Summary - Mutual funds are one of the most popular investment instruments particularly for novice investors or investors with only a modest amount of money to invest. However, one of the important responsibilities for every investor is to understand the cost of owning the fund. One of the most important, and potentially largest, expenses associated with fund ownership is the concept of a load. A load is a sales charge or commission that mutual fund companies charge either at the time shares are purchased (front-end) or when the shares are redeemed (rear-end).
Front-end loads are paid whenever new money is put into an investor’s account to buy shares. This purchase fee can be up to 5.75%. Investors who are willing to put up a larger dollar amount can achieve what is called breakpoints that will lower the percentage of the front-end load on any new shares purchased. Even if an investor’s initial investment is not at a breakout level, they can still get the lower percentage if the fund’s earnings rise to a particular breakout level. If a fund’s total assets under management exceed $1,000,000, the front-end load is waived.
Investors are frequently told to never buy a load mutual fund, particularly one with a front-end load because it means the fund is always starting at a deficit that it may never be able to make up. However, a front-end load is a one-time fee that is charged for owners of mutual funds. Although they are still subject to additional service fees that can over time reduce the amount of their fund assets, the fees are generally lower than other classes of shares. This is why, over time, a fund that charges a front-end load can be more cost-effective than investing in a no-load fund. In fact, personal finance professional Dave Ramsay advocates that investors always own funds with front-end loads as part of their portfolio.
When comparing the real cost of owning a mutual fund, the concept of a sales charge (or load) can be summed up in the expression pay now or pay later. Loaded funds are a source of debate among investment professionals. A load mutual fund comes in two varieties. Funds with front-end loads charge fees that investors will pay when they purchase their shares. Funds with rear-end loads are paid when an investor decides to redeem shares. A rear-end load fee is generally smaller than a front-end load and may shrink as a percentage the longer an investor owns their shares. Loaded funds of either type are an incentive to prevent excessive buying and selling activity within a fund.
There are also “no-load” funds which have become popular as both the number and type, of mutual funds has exploded. Although frequently touted because more of an investor’s money is going into the fund initially, these funds are not “no fee”, just no load. This means an investor should pay particular attention to the varying fees that can reduce the value of their investment over time.
In this article, we’ll break down front-end loads and in addition to defining what they are, we’ll answer questions like how front-end loads impact an investment, why the percentage of a front-end load may be different for different investors, and review some of the benefits of front-end loads.
What is a front-end load?
A front-end load is a sales charge that an investor pays at the time they purchase shares in a mutual fund. They are called front-end because they are paid once, at the time the shares are purchased, but they are not paid again. The opposite of a front-end load is a rear-end load. This is a redemption fee that is paid at the times the shares are withdrawn from the fund. Although most commonly thought of in reference to mutual funds, front-end loads are common for other investment instruments like annuities and life insurance policies. Front-end loads are paid to financial professionals (e.g. financial planners, brokers, investment advisors. This load is waived if the investor is putting money into a retirement plan such as a 401(k).
Front-end loads are referred to as a fund’s “Class A” shares. The sales charge (or load) is added into the price that an investor pays for their shares. If the net asset value (NAV) of a particular fund’s shares is $19 and come with a 5% sales load. An investor would pay $20 per share on their initial investment. However, each share would then be worth the NAV price of $19.
A front-end load is not part of a fund’s operating expenses. This is important in evaluating the true cost of fund ownership because a load is only one of many fees associated with a mutual fund including 12b-1 fees, which pay for the marketing and distribution expenses associated with the fund and other service fees such as the yearly maintenance fees. These additional fees and charges are typically very small individually but can eat away at any profit made in the fund. The fees associated with class A shares are usually less than those charged for rear-load and no-load funds. This can help ensure that an investor recovers the cost of their front-end load quickly and retains more of their profit. An investor should be sure to check the fee table associated with any mutual fund they are considering investing in, whether it carries a load or not.
Loads can serve as an incentive for investors to avoid frequently trading into and out of mutual funds because such activity will eat away at their initial investment. For this reason, if investors are looking to purchase a front-end load, they should do so with the intention of staying with the fund at least until the point where the fund’s earnings have offset the initial load.
How do front-end loads impact an investment?
