Yes, Virginia, There Are No-Load Products

Is there really such a thing as a no-load mutual fund?

Depending on whom you talk to, you might conclude that this, like other supposed free lunches, doesn’t exist.

Cella Quinn, an investment broker in Omaha, Neb., gave the issue some visibility recently in an open and widely circulated letter she wrote to the Securities and Exchange Commission. Among other things, she complained that there aren’t any no-load portfolios, since all funds charge costs borne by shareholders.

“I always put the ‘no’ in quotes because we both know there aren’t any no-load funds,” Quinn told the agency. She agreed that the idea sounds great, “like free beer, free cable TV, free legal advice.”

Yet this sort of criticism of no-load funds, which undoubtedly is shared by more than a few commissioned investment salespeople, merely muddles the issue. For although there aren’t any free funds, there are plenty of no-load products.

The key is to get your definitions straight.

“To the extent that you define ‘load’ to mean ‘sales charge’--as it’s typically thought of--then there are true no-loads,” says Steve Norwitz, a vice president at T. Rowe Price Associates, a no-commission fund family in Baltimore.

No-load funds do have operating expenses that are borne by shareholders, typically averaging about 1% to 1.5% a year. In this sense, they are certainly not free.

But, unlike load portfolios, they don’t have both operating expenses and a sales charge. This latter cost can run as high as 8.5% but usually ranges between 3% and 6%.

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What about other marketing expenses borne by no-load funds--to buy ads, print prospectuses, operate toll-free phone lines and hire shareholder-service reps?

“You have to charge something someplace,” Quinn rightly noted in a follow-up interview.

But again, these aren’t commissions that go to the broker and his or her firm.

Some costs, such as those for marketing literature, 800-numbers and telephone service representatives, are charged to shareholders as part of the fund’s operating expenses. The annual report will break down these outlays in varying detail.

For example, the annual report of the T. Rowe Price International Stock Fund shows that investors shelled out $4.2 million last year in shareholder service expenses, plus $300,000 for the prospectus and shareholder reports.

Spread over the portfolio’s $1.9-billion asset base, these charges came out to about 0.25%, or $2.50 for each $1,000 investment in the fund.

Advertising outlays can work a bit differently. Some companies, such as T. Rowe Price, absorb this cost directly, without passing it along to fund shareholders. Other firms finance advertising through what’s known as the 12b-1 charge.

Advertising “was the original announced purpose of the 12b-1 fee, although its main utilization has since been as an alternative to the front-end load,” says L. Erick Kanter, a vice president at the Investment Company Institute in Washington.

“The companies that do the most advertising are the pure no-loads, which in essence are paying for it out of their management fees,” Kanter says.

Any 12b-1 fees, whether for advertising or broker compensation, will show up in the fund’s expense ratio inside the prospectus or annual report. The prospectus will also highlight any sales load, which isn’t included as part of the expense ratio.

If anything, brokers, rather than no-commission fund companies, have been more sinful about using the term no load in a loose or inaccurate fashion.

In fact, SEC regulations that went into effect in July seek to remedy this problem: They prohibit salespeople from describing funds with a 12b-1 fee greater than 0.25% as no-loads.

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All this isn’t to denigrate the assistance a good broker can give. Investors who don’t have the time, patience or skill to pick and monitor mutual funds by themselves would be penny-wise and pound-foolish not to let a professional do it for them.

“My investment judgment is a valuable asset that I give my clients because I know them and I know my mutual funds,” wrote Quinn, whose main criticism of no-load funds is that they are open for sale to anybody, including people who don’t understand what they are buying.

That is a fair argument to make.

But it is incorrect to deny that no-load portfolios exist just because they are not free of all costs.

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Fears that the mutual fund boom has been fueled by novice investors fleeing low bank yields may be exaggerated, a new survey suggests.

Only 5% of the respondents who bought a stock or bond fund for the first time between July, 1991, and July, 1993, did so with proceeds from maturing certificates of deposit, according to a telephone survey conducted for the Investment Company Institute of Washington.

Among the more common ways that novice investors paid for mutual funds, 43% cited current-income sources such as bonuses and tax refunds, while 33% said they liquidated financial holdings other than CDs.

These findings address fears that first-time mutual fund buyers--many of them unsophisticated bank customers--could panic and sell during the next stock or bond bear market, putting additional downward pressure on fund prices.

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It’s been little more than a year since short-term world income funds--which once were deemed to be pretty safe, high-yielding investments--got an unexpected and widely publicized black eye.

It happened when European currency exchange rates gyrated wildly in August and September, 1992, leading to losses on some short-term foreign debt securities the funds held.

The currency markets have since settled down, but the short-term world funds, also known as multimarket portfolios, are still having a rough time of it.

Assets for the group have dropped about 50% since peaking in the summer of 1992, and the funds have returned a mediocre 4.2% for the year to date through Oct. 22, according to Morningstar Inc., the Chicago-based fund rating service.

In addition, some of these portfolios are more volatile than they were in the past, as managers have been forced to buy slightly longer-term or lower-rated bonds to prop up yields.

In general, Morningstar is lukewarm, predicting that the funds will not resemble “the terrific products they appeared to be early on.”

The No-Load Edge

From a cost perspective, no-load mutual funds enjoy an advantage over load portfolios because they don’t levy a sales charge. But what about other, ongoing expenses that all funds pass along to shareholders--are no-loads also cheaper here?

In many cases, yes. The following table shows median annual expense ratios for selected categories of funds, using information compiled by Morningstar Inc. of Chicago.

Note that while expense ratios don’t include loads, they do include 12b-1 fees, a type of marketing cost applied mostly to funds with either a front- or back-end sales charge.

Load funds No-load funds Fund category Avg. expense ratio Avg. expense ratio Balanced (stock and bond) 1.15% 1.15% Corporate bond 0.88% 0.77% Growth stock 1.32% 1.12% International stock 1.75% 1.65%

Source: Morningstar Mutual Fund Performance Report