Mutual funds can be categorized on the basis of the type of sales commission, or load, that is levied. If loads are charged when the investor initially makes the purchase, they are called front- end loads; if they are charged at redemption, they are called back-end loads. Most load funds have optional sales charges that let the investor choose between front-end or back-end charges. The actual level of the sales charge levied by load funds depends on the type of fund, its sponsor and method of distribution, the amount of money being invested, and the method of purchase (i.e., lump sum purchases versus contractual purchases spread out over a period of time). A client may be able to negotiate with the representative over the front-end load, especially if a large amount of money is involved, as it is set by the distributor. The back-end load is set by the dealer and not negotiable.
Trying to calculate the impact of the various types of fees on mutual funds can be very complicated. The Ontario Securities Commission and Industry Canada’s Office of Consumer Affairs have developed a new online calculator that allows investors to determine the impact mutual fund fees have on investment returns over time. The Mutual Fund Fee Impact Calculator is located at www.investored.ca.
NO-LOAD FUNDS
Many mutual funds, primarily those offered by direct distribution companies, banks and trust companies, are sold to the public on a no-load basis, with little or no direct selling charges. However, some discount brokers may levy modest “administration fees” to process the purchase
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and/or redemption of no-load funds. These funds, like other funds, do charge management or other administrative fees.
There was a great deal of controversy when no-load funds were first introduced. Many felt that the fund had to make the money somewhere. The no-load funds were said to have higher management fees. Prospective purchasers of no-load mutual funds should read the prospectus carefully, as this may or may not be true. Higher management fees may allow some no-load funds to compensate the salespeople through ongoing trailer or service fees, which are described in more detail below.
FRONT-END LOADS
A front-end load is payable to the distributor at the time of purchase. It is usually expressed as a percentage of the purchase price or NAVPS. The percentage typically decreases as the amount of the purchase increases.
Investors should be aware that the front-end load effectively increases the purchase price of the units, thereby reducing the actual amount invested. For example, a $1,000 investment in a mutual fund with a 4% front-end load means that $40 (4% × $1,000) goes to the distributor by way of compensation while the remaining $960 is actually invested.
Regulations require that front-end loads must be disclosed in the prospectus both as a percentage of the purchase amount and as a percentage of the net amount invested. In the example above, the prospectus would state that the front-end load charge would be 4% of the amount purchased ([$40 ÷ $1,000] ×100) and 4.17% ([$40 ÷ $960] × 100) of the amount invested.
To determine a fund’s offering or purchase price when it has a front-end load charge, you must first determine the NAVPS and then make an adjustment for the load charge. Using a NAVPS of $12 and a front-end load of 4%, the offering or purchase price is calculated as:
Offering or Purchase Price NAVPS Sales Charge
100% So:
Offering or Purchase Price
4% $ % $ . . $ . 12 100 12 1 00 0 04 12 0 96 $ .12 50
Note that the sales charge of 4% of the offering price is the equivalent of 4.17% of the net asset value (or net amount invested):
4 0 50 0 50 12 4 17 % $ . $ . $ . % of $12.50
BACK-END LOADS OR DEFERRED SALES CHARGES
A growing number of funds apply no sales charges on the original purchase, except for perhaps a nominal initial administrative fee, but instead levy a fee at redemption. This type of fee is known as a back-end load, redemption charge, declining sales or deferred sales charge. The fee
may be based on the original contribution to the fund or on the net asset value at the time of redemption.
In most cases, deferred sales charges on a back-end load fund decrease the longer the investor holds the fund. For example, an investor might incur the following schedule of deferred sales charges with this type of fund:
TABLE 18.1 BACK-END LOAD SCHEDULE
Year Funds Are Redeemed Deferred Sales Charge
Within the fi rst year 6%
In the second year 5%
In the third year 4%
In the fourth year 3%
In the fi fth year 2%
In the sixth year 1%
After the sixth year 0%
For example, an investor purchases units in a mutual fund at a NAVPS of $10. If the investor decides to sell the units in the fourth year when the NAVPS is $15, the fund will charge a 3% back-end load or commission.
If the back-end load is based on the original purchase amount, the investor would receive $14.70 a unit, calculated as follows:
Selling/Redemption Price = NAVPS – Sales commission
= NAVPS – (NAVPS • sales percentage) = $15 – ($10 × 3%)
= $15 – $0.30
= $14.70
If the back-end load is instead based on the NAVPS at the time of redemption, the investor would receive $14.55, calculated as follows:
Selling/Redemption Price = $15 – ($15 × 3%) = $15 – $0.45
= $14.55
TRAILER FEES
Another kind of fee is the trailer fee, sometimes called a service fee. This is a fee that a mutual fund manager may pay to the distributor that sold the fund. This fee is paid to the mutual fund representative annually as long as the client holds the funds. Service fees are usually paid out of the fund manager’s management fee.
The justification for paying this fee is that the representative provides ongoing services to investors such as investment advice, tax guidance and financial statements. Proponents of trailer
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fees argue that the ongoing services are a valuable benefit to investors and that salespeople must be compensated for their work. Critics believe that such charges have the potential to produce a conflict of interest for the salespeople who could encourage investors to stay in the fund even when market conditions might indicate that they should redeem their shares. Critics of trailer fees also argue that investors who hold funds for the long term end up paying higher overall fees than they would if they had paid a one-time front- or back-end load.
OTHER FEES
A small number of funds charge a set-up fee, on top of a front-end load or back-end load. A variation of the redemption fee is the early redemption fee. Some funds, even no-load funds, note in the prospectus that funds redeemed within 90 days of the initial purchase may be subject to an early redemption fee, such as a flat fee of $100 or 2% of the original purchase cost. These fees are charged to discourage short-term trading and to recover administrative and transaction costs.
For example, $5,000 is invested in a fund that charges a 2% early redemption fee. If the investor redeems the units 45 days later, the early redemption fee is $100 ($5,000 × 2%).
SWITCHING FEES
Switching fees may apply when an investor exchanges units of one fund for another in the same family or fund company. Some mutual fund companies allow unlimited free switches between funds, while others permit a certain number of free switches in a calendar year before fees are applied. In many cases, the financial advisor may charge a negotiable fee to a maximum of 2% of the amount being transferred, but an advisor may choose to waive this fee altogether. A common requirement for switching is that the funds involved are purchased under the same sales fee options.
In other words, clients generally aren’t allowed to switch between a front-end fund and a back- end fund, or vice versa.
As well, switching fees generally do not apply if a fund merges with another or is being
terminated for any other reason. In such cases, the investor would be allowed to transfer to the existing fund or withdraw the cash value of the contract without incurring withdrawal fees. MANAGEMENT FEES
The level of management fees varies widely depending on the type of fund, with fees ranging from less than 1% on money market and index funds to as much as 3% on equity funds. In general, fees will vary depending on the level of service required to manage the fund. For example, the management fees associated with money market funds are low, in the range of 0.50% to 1%. The management of equity funds (with the exception of index funds) requires ongoing research and therefore the management fees are higher, ranging from 2% to 3%. Index funds try to mirror the market with occasional rebalancing. Since this strategy is largely a passive buy-and-hold strategy, management fees are usually lower. In all cases, the management fees charged would be outlined in the prospectus.
Management fees are generally expressed as a straight percentage of the net assets under management. For example, “an annual fee of not more than 2% of the average daily net asset value computed and payable monthly on the last day of each month.” This method of compensation has been criticized because it rewards fund managers not on the performance of