Just say no to load funds.
When you buy a load fund, you must pay a sales commission or "load," which is deducted from your mutual fund investment. On the other hand, "no load" funds are offered directly to investors without a commission charge. You should invest in a load fund only if you expect the fund to earn enough over the time that you own it to recover the sales commission.If you invest $1,000 in a load fund having a 4 percent sales commission, or load, only $960 of your money will be placed in the fund. The majority of the remaining $40 is paid to the person who sold you that fund (either a stockbroker, financial planner or the fund's distribution company).
Loads advertised by mutual funds are actually understated because they are expressed as a percentage of the sales price. In the above example, the $40 sales charge is 4.2 percent of the $960 actually invested. So the fund would have to earn at least 4.2 percent to make up for the 4 percent sales load - and that is before income taxes. Never assume you can earn back a commission rate simply by getting that same return the following year.
Clearly, a load fund must outperform a no-load fund or it makes no sense whatsoever to pay a commission. Generally speaking, equity load funds do outperform the no-load funds, but only by about 1 percent per year.
Therefore, unless you plan to hold the same equity fund for several years (six years is often a good rule of thumb), you are generally wiser to select a no-load fund.
With this principle in mind, many mutual funds are offered with a feature called the rear-load or contingent sales charge, which is not applied until you withdraw your investment. In that way, all your money is invested from the beginning, but assuming your investment grows, you pay the load on a larger amount when you sell the fund.
Most rear-loads decline the longer you stay with the fund. For example, if you withdraw in the first year, a 5 percent sales load will be deducted from your withdrawal. But if you don't withdraw your investment for five years, then only 1 percent might be deducted. If you may need your money back after a short period, it is important to determine that the fund does not have a rear-load charge or a front load.
You may be wondering how the managers of no-load funds make money. Remember that the sales load is paid to the salesperson, not to the fund manager. The managers of both load and no-load funds are paid a management fee, which is regularly withdrawn from the operating capital of the fund.
Because returns are reported after management fees and other expenses have been deducted, the average investor does not have to be especially concerned about the fee. If a fund reports superior results, it was able to earn enough money to more than cover its fees. Returns are not shown net of sales loads.
However, if the fund's manager is paid directly from the fund, why are sales charges imposed on some funds? The decision of whether a fund is offered on a load or no-load basis is made strictly on the company's marketing plan.
By offering load funds, companies are able to use stockbrokers and financial planners all over the country to stimulate sales of relatively unknown funds. Loads are also added to well-known funds as an additional source of revenue.
For example, when you buy shares of the Fidelity Magellan fund directly from Fidelity rather than through a broker, Fidelity retains the sales load for itself. Many companies offer both load and no-load funds. Many funds are introduced into the marketplace as one type and are changed later as the fund manager revises its marketing strategy.