Sunday, November 29, 2009

Deferred Sales Charges Permit Up-Front Commissions

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

All mutual funds have a management expense ratio (MER) that covers the costs of running the fund. In addition to the MER, some mutual funds charge “loads”. Loads are fees paid either when you buy into a fund (front-end load) or sell out of a fund (back-end load). Back-end loads are also called deferred sales charges.

The purpose of a front-end load is simple enough. The financial advisor who sells you a mutual fund is paid out of front-end loads. But what about funds that have deferred sales charges? Does the financial advisor have to wait until you sell to get his money?

Things look even worse for the financial advisor when the deferred sales charges are “contingent”. This means that the sales charge declines over time. In a typical arrangement, if you sell in the first year, you get charged 5% of your initial investment, but only 4% if you sell in the second year, and so on until it drops to zero in the sixth year.

Does this mean that if you hold on for more than 5 years your financial advisor doesn’t get paid? No, it doesn’t. The financial advisor gets paid up front regardless of whether the load is up front or deferred. This is easier to understand if you look at deferred charges another way.

Suppose that you invest $100,000 into a mutual fund with a 2% MER with a declining deferred sales charge starting at 5%. A better way to think of this is that you pay $5000 up front and get a $1000 rebate on the MER for the first 5 years. After the fifth year, you pay the normal MER. While your account won’t actually be docked $5000 up front, you are committed to paying a minimum total amount of fees either through several years of MERs or the deferred sales charge.

With this view, the only difference between front and back-end loads is the MER rebate. It is easy to see now how the financial advisor can get paid up front either way.

If two funds have the same MER, then a deferred sales charge is preferable to a front-end load, but both types of load are equally painful for the investor who wakes up to the fact that mutual funds have high fees in the first year or two and wants out. Deferred sales charges ensure that when you enter a fund you are committed to paying a minimum total amount of fees regardless of how long you stay invested. In this sense they aren’t much different from front-end loads.

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