In today’s investment world there are some investments that should have died off a long time ago. But because of the way they are sold they are thriving. These investments are called “Loaded Mutual Funds.” I explain in this post why they are so bad and why you should never buy them.
What’s a Loaded Mutual Fund?
First let me explain what a “Loaded” fund is. Let’s say you go visit a financial advisor and he says, “I have the perfect investment for you. It’s diversified and should provide you excellent returns over time. It’s called Fund ABC!” So, you give him $100,000 and buy the fund. Great, now you have $100,000 investment set aside for your future. Wrong! You have a $94,250 investment. This is because of the “Load” or front-end sales charge of 5.75% that you had to pay to buy the investment. Sadly, in today’s investment world this fee is completely unnecessary because of the wide range of no-load funds that are available that invest the same exact stocks as the loaded funds.
What’s amazing is that a lot of people still purchase these funds. About 5% of all mutual funds purchased have a load of 4% or more. This fee is charged by the mutual fund company but most of it goes to the broker who sold them to you. This is why some financial advisors say it’s free to work with them because you aren’t paying them directly but instead through these loads. And that is exactly why these type of funds are still around – brokers are still selling them to un-educated investors to get their large commissions. Note: not all financial advisors work through commissions. Fee-Only financial advisors work for a set fee that is paid directly to the advisor, removing the conflict of interest, and incentive to sell these bad investments. The good news is loaded mutual fund sales are decreasing as consumers are becoming more aware of the costs of investing and with the rise of ETFs (exchange traded funds) which work just like mutual funds but never have the loads. There is also new regulations coming that could do away with these funds altogether.
It Gets Worse
These loads are transactional based meaning they brokers have the incentive to sell more products. This leads to unnecessary transactions being placed in the account sometimes called churning. Churning is when the advisor gets the upfront load and the after a couple years sells that fund and buys another one with, yep you guessed it, another load. The advisor might give a reason such as the market changed, or this fund is better than that fund, but in the end the incentive is there to buy and sell every couple of years regardless of whether or not it is actually needed.
On top of that, Loads are not the only fee that investors pay. There are also 12b-1 fees that are “hidden” in the fund’s annual expense ratio. This fee also flows through to the broker/salesmen and add up to billions of dollars each year of more unnecessary costs for investors. I’m not surprised the financial advisor industry has gotten a bad reputation over the years.
Believe it or not brokers try to defend these outrageous fees as a cost of investing advice. But that doesn’t hold up when you start comparing funds. American Funds, the largest loaded mutual fund company, sells the loaded version of their US Large Cap Growth AMCAP Fund with a 5.75% load and ongoing annual expenses of 0.68%. They sell a non-loaded version of the fund with a 0.74% annual expense ratio. While this is slightly better, you can buy multiple funds that hold very similar investments for a fraction of the cost. Vanguard sells a non-loaded US Large Cap Growth fund (VWUAX) with only a 0.30% expense ratio and Charles Schwab has a similar fund with 0.07% annual expense ratio - SCHG. The problem again comes back to the financial advisors with an incentive to sell these high expense products. Without them these investments would go away very quickly.
Most experts in the financial field agree that loaded mutual funds are not good investments when compared to the alternatives.
Loaded Mutual Funds are a Symptom of an Underlying Disease.
Brokers who are paid via loaded mutual funds, 12b-1 fees, and other commissions are only required to recommend a product to a client if it is “suitable” for them. This means the advice does not need to be in the client’s best interest. Instead it is in the broker’s best interest and the interest of the company they work for. There is another standard that fee-only financial advisor have to follow and that is the Fiduciary Standard. This requires the advisor, by law, to do what’s in the best interest of the client, which is why they would never sell these loaded funds.
The current debate going on in the United States is over whether all financial advisors and brokers need to be fiduciaries and be held to this higher standard. If something like this were to be turned into law then, in theory, loaded mutual funds could be done away with overnight.
There is evidence too that brokers, who are not held to the fiduciary standard, provide their client’s with worse advice. Harvard Business School found that investments sold by brokers (from 1996-2004) underperformed compared to other funds. This is even before taking the commissions into account. So not only are the investments much more expensive but because the advice is based on questionable motives the recommendations are worse too.
So what are you supposed to do about this? Well, first if you are looking for a financial advisor make sure they are held to the fiduciary standard. Then ask what the total cost of working with them is. Not just what you are directly to the advisor but the total cost. Make sure you are working with a fee-only advisor. The advice is more objective and any conflicts of interest are minimized. If you already have an advisor whom you suspect is selling loaded mutual funds, check your account statements. Look for A, B, and C share classes. If you see any of these investments you own loaded mutual funds. It's time for a second opinion.
Read my earlier posts on the the Fiduciary Standard or What to Look for when Shopping for a Financial Advisor for more information.