge in the range of 1 to 1.5 percent of assets, and, the larger the account, the lower the percentage. Most major brokerage firms have a similar arrangement, called the "wrap" account-so-called because it wraps all costs into one price. But the fees may be as high as 3 percent. For a portfolio of mutual funds, that's much too high since the fee mainly covers fund selection and monitoring. The actual stockpicking-which is far more complex-takes place within the mutual funds themselves, and that's paid for through the funds' operating expenses.
The fee-based arrangement isn't for everyone. For starters, do you need or want the help? If you feel comfortable and have the time to do it yourself, you don't need an adviser. If you'd like one-but don't have a minimum $25,000 to invest, it may be hard to find an independent adviser to take your account. Even with a 1.5 percent fee, the account might only generate $400, which probably does not come close to covering the annual cost. Some larger advisory firms, in fact, want a $50,000 or $100,000 minimum investment. If you can't meet those minimums, and want an adviser, you will have to pay steep hourly rates or go for traditional load-fund products. If you're successful, you may eventually accumulate enough money to switch to an asset-based arrangement.
Considering hiring an adviser to manage a portfolio of mutual funds? Lots of people are doing it, even those who have the savvy to invest the money themselves. Many of those who have the ability just don't have the time. Many people find investment advisers the same way you find other professionals-through referrals and recommendations from friends, relatives, and coworkers. But don't hand over your money to anyone without a thorough investigation-sometimes known as "due diligence" in the investment world-of your own.
Many people who give investment advice, sell securities, and manage money are registered with the U.S. Securities & Exchange Commission. That may sound august, but it means little and assures nothing. All it takes to become an SEC-registered adviser is to complete a lengthy form and pay the $150 fee. No examinations are required, and there is no requirement for education in investment theory and practice. The SEC's Form ADV, which advisers must complete, asks about education, professional credentials, work experience, and the like, but having none of that is no bar to getting the registration. That's why it's imperative to ask an adviser for a copy of his or her ADV. The law requires that he or she provide you with Part II, which describes the investment program, fees, and charges. But ask for Part I as well. The SEC can investigate investor complaints against registered advisers, but as far as regular audits, they are few and far between-on average, once every four decades.
All but a handful of states require investment advisers to register, and many also require they pass some national examinations. But the tests usually deal with the rules and regulations of dealing with clients. They don't test for the adviser's knowledge and understanding of the investments. There are private organizations and professional associations that do that, such as the Association for Investment Management and Research, which awards the Chartered Financial Analyst designation, and the College of Financial Planning, which grants the Certified Financial Planner certificate. If the adviser has one or more such designation, it's definitely a plus. And don't take the adviser's word for it. You may want to call the professional group yourself to verify the credentials.
Most advisers have a track record they can show you. But it's not necessarily going to be useful information. Putting on the best show, the adviser might show you a sample portfolio with what seems to be a high return. But that portfolio might have been devised for a client with far more risk-taking ability or tolerance than you have. So if you are a conservative investor, ask to see what the adviser has done for someone more like yourself. And a really good adviser won't take your word for it that you're a conservative investor. He or she should ask probing questions and perhaps give you a little written quiz to get a better sense of your risk-taking ability. Most people can take more risk than they think they can, and as a result short-change themselves in the long run. A good adviser will spot that and encourage you to correct it.
Once you have decided on an adviser, make sure you understand what services-such as regular consultations and monthly or quarterly reports-the adviser is going to provide, what it's going to cost, and how payment will be collected. Then, the adviser will open up an account for you, probably with a brokerage firm that has a mutual funds network. The account must be in your name, not the adviser's. You should give the adviser the power to make buy and sell decisions for the portfolio. After all, that's the point of having an adviser. But make sure you receive the confirmation slips and brokerage statements that show the activity in the account. Do not give the adviser the power to take money out of the account. Only you should be able to do that.
Buying onMargin
The convenience and simplicity of the mutual fund networks have also made them popular with mutual fund "market-timers," investors who move assets around, following rigorous technical formulas, trying to capture upside moves in the stock market while steering clear of downdrafts. For more aggressive investors, the program allows the purchase of mutual funds on "margin."Margin buying works this way. Suppose a fund investor thinks stocks are about to stage a big rally and thinks highly of the Janus Mercury Fund. She decides to invest $10,000 in that fund. If the fund goes up 25 percent in the next six months, the investment is worth $12,500, and the investor can cash out at a profit of $2500. But if the investor buys on margin, she could invest $20,000 in the fund: $10,000 is her money and $10,000 is a loan from the brokerage firm. The interest rate on the loan is usually the broker's loan rate (a figure similar to a bank's prime rate) plus anywhere from 0.5 to 1.5 percent, depending on the size of the loan.
