Investors are increasingly faced with the problem of sorting through front-end loads, back-end loads and 12b-1 plans in their mutual fund investment decisions. It wasn’t long ago that a recommendation to investors to seek no-load mutual funds was straightforward. The rationale was simple: Loads are commissions that go to sales personnel and do not improve mutual fund performance; in fact, loads reduce total return to the investor.
The advent and continuing spread of the 12b-1 plan has made the situation complex. A 12b-1 plan permits fund assets to be used to cover distribution costs; in most instances, this involves an annual percentage charge against fund assets. These costs include distribution of prospectuses and other material to prospective investors, and advertising; in addition, some funds use the plans to pay commissions to sales personnel.
A number of mutual funds that have adopted 12b-1 plans do not actually use them. A number of other funds adopted 12b-1 plans to allow the adviser to pay the distribution costs from the advisory fee. Still other funds have hefty 12b-1 charges against the fund that are comparable to—and can be more onerous than—a full front-end load. Despite this latter use of a 12b-1 plan, the SEC allows such a mutual fund to call itself a no-load fund if there is no front-end or back-end (sometimes known as a contingent deferred sales charge) load. In addition, mutual funds with back-end charges have introduced the concept of “no initial load” in their advertising, a phrase that is frequently misinterpreted.
This leaves investors with a real dilemma: They cannot fully rely on the term “no-load” to distinguish funds without sales charges, and they cannot make the distinction based on whether a fund does or does not have a 12b-1 plan. Furthermore, how do you analyze a mutual fund that has a back-end charge that disappears after a certain time period? The question remains: How can an investor determine the lowest-cost mutual fund?
The most practical solution for investors is to convert all of the expenses into equivalent charges. This means, for instance, either converting the annual percentage 12b-1 charge into an equivalent front-end load, or converting the front-end load into an equivalent annual charge; similarly, back-end loads can be converted into 12b-1 equivalents.
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The tables presented in this workshop allow investors to do just that. However, you must be aware of certain assumptions that must be made. First, the comparisons depend upon an assumed time horizon, since some payments are made annually, and others decline depending on the time horizon. We have included a variety of time horizons in the tables, and investors must make their own assumptions here. Another assumption is the discount rate: Future payments must be restated in present value terms; to do this, you must discount the future amount based on an assumed interest rate (the discount rate) for that time period. For the purposes of these tables, we made the assumption that the discount rate will be the same as the investment growth rate. Of course, most investors will hope to have a return that is higher than the discount rate. We used this assumption to simplify the math so that you can work out situations not shown in the tables; deviations in actual experiences should not materially affect the decision in most instances.
Table 1 converts various front-end loads to 12b-1 equivalents for a variety of holding periods. For example, a front-end load of 3% and a four-year holding period translates into the equivalent of a 0.75% annual 12b-1 charge. The table lets you compare front-end load funds with no-loads that have 12b-1 charges. For example, if you are considering a 4% front-end load fund versus a no-load fund with a 0.50% 12b-1 plan, and your contemplated holding period is five years, you will find that the no-load is cheaper, since the front-end load fund is equal to a 0.80% 12b-1 fund.
Table 2 presents a similar concept from a different perspective by allowing you to convert a 12b-1 annual charge into a front-end load equivalent. For example, if you have a no-load fund with a 12b-1 plan of 0.75%, what is the front-end load equivalent if your holding period is five years? The answer is 3.75%.
Table 3 introduces yet another perspective: the breakeven point. Estimates of your probable investment holding period are at best uncertain, and one way to judge the front-end load versus the 12b-1 decision is to think in terms of a breakeven holding period. At this point, the investor is indifferent between the front-end load and the no-load fund with a 12b-1 charge. For example, you would be indifferent between a 0.25% 12b-1 annual charge and a front-end load of 3% if your holding period were 12 years. The annual charges become more onerous the longer your holding period; thus, if your expected holding period were greater than the breakeven period, then the front-end load would be lower cost and, conversely, if your holding period were less than the breakeven period, then the 12b-1 plan would be more cost advantageous.
