Mutual funds can be divided into two broad categories load funds and no-load funds. Load funds use the assistance of a professional to market the fund to investors. The intermediary may be a mutual fund salesperson, a stock broker, or an insurance agent. In such cases, the initiative is taken by the salesperson and we say that the fund is sold and not bought.
The standard practice earlier was to levy a sales charge known as an entry load or a front-end load. That is, investors were required to purchase the shares by paying more than the net asset value (NAV) of the fund, with the difference being used to compensate the salesperson. In the case of no-load funds, there is no intermediary. The fund will usually advertise and give a toll-free number, which can be used by investors to obtain a fund prospectus. Since the initiative in such cases is being taken by the potential investor, we say that the fund is bought and not sold.
There was a time when people in the West thought that load funds would cease to exist. The argument was that, given the fact that investors are getting more market-savvy by the day, why would a rational investor continue to use an intermediary whose services have to be paid for However, load funds continue to be popular. There are two reasons for this. One is many investors psychologically continue to be dependent on the advice of a sales professional. Secondly, mutual funds have devised alternate methods of imposing loads, which appear relatively painless to a potential investor.
One innovation is what is known as a back-end or an exit load. In such cases while an investor enters the fund at the prevailing NAV, a sales charge is deducted when he or she exits the fund. A very popular version of an exit load is what is known as a contingent deferred sales charge (CDSC). In this case, the exit load percentage decreases, the longer one stays invested with the fund, and usually tapers off to zero over a period of time.
Take, for instance, a 3,2,1,0 contingent deferred sales charge. It would mean that an exit load of 3% is applicable if one were to exit within a year; 2% if the investor were to stay longer than a year, but less than two years; 1% if he were to stay longer than two years, but less than three years; and that no load is applicable if the investor were to exit after three years. A second innovation is what is known as a Level Load. In such cases, the investor enters and exits the fund at its prevailing NAV.
However, the fund levies a sales charge every year in the form of an annual fee, which manifests itself as a decrease in the NAV. Behavioural research in US has shown that there exists a category of investors who have been labeled as fee-based planners. Such investors are uncomfortable paying levies, such as loads or commissions, but find an annual fee, such as a level load, to be perfectly acceptable. In the case of both exit loads as well as the level loads, the entire amount paid by an investor to acquire the shares of the fund, is invested in the fund portfolio. This is unlike funds with entry loads, where the load is deducted from the price paid, and only the balance is invested.
There are funds that allow the investor to choose the kind of loading mechanism that he would like by offering multiple share classes. These funds typically offer three classes of shares. Class A shares, if acquired, would entail the imposition of an entry load; class B shares are characterised by an exit load; and class C shares are suitable for investors who prefer level loads.
From an investment standpoint, such as the composition of the funds portfolio, an investor gets the same market exposure, irrespective of which class of shares he chooses to opt for.
It was observed over a period of time that while loads provide a one-time compensation to a salesperson for his initiative, there is a need to motivate him or her to continue to service the account and induce further business for the mutual fund. Most of you would be familiar with this in the context of a life insurance agent. Such a salesperson would approach an investor once a he gets a job in order to sell a policy. Subsequently, he will return on other occasions in the clients life, such as marriage and/or the birth of children. For this reason, the Securities Exchange Commission in the US approved the levy of an annual fee known as a 12b-1 fee. This is an annual fee, a portion of which is used to offer an ongoing compensation to sales professionals for their services. The balance is intended for the funds advertising and marketing expenses.
The writer is author of Fundamentals of Financial Instruments, published by Wiley India