If the fund goes up 25 percent, the leveraged investor's holding climbs to $25,000, and if she sells it, there is a 50 percent return on the original $10,000 investment-a $5000 profit. Well, not quite. Remember, the investor took a loan from the broker to buy the shares. Suppose she borrowed $10,000 for six months at 10 percent interest. That comes out to $500. All told, the investor nets (before commissions) $4500 on her original $10,000. In a cash account that does not use margin, the net profit would be $2500.
But not all margin plays work out so well. What if the value of the investment remained unchanged for six months? Then the margin investor is out the interest. Worse yet, the fund headed south instead of north and declined by 25 percent. So the $20,000 investment is now worth $15,000. What if the margin investor sells at that point? She owes the broker the $10,000 originally borrowed and $500 interest to boot, leaving her with $4500 out of an initial $10,000 investment. Don't use margin buying unless you know exactly what you're doing and can stand the loss.
Prospecting theProspectus
Let's face it. Nobody wants to read a prospectus. It's a legal document that describes a mutual fund, often in legal and financial terms that may sound awfully technical. But the language is precise for a reason. The SEC has strict guidelines about what the fund can say about itself and how it must present information on past performance, expenses, and fees. Remember, the SEC's approval of a prospectus is only that. It is not an endorsement of any particular investment.
If the prospectus looks daunting today, it's only a shadow of what it was just a few years ago. It's easier to read; its figures are easier to compare; and there's a lot less bulk. Most of the objective information you need is in there: sales charges and fees, investment policy, and administrative matters like the procedure for redeeming shares or switching into other funds. If the fund has an operating history, the prospectus will provide historical data too. What the prospectus won't have is a glowing recommendation from a sales rep or a complimentary article from a financial publication. That may be included in sales literature that's stuffed into the same envelope.
Believe it or not, prospectuses are improving. Direct marketers like Fidelity, who don't have salespeople to explain their funds to investors, are making efforts to both simplify the prospectus and, as much as the lawyers allow, explain things in "plain English." In fact, with the blessings of the SEC, eight fund companies are currently providing vastly simplified "plain English" prospectuses that fit neatly on two sides of an 81┌2-inch by 11-inch piece of paper-with room to spare.
Simplifying a prospectus is never easy because it's a document that's trying to serve two purposes. Its stated objective is disclosure, informing investors on how a fund invests and operates. But it's also a document that mutual fund company lawyers design as a litigation shield, making sure the fund managers will be able to run the fund without inviting lawsuits.
STATEMENT OF ADDITIONALINFORMATION
There's plenty of detail in the prospectus, but the investor can also ask the fund to send the Statement of Additional Information (SAI). This bulkier presentation is more of what prospectuses used to be. It covers the same ground as the prospectus, but in far more detail. For instance, the prospectus for the Fidelity Magellan Fund (dated May 20, 1995) is 30 pages, set in double columns, double-spaced, with charts and tables. Each page is 8 3/8 by 5 3/8 inches in size. That's a fairly slim mutual fund prospectus. The SAI for the same fund is twenty-two 8 1/2- by 11-inch pages-single-spaced, largely unbroken by charts and tables.
How do they differ? The prospectus, for instance, has a heading worded "Adjusting Investment Exposure," followed by two paragraphs outlining in summary form that the fund can use "various techniques" to increase or decrease its exposure to changes in security prices, interest rates, foreign exchange, and other factors that affect security prices. In contrast, Magellan's SAI details those techniques in two single-spaced, 8 1/2- by 11-inch pages.
For most investors, the prospectus will suffice. But you should be aware of the SAI. In a 1991 case decided in a federal appellate court in New York, the judges ruled investors are responsible for knowing what's in the Statement of Additional Information. An investor challenged a fee that he said wasn't in the prospectus. The court said it was-but in the SAI. And since the existence of the SAI was noted in the prospectus and is legally part of the prospectus, he could not claim he was unaware of the charge. In Magellan's case, the mention of the SAI is right on the cover of the prospectus, along with a toll-free telephone number which a prospective investor can call to obtain it.
State securities administrators, who oversee the activities of securities firms at the state level, have been urging fund investors to request SAIs and urging the SEC to require more detailed information in the prospectuses so investors don't have to read both documents. The SEC's Division of Investment Management, which regulates mutual funds, has resisted any moves that might fatten up the prospectuses. If the prospectus is a little-read document now, it will be even less so if it is a thicker and more detailed document.
