Mutual Fund Pricing Is a Mess

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.)

Devolution All this disappeared with the introduction of the 12b-1 fee, which put distribution charges into the expense ratio, and thus muddied the payment waters.

For example, direct investors will only be able to access the American Funds offerings through F1 shares, carried on Schwab's and Fidelity's brokerage platforms. Those F1 shares contain 0.25% annual 12b-1 fees, which are distribution costs levied by the fund, on an ongoing basis, and then funneled to the brokerage firms.

In other words, the 12b-1-fee performs the function previously conducted by the front-end sales charge: It collects the distribution fee from the fund buyer, and then passes it along to the distributor. However, unlike with the traditional mutual fund business, wherein the distribution cost was separated from that of ongoing management, today's distribution cost is attached to the management fee. And it is perpetual, not one-time.

Another way of putting the matter is that, absent 12b-1 fees, expenses for American Funds stock funds are about 0.40%. I've written recently about how if active management wishes to regain its share of investors' wallets, it needs to price its funds much lower. It needs to narrow the cost difference between passive and active funds, so that its portfolio management has a realistic chance of overcoming the expense gap. An expense ratio of 0.40% accomplishes just that.

But investors cannot buy American Funds at that price, except through very large 401(k) plans, because the classes that are available to them all have distribution costs baked into them, in the form of 12b-1 fees.

Make no mistake: The American Funds announcement is a good thing. Going forward, direct investors can buy excellent stock funds from the company without paying an initial charge. Expense ratios for those funds vary, but mostly range from 0.60% to 0.70%. Those are very moderate costs by industry standards, and the package includes not only the funds themselves, but also the services provided by the brokerage firms. That is an attractive offering.

But the offering would be better yet if the 12b-1 fee had not been invented. It would be better yet if distribution costs were once again separated from management costs, so that investors who wished to purchase a bundle that includes advisory and/or brokerage services could do so, and those who do not, need not. In the good old days, this was always possible. Today, it is not.

Summary In case there is any confusion, this column is not a knock on American Funds. Indeed, it is a compliment. The company faces the same pricing structure as does the rest of the mutual fund industry, and it has responded in much the same way. What makes this case particularly interesting is the strength of the company's funds. They are appealing in whichever form they are bought. It would be nice if they are available in all forms.

And this column is a reminder that "no load" does not mean "no distribution costs." There are many flavors of no load, but the only one that does not carry explicit distribution costs is the one that lacks 12b-1 fees entirely. There aren't very many of those funds around. (Vanguard's stable would be a highly notable exception.) It might seem that fund-industry pricing is becoming easier to understand--and gentler on consumers--because load charges are fading away. That is decidedly not so.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.