Because mutual funds can be purchased in partial share increments, it’s better to look at a load from the standpoint of the total investment. Let’s look at an example where an investor is interested in investing $10,000 in a particular fund that charges a 4% front-end load. In this example, of the entire $10,000 investment only $9,600 will be invested into the fund. The remaining $400 is paid as a sales charge (or commission) to the fund company. Before making this investment, the investor should review the fund’s performance over several years. The goal is to ensure that in a fairly short period of time, the fund’s earnings should offset, and surpass, the cost of the front-end load. If the fund has a great year and generates a 10% return, an investor who bought a rear-load, or no-load, fund would have a balance of $11,000 (less fees). The investor with class A shares would have a fund balance of $10,560 (less fees). They would require an additional 4.6% return per year to match the fund balance of a fund without a front-end load.
Is the amount of a front-end load the same for every investor?
The load percentage an investor pays correlates to the amount of money being invested. The larger the amount of capital being invested, the smaller the load percentage they will be charged. The levels at which the sales charge is reduced are called breakpoints. Typical breakpoints are $25,000, $50,000, or $100,000. If an investor cannot put up the full amount to reach a certain breakpoint at the time of their initial investment, but knows they will have the additional funds within a period of time (usually about a year) to reach a particular breakpoint threshold, they can sign a letter of intent stating that they will invest enough over that year to reach the breakpoint.
Breakpoints also apply to the earnings of a fund. If the investor’s assets in the fund reach a breakpoint level, they will pay the reduced load on any new fund purchases. This is one way that a front-end load can encourage investors to buy and hold particular funds.
Do investors pay a separate front-end load every time they buy additional shares?
The short answer is yes. In a mutual fund with a front-end load, there will be a separate sales charge for every new investment beyond the initial investment. There are two exceptions. The first is if an investor is making a contribution of over $1 million. At this level, investors reach a breakpoint where the load percentage goes to zero. The second way is to reinvest dividends and capital gains distributions. The additional shares that are acquired in this transaction are purchased at the net asset value (NAV) price without a sales charge.
The front-end load is charged on the initial investment and any shares that are purchased with new money that enters the fund. If an investor wants to exchange their shares in one fund and move it to another fund within the same fund family. They will not pay a separate sales charge on this transaction.
Benefits of front-end loads
Despite the fact that many advisors would tell an investor to never invest in a fund that charges a load, there are several potential benefits to paying a front-end load. First, the total annual expenses of class A shares (those charged a front-end load) will be less than with class B shares. This is because the 12b-1 fee for class A shares is typically anywhere from 0.6 to 0.75 lower than class B shares because investors have already paid their broker’s commission. This also means that if investors are only looking at the NAV price, class B shares will underperform class A shares by up to 0.75 percent on an annual basis for every year the fund is owned. The second benefit comes if an investor is willing and able, to invest a sum of money that qualifies them for a breakpoint. In this case, an investor could actually be paying a lower percentage front-end load than they would on a back-end load.
Another advantage to paying a front-end load is that it is a one-time expense. This means that the fund – and any future earnings can continue to grow without any erosion that can be caused by expensive fees. This means that the longer an investor owns a fund, the less of an impact the initial load will have. In fact, personal finance professional Dave Ramsay cites the idea of more fixed fund costs as one important reason for investors to own mutual funds that charge front-end loads.
Yet another benefit of the front-end load is the reason it exists. Namely, that an investor is paying a front-end load to receive knowledgeable advice from a financial professional. For novice investors, the front-end load is not a significant cost to get expert advice.
The bottom line on front-end loads
Front-end loads are sales charges, or commissions, that an investor pays on their purchase of class A shares in a mutual fund. These funds are deducted from an investor’s initial purchase in such a way that the investor’s shares are still worth the net asset value (NAV) of the fund at the time of purchase.
Not all front-end loads are the same. The exact amount of the load will depend on how much an investor is putting into a fund. At certain breakpoints – such as $25,000, $50,000 and $100,000 an investor will pay a lower front-load percentage. There is no load charged on funds whose value is over $1,000,000. Once an investment reaches a certain breakpoint level, the investor will receive a lower percentage on subsequent purchases.
This is significant because although the front-end load is a one-time charge (meaning that there is no redemption charge), investors will continue to pay this sales charge every time they purchase new shares. One exception is typically given if they are purchasing new shares as part of a dividend reinvestment plan or because they are reinvesting capital gains.
Proponents of front-end loads will argue that the front-end load is simply the cost that an investor pays to received expert advice on their fund selection. The counterargument to this is that performance over time does not suggest that load funds outperform no-load funds. Still, for buy-and-hold investors, a fund with a front-end load will have lower annual expenses over time.