TAKING A CLOSER LOOK
Don't let the prospectus unnerve you. The financial matters and investment policies may be unique. But much of the other material is boilerplate and doesn't vary much from fund to fund. And not all of it is pertinent to every investor. As long as your planned investment isn't for your Individual Retirement Account or other tax-deferred program, you don't need to read the IRA section in the prospectus.
When thumbing through the prospectus, look for important statistical nuggets like the fund's results and expenses. The documents plainly outline all sales charges, deferred sales charges, redemption fees, exchange fees, management fees, 12(b)-1 fees, and other pertinent expenses. There will also be a condensed financial history of the fund. (Most of these data are also available in the Business Week Mutual Fund Scoreboard.)
Want to take a closer look? Go to Figures 3-1 and 3-2, which are pages four and five from the Fidelity Magellan Fund (the prospectus is dated May 20, 1995). Look at the expense summary. You can see the maximum sales charge, 3 percent. The introductory note tells you on what pages you can find more detailed information on the sales charge. For instance, under certain circumstances, the sales charge can be waived.
You can also see in plain language that there is no sales charge on reinvested dividends, and no deferred sales charges or fees for exchanges (that is, moving money from fund to fund within a family of funds). What's new this year is a $12 annual account maintenance fee for accounts with less than $2500-and it applies across the Fidelity universe.
True, the cost of servicing small accounts is high (it pretty much costs the same to service a $2500 account and a $250,000 account), but fund companies don't bear that cost, the funds do. So in theory, at least, any maintenance fee should go to the fund, not the fund company. But that's not the case here. Putting the $2500 minimum into Magellan may not protect you from the maintenance fee, either. After paying the 3 percent load, that $2500 investment is only $2425. And what if the value declines after you invest? Even with Magellan, it does happen. One way to avoid the fee is to sign up for the Automatic Account Builder program, which allows smaller initial investments as long as you make them regularly.
Then come the operating expenses. The introductory note explains what goes into the charges. The management fee, which can vary depending on the fund's performance, is estimated to be 0.75 percent, or 75 cents per $100. "Other" expenses, which include such administrative costs as maintaining shareholder records and furnishing reports and financial statements, amount to another 0.21 percent.
If you add up all the fund operating expenses, they amount to 0.96 percent, or slightly less than 1 percent of the fund's net assets. So what does that mean to your bottom line? You can find that right below, which shows the cumulative impact of sales charges and expenses. If you invest $1000, and earn 5 percent a year, you've spent $40 on sales and operating expenses in the first year; $60 after 3 years, and up to $144 after 10 years. Actually, a 5 percent assumed rate of return for this fund is absurd, and if that's all you thought you could earn, you certainly would not invest in it. However, that's not the point. The SEC requires funds to use that reporting format account to make it easier for investors to compare fees and expenses.
If the fund is brand new, be sure to check whether the fund management company is subsidizing the fund's overhead or waiving management fees. Don't snub these funds-if someone's going to give you a free lunch, take it. But free lunches don't last forever. It's common for fund management companies to subsidize money-market and bond funds when they're trying to build assets, and they'll often do it for equity funds as well. If the fund company absorbs 0.50 percentage point in expenses, it can really make a money-market or bond fund stand out. And, of course, that's the point. The yield looks alluring, and the money flows in.
But watch out. The prospectus must disclose the full fee structure even if shareholders are not paying it. The point is, you should be aware of what the fees are and what they would be if they were paid. Without the waiver, some of these funds may not look as attractive as others with no waiver, but lower expenses. You can put the money in and take the free lunch. But be ready to leave if and when full rates are levied.
The financial statements also give you some feeling for the fund. The numbers may look scary, but they're really pretty simple. Go to Figure 3-2. Start with the last column, which is for the fiscal year ending March 31, 1995. The top line, net asset value, beginning of the period, tells you just that-what a fund share was worth on April 1, 1994, the start of the fiscal year. Seven lines down, you come up with net asset value at the end of the period, $72.44. The steps in between explain how the fund got from the beginning NAV to the end-of-period NAV.
Start with "net investment income." That's 27 cents a share. It's what's left from stock dividends and interest from fixed-income or money-market holdings after paying for fund expenses. Such expenses include fund managers, record-keeping, postage, auditing, and legal fees. That 27 cents is available for distribution to Magellan shareholders. Of course, that's not a lot of money, considering the NAV is over $70 a share. But Magellan's primary goal is growth of capital, not generation of income. What it collects in income is purely secondary to the fund's main goal.
