Fund companies have moved on--you should, too.
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By Eric Jacobson | 09-22-11 | 06:00 AM | Email Article

The debate over load versus no-load funds has flared for so long, and with so much more smoke than fire, that it seems like a trick birthday candle. It reignited for me when reading some of the reader comments--in some cases, arguments--on columns that have appeared on Morningstar.com in recent months because they mentioned specific funds: that is, specific funds that carry loads. To some, the very deed is inexcusable. 

Eric Jacobson is a senior analyst covering active strategies on Morningstar’s manager research team.

The participants often resemble the Montagues and the Capulets, with neither side willing to cede a millimeter of ground. That kind of intransigence has never been helpful, but one could at least understand the debate--15 years ago. Until then, many funds were only available with loads and through brokers. Others were sold without loads, and you had to buy them directly from their fund companies--no broker involved and no outside help given. There was really no overlap across those two worlds, and disciples of each actually refused to do business with each other in many cases.

Here's the thing, though: The debate never made much sense to begin with, it's over, and nobody actually won.

We Hold These Truths to Be Self-Evident
Of course it's cheaper to buy a fund with no commission rather than paying a 5.75% up-front load, but the different structures were meant for different people and promise different things. But more to the point, that black-and-white world no longer exists.

Loads have always been used as a tool to compensate intermediaries for selling funds. Full stop. An investor who works with a broker expects to receive help and an ongoing relationship that, in the best circumstances, benefits the investor for a lifetime. In return, the broker expects to receive payment--in an admittedly complex and arguably antiquated way--mainly through the loads charged by mutual funds and the commissions charged for trading other securities.

You may have heard other reasons for the load structure. Some once opined that better managers worked at load shops (a myth). Others have claimed that loads are there to help encourage investors to avoid selling funds too quickly after buying them (not true). That story confuses happy consequence with intent. Some firms have occasionally added redemption fees in an attempt to slow down fund share trading, but loads aren't part of that narrative. Rather, in the most traditional sale of A shares, a small slice of each load goes to the fund company's internal distribution arm, in part to compensate its wholesalers, while the rest goes to the brokerage firm with some of it headed directly to the broker who sold the fund, to split based on whatever formula on which the two have agreed.

The fund industry looks remarkably similar to any manufacturing business, except that you know roughly how much the commission is--because it's the load.

The fund company manufactures the fund (that is, Franklin Templeton, for example, with Franklin Templeton Distributors acting as its wholesaling arm); the dealer handles the heavy lifting elements of distribution (that is, Merrill Lynch); and the broker, who works for the dealer, connects directly with the customer to make a sale. (The "dealer" in this case is referred to in the industry as a "broker/dealer" or brokerage firm, but they really function as "dealers," just like car dealers would, but in the mutual fund context.) There are plenty of decent brokers, making the purchase of funds with loads a reasonable decision for those who want help making their investing decisions. But because we're talking about money, the business naturally attracts people who have skill with sales and a particularly strong desire to make money.

Conversely, no-load fund companies historically tried to do it as  Dell  does with retail computers--direct from the manufacturer to consumers, with no intermediary. Most people came across them via TV or newspaper ads, or heard about them from friends. They might have come to Morningstar for some more information but otherwise--in the pre-Internet age especially--had to find and dial an 800 number to ask for more information and the mailing of a prospectus. The investor mailed a check in or perhaps had money wired to the company. In exchange for not having to pay an up-front fee, the investor had to do everything himself--discovering the fund, buying it, monitoring, and eventually selling.

Paradigm Shift: This Time It Really Is Different
We've since moved way beyond that system. Currently, very few fund companies distribute their funds exclusively with load or no-load structures. Instead, they use both methods. Former "pure no-load" shops such as Janus and American Century now offer shares through advisors as well, and many investors buy funds from former "pure load" shops such as Franklin Templeton through 401(k) plans or via fund "supermarkets" run by the likes of firms such as Fidelity or Schwab.

Just as important, the vast majority of no-load fund firms have evolved to distributing via those same platforms from Fidelity and Schwab, et al. Those firms originally got in the business of "selling" funds without regular loads via employees who were still compensated by the extra fees the no-load companies pay (and charge to their investors as part of their expense ratios) to be on the platforms. 

Nowadays, though, a lot of that platform business comes through Registered Investment Advisors. These RIAs are often labeled fee-based or fee-only advisors who often don't get brokers' licenses but are typically overseen by state and federal regulators. Their clients can usually buy either "load" or "no-load" funds from them, paying no up-front commissions for either kind. Thus, the division between the two once-opposed types of funds disappears. They usually charge clients directly or share expense ratio-driven revenue with the platforms and fund companies because they're not collecting commissions via loads.

Meanwhile, traditional brokers almost all now have the capacity to work in a similar way because most of the traditional dealers (that is, Merrill Lynch) now register themselves as RIAs and have developed internal platforms similar to those of Fidelity and Schwab. Those brokers can therefore sell traditional load funds or no-load funds, and most of the former are available on a "load-waived" basis on those firms' platforms, right alongside no-load funds that they would have never sold in the past. Under that system, brokers and their firms make money by assessing their own fees, rather than taking commissions from the fund company's sales transaction.

Are You Still a Montague or Capulet?
It's true that a few holdouts still buy pure no-load shares via an 800 number or purchase A shares through a broker, paying the full 5.75% load. For the most part, though, the 1990s world of pure load versus pure no load is no more. Nearly all funds are bought through some kind of intermediary, even if that intermediary is an online platform.

Whichever kind of intermediary you might use, the bottom line is that the commissions or fees you pay on top of a fund's management and operational expenses are almost always designed to compensate them. Ideally, the added fee provides for excellent service and help or assistance of one kind or another. There's absolutely nothing wrong with paying for those services as long as you're getting what you wanted and expected when you decided to shell out your bucks. Similarly, there's nothing wrong with going it on your own, as long as you understand what you give up.

The decision to buy no-load funds directly from fund companies and not pay an intermediary of any kind is therefore best made out of the conviction that one is going to do all the necessary work of research, monitoring, and so on for himself or herself. If you're not willing to do that, however, buying funds will ultimately look little different than tossing coins into a fountain. It's probably best to start by appreciating that for most people these days, the decision is no longer whether to go the "load" route or to go fully "no load," though both remain valid choices, Rather, most investors are just trying to decide what kind of intermediary to use and at what price for which services.

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Eric Jacobson has a position in the following securities mentioned above: DELL Find out about Morningstar's editorial policies.
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