Wednesday, October 31, 2007

Common Investment Traps: Back-End Loads

I enjoy talking about investing and have had discussions with a great many people with widely-varying investment knowledge. Over the next three days, I will be going over some of the common costly mistakes that people make in the course of investing with their financial advisors.

The first mistake is repeatedly getting hit with back-end loads on their mutual funds.

What is a back-end load?

A back-end load is a percentage of your investment that you pay when selling out of a mutual fund. Other names for this are “contingent deferred sales charge”, “redemption fee”, and “exit fee”. A common arrangement is for the mutual fund to charge a 5% load if you sell within the first year, 4% if you sell in the second year, and so on until the back-end load drops to zero after 5 years. In such cases, the fund typically does not charge a front-end load.

You may wonder how the fund could afford to eliminate the back-end load after 5 years if they had to pay the financial advisor at the beginning without collecting a front-end load. The answer is that the management expense ratio (MER) collected each year is high enough to cover the advisor’s up front commission if the money stays in the fund long enough. So, the mutual fund pays commissions out of either the MER or the back-end load depending on how long you stay in the fund.

How do investors get into trouble?

Many people feel vaguely uneasy about their investments, and some of them act on this feeling by periodically firing one financial advisor and jumping to another one who puts them into new mutual funds. Investors often do this without understanding back-end loads.

Suppose that impatient Ian switches financial advisors three times in 5 years paying a 4% back-end load each time in addition to a 2% MER each year. If he had an average of $200,000 invested over the 5 years, Ian would pay $20,000 for the MER, and another $24,000 in back-end loads. Ouch!

Sometimes getting out of a bad situation and paying the back-end load may be the right thing to do, but doing it repeatedly out of ignorance and impatience can be costly.

This is part 1 of 3 parts. Next part.

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