In a fund like Magellan, the big money is made from capital gains. Look at the line "net realized & unrealized gain (loss) on investments." When a mutual fund sells a security at a profit, it has a "realized" gain; when it sells at a loss, it's a realized loss. If a fund continues to hold stocks that are worth more than the fund paid for them, the stocks represent unrealized gains. Likewise, stocks in a portfolio that are valued at less than their cost are unrealized losses. To get "net" gains, the fund tallies the gains and losses, both realized and unrealized. If the number is positive, as it is here, the fund had net gains. If negative, net losses. In fiscal 1995, the Fidelity Magellan Fund had net gains of $5.22 per share. That, plus net investment income, gives you the next line, "total from investment operations" of $5.49 per share.
Now, if the fund made no distributions during the year, the NAV at the end of the year would be $72.44. But funds, of course, must make distributions to preserve their unique tax status (see more on that in Chapter 6). So go to the next section, "less distributions." The next line tells you there was 14 cents a share in income distributions. But wait! The fund earned 27 cents in net investment income. Well, fund distributions for tax purposes are made on a calendar year basis, and for book purposes, on a fiscal year basis. So since Magellan keeps a different fiscal year, the distributions aren't usually the same. Nonetheless, that 14 cents came out of each fund share in fiscal 1995, so it's recorded here. Then there was a distribution of $2.63 a share in net realized gains, for a total of $2.77. Subtract $2.77 from $75.21 (what NAV would be if there had been no distributions) and you get the end of year NAV, $72.44.
Look for a moment at net realized and unrealized gains for fiscal year 1991. The fund actually had a higher per-share gain, $8.10 versus $5.22 for fiscal 1995, but a slightly smaller capital gains distribution, $2.42 versus $2.63. That tells you that in 1991, at least, most of the gains were unrealized, that is, the fund kept more of its profitable positions without selling them.
The next group of figures, "ratios and supplemental data," should help compare this fund to others. Ratio of expenses to average net assets is 0.96 percent, which is a little less than average for equity funds. Now, the footnote indicates that the fund management company has recaptured part of the brokerage commission rebates (known in the investment business as "soft dollars") to pay for some fund expenses. However, this is not terribly significant, since the next line shows that without such rebates the expense ratio would have been 0.99 percent. Before moving on, look at the expense ratio and how it changes from year to year. The number is trending downward. That's to be expected, since the Fidelity Magellan Fund is by far the largest equity fund and should have some economies of scale in its operations that benefit its shareholders. Be wary of funds in which this ratio is moving up.
The last line, "portfolio turnover rate," 120 percent, means that securities amounting to 1.2 times the total assets of the fund changed hands during the year. That means if a fund had $100 million in assets, the value of the securities that "turned over" during the year amounted to $132 million. Now remember, this is the Fidelity Magellan Fund, which had an average of $36.5 billion in assets during this fiscal year. Roughly, that's securities trades with a face amount of nearly $44 billion. (There's more about portfolio turnover in Chapter 7.)
INVESTMENT POLICY
After the financials, the prospectus turns to the investment objective. In the Magellan prospectus, for instance, the section is called "Investment Principles and Risks." The investment policy section will outline the overall strategy, the permitted investments in the broadest of terms (i.e., stocks or U.S. government or government-guaranteed securities), and restrictions, if there are any.
For a fund with a descriptive name (i.e., a fund that says small company or health care or North America in its name), pay particular attention to what else the fund can do. For instance, in early 1995, a group of shareholders filed a lawsuit against the Alliance North American Government Income Fund, which suffered severe losses during the Mexican currency crisis. The lawyers' complaint? The fund name said it was North American, but the fund had invested in Argentina, which, of course, is in South America. But the prospectus noted that only 65 percent of the fund had to be in North American debt obligations-and the fund met that condition. (In addition, in reports to shareholders, the fund had advised them of the Argentine holdings-yet another reason to read those shareholder reports.)
Pay careful attention to the investment objective and how the fund managers plan to achieve it, especially the kind of risk they might undertake (with your money). Be forewarned. Most fund prospectuses are written in a way that gives fund managers the widest latitude and discretion.
Some funds try to boost returns by trading futures and options contracts or other derivatives. That must be spelled out. Is preservation of capital the utmost priority? Don't assume it is, even if the investment is a government bond fund. Some sacrifice net asset value in order to deliver a high payout, and it says so-though not in such blunt language.
