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Mutual Fund Pricing Is a Mess

"No load" sounds simple--but it is not.

John Rekenthaler, 10/12/2016

Dream On 
Once, fund investors had a dream. They dreamed that one day, mutual funds would no longer be divided into "load" and "no-load" families. No longer would half the industry consist of funds with sales charges, to be purchased through financial advisors, and the other half without such loads, to be purchased directly. No longer would the two groups never meet. (Quite literally--in the early 1990s, Morningstar offered segregated versions of its annual Investment Conference, one for load funds and one for no-load funds.)

That dream has been realized. The long, gradual movement recently reached its conclusion, when the largest load-fund family, American Funds, announced that it would make no-load shares available to direct investors. That's excellent investment news. Morningstar's Alec Lucas tells the story in "(Re)introducing Capital Group's American Funds." The company has several stock funds that have reliably beaten the major indexes, over time, and they now can be bought without paying either a front- or back-end sales charge.

(The common rejoinder to the praise of American Funds' performance is the rejoinder that the company is riding its reputation. American Funds once posted excellent returns, goes the argument, but in recent years its offerings have been decidedly mediocre. Not so. Currently, seven of the company's 13 stock funds land in the top third for the category over the trailing five years, and none in the bottom third. That sort of performance--often good, rarely bad--is the secret behind index funds' success, and it is typical of American Funds as well.)

The Good Old Days
However, the pricing news is not so pleasant.

Way back in the day, mutual fund pricing was simple. Those who used financial advisors paid a one-time load. While technically levied by the fund, that charge was in reality a payment to the financial advisor, as the fund passed along the receipts to the investor's advisor. After that initial transaction, the investor paid no further distribution charges. The ongoing expense ratio was used to cover the costs of investment management and fund operations. Fund expense ratios paid for fund expenses, not for acquiring new shareholders.

The same structure applied to the no-load investor, except that because no financial advisor required compensation, there was no upfront payment. Thus, the initial experience differed for no-load buyers. Once the two sets of investors entered their funds, though, they were treated identically. No-load investors paid for the same ongoing fund services as did load investors, at similar expense ratios.

That approach was clean. It was unbundled. If the investor chose to pay for the fund's distribution, by going through a financial advisor, the transaction was upfront and clear. (The underlying mechanism that funneled monies from the fund to the advisor was obscure, but the charge itself was not.) If the investor chose not to pay for distribution, then that process was clear as well. Two paths existed, to address two needs.

(That account is a bit oversimplified, as the fund companies set their investment-management fees high enough to generate substantial profits, some of which were used by them to to pay for distribution activities. So the costs to investors were not perfectly unbundled. But as a first approximation of the truth, it's close enough: The load charge primarily covered the activity of distribution, and the expense ratio paid for the rest.)

is vice president of research for Morningstar.

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