Opinion and Investing Column

KIM: Protect yourself when buying mutual fund shares

February 16, 2013

KimMutual funds offer investors access to a professionally managed, diversified portfolio of securities that would be difficult for a small investor to replicate. While the concept of a mutual fund is beautiful in its simplicity, actually investing in one can be complicated.

To a great extent, mutual funds are still sold, not bought. This may seem like an insignificant twist of semantics, but it can make a huge difference in how your investments perform.

In general, mutual funds can be divided into two broad categories. “Load” funds levy a sales charge, paid for by the investor, that compensates financial advisers for their advice in choosing the fund.

“No-load” funds, by contrast, are for the do-it-yourself investor and do not carry a sales charge. It’s like buying directly from the manufacturer, cutting out the cost of the middleman. Since there is no sales charge from which to pay an adviser, it is highly unlikely that a commission-based (vs. fee-only) adviser will ever recommend a no-load fund, regardless of its merit. We are familiar with this phenomenon.

A single-load fund can have a confusing alphabet soup of 12 or more classes of shares, but the three primary classes are “A,” “B” and “C.”

Buyers of “A” shares pay a front-end load at time of purchase. Assume you write a $10,000 check for the purchase of “A” shares with a 5-percent load. That $500 is deducted immediately to pay the adviser, and only the remaining $9,500 is used to purchase shares. That means the fund has to gain 5.26 percent just to get you back to even, a deep hole to escape.

Buyers of “B” shares pay a deferred, or back-end, load when the shares are eventually sold. So that $10,000 check cited above is used to purchase shares. The sales load, which decreases to 0 percent over a set number of years, is deducted from the sales proceeds. However, “B” shares don’t ever actually escape paying a load, even at 0 percent. Distribution and service charges (known as 12b-1 fees) on “B” shares tend to be higher than those for “A” shares. While the back-end load decreases over time, the accumulated 12b-1 fees can offset most—if not all—of the entire decline.

“C” shares charge a “level load” that remains at a constant rate, also via an elevated 12b-1 fee. However, unlike “B” shares, “C” shares never convert to “A” shares. This means you are paying a load for as long as you own the shares, which can be an expensive proposition.

Sales loads are a significant drain on performance, but you don’t have to pay them. Lipper and Morningstar research and rank thousands of no-load funds. Fund supermarkets like Charles Schwab, Fidelity, TD Ameritrade and E*Trade offer easy-to-use screening tools.

If you choose to use an adviser, never make an investment until you understand the charges and expenses and exactly why your adviser is recommending a particular fund and share class. Financial incentives can color the advice you receive, so check it by using the Financial Industry Regulatory Authority’s fund analyzer tool at www.finra.org.

Protect yourself. Know what you’re paying and why.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.

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