The information in this section helps to describe the fund's character. First Eagle Fund of America, for instance, says it will pursue capital appreciation with a flexible investment strategy that may include junk bonds, foreign securities, restricted securities (illiquid securities that are not publicly traded), and "special situations"-opportunities that may arise from liquidations, reorganizations, mergers, material litigation, technological breakthroughs, or new management and management policies. Moreover, First Eagle may buy and sell options and futures contracts and even "leverage its assets for securities purchases"-that's another way to say the fund buys on margin. If you'd sleep better with a fund that invests solely in well-known blue-chips, First Eagle is probably not for you.
SHAREHOLDER SERVICES
Look for services and conveniences. The standard ones are automatic investment and reinvestment of dividends and capital gains distributions. They'll be described in the prospectus. Most money-market funds and many bond funds also offer check-writing privileges. But those that do will often require that you write a check of $500 or $1000 at the least, so don't plan on using these funds to pay at the supermarket. Convenient as they are, such privileges are no substitute for a conventional checking account. (United Services Treasury Securities Cash Fund is a U.S. money-market fund with no minimum check size, and no limit on the number of checks written.)
Automatic investing is an arrangement you set up between the fund company and your bank. You can make periodic investments from your checking account to a designated mutual fund. It's an excellent way to accumulate capital, and unlike a contractual arrangement that some funds still market, you can stop or alter the program at your discretion without any penalty.
Most fund groups ordinarily roll over the dividends and capital gains into new shares. That's one of the major benefits of investing in mutual funds. By reinvesting your earnings you have the opportunity to compound the growth rate of the fund. It's the same idea as earning interest on your interest.
Be sure to indicate on your application what you want done with the dividends and distributions. Those using funds for income sometimes take the dividends in cash or have it deposited into their money-market funds and reinvest the capital gains. If you give no indication at all, the funds will reinvest all the proceeds. If you're a long-term investor, reinvest.
Redemptions
Putting money into a mutual fund is simple. Fidelity Investments' walk-in centers, for instance, make investing easy by having personnel on hand to field questions, take applications, and accept checks. But though you can invest at one of these locations as though you were making a deposit at a local bank, you can't make a "withdrawal" on the spot. The money must come through regular channels, either a check by mail or by bank wire.
Getting money out isn't quite as simple as putting it in. But there's a whole lot less bother to taking money out if you plan for it on the way in. Some investors are surprised to find a $5 exchange or redemption fee taken out of their proceeds when they get their account statement. But if you've read about the fund's redemption procedures in the prospectus ahead of time, it should not be a shock. It has to be in the fee table, along with information about sales charges, 12(b)-1 fees, and the like.
Most funds offer telephone redemption privileges. But that's not something to request on the day you want the money. It's best to do it when setting up the account. If you have an existing account that doesn't have telephone switching privileges, request the form that permits it. And don't assume that if some funds in a family of funds offer telephone redemption, all the funds in the group do. Several of the Vanguard equity funds, for instance, are off-limits to telephone switches.
Even when a fund offers telephone redemption there may be limits on the amount of money that can be withdrawn or the number of switches within a given period. Plan on following the advice of a mutual fund timing service? Ask if the fund group has any qualms about letting frequent switchers into their funds. (That's something you won't find in the prospectus but will have to ask a fund representative yourself.) Sometimes fund groups permit intrafamily telephone switches from an equity fund to a bond fund or money-market fund, but may restrict telephone withdrawal from the fund group. Depending on the amount of money involved (sometimes it's anything over $5000), the fund company may want written instructions.
Obtaining quick access to your funds is especially important with money-market funds since they're most often used as liquid assets or "rainy day" emergency money. All money-fund accounts should be set up with telephone redemption privileges.
Ask for check-writing privileges too. Even if you don't use the checks for regular bill-paying, the checks provide quick access to your account. Most funds can transmit funds by wire to your bank, but again that's not something to negotiate over the phone on the day you need the money. If you want this service, the fund will ask for the appropriate banking information on the application. There's usually a charge for the service as well as a minimum amount of money that must be wired.
Pay particular attention to a fund group's rules on withdrawals. They're not all the same. For many funds a signature on a redemption letter may not be enough. The company may require that the signature (and that of any other person whose name is on the account) be "guaranteed." A signature guarantee is an endorsement that verifies that the signature is genuine. The guarantor will compare the authenticity of the signature to one already on file. You're supposed to sign the letter in the presence of the guarantor.
Many funds accept guarantees from commercial banks or savings institutions that are members of the Federal Deposit Insurance Corporation or brokerage firms that are members of the New York Stock Exchange. Some may accept others like state-insured thrifts and federally insured credit unions, but ask the fund service personnel first. A notary public's seal is usually unacceptable.
