Why would anyone buy loaded mutual funds?

Photo courtesy of Emilio Labrador

 

One of my first rules of investing is: don’t invest in anything that you don’t understand. As we all need to be investing experts, this carries a certain weight with me. And while the answer to “what should I invest in?” is a large and thorny topic, it’s safe to say that mutual funds will be some (or all) of your financial picture.

There are lots of ways that mutual funds distinguish themselves, but one way to divide them up is to talk about “load” versus “no-load” funds. A “loaded” mutual fund charges a fee (usually a percentage) for investing, either when you buy (“front-loaded”) or when you sell (“back-loaded”). A “no-load” fee doesn’t charge a fee.

This leads me to ask: why would anyone invest in a loaded fund?

Mutually yours

Mutual funds are pretty easy to understand. They are typically a mixture of single stocks that are picked and managed by an advisor or company. You buy “shares” of a mutual fund, and by extension you own pieces of lots of stocks. You get the balance of all those stocks’ movements, so if two go down in value but twenty go up, then you still likely make out ahead. It’s a way of spreading risk around, which is a central tenet of investing.

The number of mutual funds is ginormous, which is just one of the many reasons why investing is so daunting for people.

But remember Occam: the simplest is probably the best. Which leads me back to load versus no-load mutual funds.

How to lose money instantly

A loaded fund, as mentioned above, charges a fee for investing. Let’s talk about “front-loaded” funds here, so let’s say that this fee gets charged when you buy the fund.

If it’s not obvious, the person who pays this fee is you.

So let’s say that you invest $10,000 in a front-loaded fund. Let’s say also that the fund charges a 5% front-load. So you actually only invest $9,500. Now, that may not seem like a big deal, but you’ve started out losing money!

The average return in the stock market is somewhere between 6%-11%, depending on which source you ask (and whether they’re trying to sell you something). So it’s a good bet to try and find a stock that’s going to at least do as good as the average. (This is why index funds, which directly track these things, are the best.)

If you find a fund that nets an 8% return, then you factor in the 5% fee, it means that you’re only netting 3%! But inflation is roughly 3%, so you’re in effect netting nothing!

If the stock goes nowhere, returning 0%, then you’ve made a return of -5% (-8% if you factor in inflation)! At that rate, you may as well opt for the cookie jar method of investing.

So why would anyone willingly pay a fee to invest in a fund, when other funds don’t charge this fee?

Two reasons, neither good

There are two reasons why I think people invest in loaded funds.

They believe that the loaded fund will outperform an equivalent no-load fund. Okay, 5% might be steep fee, but what if the loaded fund returns more than 5% over the equivalent fund without a load? Then it’s worth it right?

If a no-load fund NOLOD returns 8%, and a front-loaded BGFEE fund returns 15%, then you’re ahead of the game by 2% (as 15% return – 5% fee = 10% return, which is 2% better than the 8% return).

But there are two problems with this.

Problem #1 is that you are choosing a “guaranteed loss” in the pursuit of a “potential gain.” Everyone knows that past performance is no guarantee of future results. But if you buy a front-load fund, you know with 100% confidence that you are starting 5% in the hole. That’s seems like a bad deal to me.

Problem #2 is that, according to research, on average load funds don’t perform any better than no-load funds! And in fact, according to the Motley Fool and Morningstar, no-load funds actually have a superior record to load funds over the last 3-year and 5-year periods.

So again, why would anyone willing give themselves a 5% loss then? There is a second reason: They don’t know any better.

There are plenty of people who profit off of your ignorance and inattenion, and nowhere more than in car repairs investments. If you are a typical person who knows nothing about investments and finances (not judging here) and you go to a financial planner, this financial planner may recommend that you invest in mutual funds with loads. Why? Because this advisor may be being paid to get people to invest in these funds. This is known as a “commission-based” financial advisor.

“Commission-based” advisors make me twitch a little bit, because a financial planner must have the client’s interests at heart first and foremost (and this is totally selfish, because a happy customer is a repeat customer). To recommend funds where commission is involved seems like the definition of a conflict of interest to me.

(Public service announcement: if you use a financial planner, a safe bet is to opt for a “fee-only” advisor, so at least you can know where the person makes money.)

Know your loads

How do you know if a mutual fund charges a load? It’s easy: just go to Google Finance (or equivalent), type in the five letter code for the mutual fund, and look for the word “load.”

For example, if you type in AEEAX, to take a random example, you will see that the fund charges a 4.25% front load. But if you type in VFINX, which is an index fund, you will see that the fund does not charge a load.

Understand first

All of this leads me back to the very first sentence: don’t invest in anything that you don’t understand. When you become educated, you become empowered, and less able to be taken advantage of. Know what you’re getting into, understand the risks, and then dive in with as much confidence as you can reasonably have. But it’s easier to dive in when you take a load off first.

But enough about me: Do you invest in loaded funds?

Mike Pumphrey

Mike Pumphrey

I'm the founder and author of Unlikely Radical, a site to help people succeed with money, achieve their goals, and live intentionally.

I offer a free phone consultation to anyone who is interested in changing their financial narrative. Are you ready? Click here for details.
Mike Pumphrey
Posted on February 10, 2014