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Brilliant But Not Free!

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Just a few years ago, if you wanted to sell one no-load mutual fund to buy one from another company you had to write (that’s right-snail mail!) to the first fund company to ask them to liquidate your shares and send you a check. The mail took a few days, and the fund companies took a few more days to open it. Then they sold your shares and a few days later cut you a check. Eventually the check found its way back through the snail mail to your home. Then you had to deposit it in your bank and wait for it to clear before you could open an account with company two. Of course, the check laid around in the mail and during processing before the new account was set up and credited. All in all, the process might take a month, and your money would be out of the market somewhere in limbo.

Imagine the convenience when the early discount brokers announced that they would hold no-load funds in their accounts, and do trade for a modest transaction fee! The fund supermarket was a big step forward. What had once been a long ordeal was now a reasonably pleasant telephone call and trades settled overnight. Ah, sweet progress!

But, the next step was really brilliant. The discount brokers would do the trades for free among certain participating no-load funds. Well, free wasnt quite the right word. There was no direct charge to the investor. But, surely you don’t think is was free?

In fact, the brokers were charging the fund companies 0.25% (now 0.45%) of net assets each year, for shelf space in their supermarket. The brokers reasoned that they assumed responsibility for many of the functions that the funds had to provide such as prospectus delivery, customer support, and custody. The brokerage house was only charging for services that they provided to the fund.

All true, but the reality was that the brokerage houses soon became the primary distribution channel for the funds, and that failure to participate could easily consign many small funds to oblivion. On the other hand, participation and a little run of luck in performance could propel even a tiny obscure fund to the top ranks in gathering new assets. Funds clamored to join up.

But, do the various No-Transaction Fee (NTF) services drive up fund expenses? The brokerage houses claim that the cost is the same whether you use the service or not. They are deliberately missing the point. It’s true that if you buy the same class of fund from a brokerage or the fund company directly, the cost will be the same.

But, having to pay 0.45% per year is a major expense. These costs must be included in a fund’s operating expense ratio. Some funds do not have total expense ratios that large. They can obviously not afford to pay the brokerages without increasing fees significantly.

In some cases, the fund company creates a class of shares with higher expenses simply to participate in the NTF programs. Under what has been called the “hub and spoke” arrangement some fund families issue the same fund shares at different prices The fund (hub) is the same, but shares are sold to different investors with different prices (spokes).

Many fund families feel compelled to participate in the NTF programs. The brokerages are the 900 pound gorillas of the mutual fund distribution game. Not playing may mean that a fund is denied a key distribution channel. At the end of the day, the NTF program is a prime factor in the escalating expense ratios of mutual funds. It’s also a giant part of the discount brokerage’s profits. Just multiply 0.45% times a few hundred billion of funds that the brokers hold in various NTF programs to see what kind of revenue the program yields.

It’s often much, much cheaper to pay the one time expense of a transaction fee. For instance, suppose you were considering a $10,000 mutual fund purchase. Your trade-off is to pay a one-time transaction charge of $22 for Fund A, or a continuing charge of $45 each year in hidden fees (0.45% of $10,000) in Fund B. Bigger purchases are much, much worse! The math is pretty simple, the logic for choosing the transaction fee compelling. This dirty little trade secret is one that the brokerages would just as soon that you didn’t understand.

On average, funds that participate have higher expenses than funds that do not. We think you should buy funds with the lowest expenses, and that the tradeoff between the NTF funds and the funds that carry one-time transaction fees should be understood.