Table 4 deals with back-end charges, converting them into 12b-1 equivalents. In this case, a discount rate assumption was necessary, and we used 10%. However, we have also provided the equation, which will allow you to use any discount rate if you choose to do the math yourself. It is particularly important here to judge the holding period, since back-end loads may or may not disappear after a given holding period, and in many instances they are reduced stepwise over time. Also remember that back-end loads are generally assessed on investment purchases rather than appreciation and reinvested distributions, and that is the assumption we have made here.
Table 4 is similar to Table 1. It allows you to compare funds with back-end loads to no-loads with 12b-1 plans. For example, if you were comparing a 4% back-end load fund with a no-load fund that had an annual charge of 0.75%, and you planned on holding the investment for four years, you would be better off paying the back-end load, since its 12b-1 equivalent for the time period is only 0.68%. Similarly, the table indicates the breakeven holding period: For instance, a 2% back-end load mutual fund is equivalent to a no-load fund with a 0.50% 12b-1 annual charge if the fund is held for three years.
One word of caution, however, when comparing funds with back-end loads: Many funds with declining back-end loads also have yearly 12b-1 charges, as do some front-end load funds. Typically, the back-end loads are referred to as contingent deferred sales charges. When a fund has both a load and a 12b-1 charge, you must add the fund’s yearly 12b-1 charge to the 12b-1 equivalent of the load for the holding period. For example, let’s say you were considering a mutual fund that has a back-end load that declines to 3% after three years (your intended holding period) and has an annual 12b-1 charge of 0.50%. The 12b-1 equivalent of a 3% back-end load over three years is 0.75%; the total 12b-1 charge for the fund, then, is 0.50% + 0.75% = 1.25%. Thus, you would be better off with any other mutual fund that had a lower 12b-1 charge over a three-year period.
Any charge to the investor—be it upfront commissions or charges to a fund’s net assets—reduces the amount of money you have working for you in your investment portfolio. The choices—front-end loads, back-end loads, and 12b-1 plans—are becoming increasingly confusing to evaluate. Knowing how to compare these costs and investing some time to make the analyses will generate investment returns in the years to come.
The tables provided in this workshop allow investors to compare the total expense experience of one fund to another. Here’s how it works.
Start with the “ratio of expenses to average net assets” figure, which is provided in the per share data information that must appear in every mutual fund’s prospectus. This figure contains most of the expenses that are charged against the assets of a mutual fund.
Not included in this figure is any front-end or back-end load, since this is paid directly by the investor rather than the fund. However, the loads are an expense and should be added in when comparing the expenses of different funds. This can be done by using the tables on the preceding pages and converting any loads into annual expenses—in other words, converting them into the 12b-1 expenses that were presented in the tables. That figure can be added to the expense ratio, producing a total annual expense figure that can be compared to any other fund’s total expense figure.
One word of warning: Almost all mutual funds include their 12b-1 expenses in their expense ratio figures. A few, however, do not. Although there has been considerable discussion on this issue, the SEC has not yet come down firmly on the question. Those few funds that do not include 12b-1 expenses in the expense ratio use their plans to pay commissions for the sale of fund shares; they also have contingent deferred sales charges, which typically decline. These 12b-1 expenses tend to be high—1% or more, and so inclusion would significantly change the expense ratio. Unfortunately, there is no way to tell whether the 12b-1 expenses were included in the expense ratio or not, except to look at the ratio and see if it seems reasonable enough to include any 12b-1 expense. For example, the Kemper Investment Portfolios have high 12b-1 plans (1.25%) and use them to pay commissions. But their expense ratios are also high—2.22% to 2.24% in a 1985 report; the 12b-1 expense is included in the expense ratio figure. The Keystone Custodian Funds, on the other hand, also have high 12b-1 plans (1.25%), but their expense ratios range from 0.85% to 1.12%; it is unlikely that the 12b-1 expense is included in the expense ratio.
True no-load funds with 12b-1 plans include those expenses in their expense ratio figures.
Expense ratio + “Converted load” = Total expense ratio
Find the expense ratio listed in the fund’s most recent prospectus.
Add the “converted load” figures to the expense ratio, for a total annual expense figure.
Use these figures for comparing different mutual funds.
This article was written by John Markese for the January 1986 issue of the AAII Journal. At the time, he was the director of research at AAII. Markese is also a former president of AAII and currently serves as vice chairman.