This is a post by our regular columnist Clark.
It is common knowledge, at least among personal finance circles, that mutual funds charge high fees. These fees come in a variety of forms and this series will take a look at them. Please note that this series is written with the North American readership in mind and that some charges and fees may not be applicable to both sides of the border.
When a broker (salesperson) is involved in the sale of a mutual fund, which typically is the case, the fund company pays a commission to them. This commission is termed as “sales load” and can be treated as being similar to the trading commission that investors pay their discount broker when they buy stocks or exchange-traded fund (ETF). Please note that the comparison is only meant to show similarities in the transaction chain and not to equate the actual percentages themselves. There are two types of sales loads.
Front-end Sales Load
This type of fee is charged at the time of purchase of mutual fund units. Front-end fees are a load on purchases since it decreases the amount of money available for purchasing mutual fund units. E.g., Mr. Investor may contribute $5000 to buy units of mutual fund ZYX, but if the fund has a 5% front-end sales load, then they will be left with only $4750 [($5000-($5000*0.05)] for the actual purchase. The ‘missing’ $250 was deducted from the contribution to pay the seller (broker).
Deferred Sales Load
As the name implies, this type of fee is charged after purchase (hence, deferred). To be specific, the charges are paid when Mr. Investor redeems their fund units. For such a back-end sales load, there is no front-end sales charge and Mr. Investor would have the full $5000 (assuming there are no other fees) for purchase of ZYX fund units (continuing from the example above). If the fund has the same 5% charge but in the deferred form, then the sales load will be withheld at the time of sale (redemption). Generally, mutual funds will use the lesser amount of the initial and final value of the investment to deduct the back-end sales load. However, it would be negligence on the investor’s part if this was assumed to be the case all the time; a look at the fund’s prospectus should clarify whether this is the case for that fund.
Contingent Deferred Sales Load
The widely used type of deferred sales load is the contingent deferred sales load – the contingency being the length of time that the investor holds the fund units. So, the longer the holding period, the lower the back-end sales charge and may become zero if the investor stays invested for the maximum number of years as outlined in the fund’s prospectus. E.g., Fund ZYX may have a contingent deferred sales load as given below:
- Held for 1 year: 6%
- Held for 2 years: 5%
- Held for 3 years: 4%
- Held for 4 years: 3%
- Held for 5 years: 2%
- Held for 6 years: 1%
- Held for 7 years: 0%
Typically, a fund with a contingent deferred sales load may also have a 12b-1 fee (discussed in Part II) that is collected annually.
A fund with no load will not charge any sales fees. However, there are certain fees that are not classified as sales load and hence, they can be collected while still maintaining the “no-load” tag. E.g., sales load does not include purchase fees, redemption fees or account fees.
Part II of the primer will discuss some of the other charges associated with owning mutual funds.
Have you held a mutual fund with front-end or deferred sales loads? Have you paid the contingent deferred sales load? Or, did you consciously hold onto the fund to avoid the charge?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.If you would like to read more articles like this, you can sign up for my free newsletter service below (we will not spam you).