Wednesday, March 12, 2008

Deferred Sales Charges are Really Up-Front Fees

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 $50,000 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 $2500 up front and get a $500 rebate on the MER for the first 5 years. After the fifth year, you pay the normal MER.

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 gets paid up front either way.

Don’t be fooled by deferred sales charges. They are effectively large up-front fees that aren’t much different from front-end loads.

5 comments:

  1. Hi Mike, the only thing I might add to avoid confusion is that the investor's initial investment is not docked that $2500 (directly).

    I've always thought of it as the advisor getting an upfront commission instead of a higher ongoing trailer.

    Front end funds can be sold as "front end zero" which is common. The trailer is higher for front end funds than for DSC funds, and can be even higher with no-load funds (which aren't really no load when you think of it).

    For DSC funds, the deferred (or declining sales charge) is the fund company's way of recouping the upfront payout to the advisor should the investor sell out of the fund family earlier than desired. If the investor holds on to the funds long enough (say until the fees have expired) then the fund company will have recouped their up front payout to the advisor through the lower ongoing trailer and be paying out less to the advisor going forward (unfortunately the investor does not share in this cost reduction!).

    This can lead to your advisor churning your funds. Once DSC fees have expired, you are more likely to get a call from your advisor saying it's time to look into a new fund family, etc. OR they might switch you to a front-end zero fund to collect a higher ongoing trailer from that point on.

    Here is an example of how a fund company might structure the advisor's commissions:

    Front End Fund:
    0-2% up front (dependent on advisor), 1.00% trailer

    DSC version:
    5% up front, 0.25% trailer

    No Load version:
    0% up front, 1.00% trailer

    Low-Load version:
    2% up front, 0.25% trailer first year, 0.50% trailer second year, 0.75% trailer third year, 1.00% fourth year and on.

    Low load funds are newer and usually have a 3 year DSC schedule with the back end fees starting at 3% and declining from there, expiring at the end of the third year.

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  2. Preet:

    My point is that investors are better off thinking of the DSC as an up front charge of 5% ($2500 in my example). This is because there is no way to prevent losing this money once you buy into the fund.

    Either you sell and pay the DSC, which will cost you $2500 during the first year, or you pay part of the DSC each year you are in the fund in the form of a portion of the MER dedicated to paying 5% up front to the advisor.

    As soon as you buy into the fund, the $2500 is gone; it's just a question of when it is taken from you.

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  3. True, but if they choose the no-load version (which in some cases have a higher MER), then if they hold the fund for more than the 5 years (or whatever the DSC period is), the DSC version would've been better, no?

    In cases where the MERs are higher for a no-load version of the fund versus the DSC version, the investor will have to take this into account.

    Where the MERs are the same, then the no-load fund is the version to use - but only because there would be no extra costs if you redeemed funds during the DSC period.

    Another point is to look at what the DSC percentage is applied to as this varies between firms as well. Some may choose to charge 5% of the original investment, and some choose 5% of the market value at time of redemption.

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  4. Preet:

    Any investor capable of doing the analysis you describe should be able to figure out that a low-cost index fund is the best choice. The danger with deferred sales charges is that when an investor wakes up to the fact that mutual funds charge exorbitant fees, his losses are locked in just as much as if he had taken a front-end load. At least with no-load funds, when an investor decides to get out, his losses are limited by how long he was in the fund.

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  5. Totally agree.

    Love your blog, BTW. I've added it to my blog-roll.

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