Loaded Down

iktor Frankl, the Viennese psychotherapist who survived the horrors of Auschwitz, suggested in his classic book Man's Search for Meaning that life's demands and stressors strengthen us. Dr. Frankl also used a metaphor which has application here. If architects want to strengthen a decrepit arch, they increase the load which is laid upon it, for thereby the parts are joined more firmly together.

Thus, Dr. Frankl believed that life's meaningful demands and stresses build stronger souls. Carrying the loads of life, he suggested, makes us stronger. Frankl was fond of a thought from Friedrich Nietzsche, "What does not destroy me, makes me stronger". (Such a perspective, after the equity meltdown of 2000-2002, might be a helpful paradigm for many planners…and their clients.)

Transitioning from the sublime to the mundane, this article examines how well mutual fund portfolios have held up in recent years under the "loads" (i.e. front or deferred commissions) placed on them. Indeed, the never ending question understandably is "do load funds earn back their load?"

A particular point of emphasis in this research was to investigate the notion that load funds have lower expense ratios, a point which is occasionally advanced by firms which assess loads. The party line being that - over time - a lower expense ratio partly, or perhaps fully, offsets the impact of a front or deferred load.

Funds (whether load or no-load) included in this study were domestic funds in the Morningstar Principia Pro database which were in existence over the entire 3 year period and which had less than 20% of their portfolio in bonds, non-U.S. equities, and cash. The "distinct portfolios" filter was used, meaning that only one share class of multiple share class portfolios was retained. Typically this would be the share class with the largest asset base. Institutional funds were omitted from the sample. The final sample size is shown in Figure 1.

Funds which were included as "no-load" funds were funds which had no front or deferred commission. However, Morningstar includes funds which have a 12b-1 fee of .25% or lower in their "True No-Load" category. Thus, no-load funds in this study had, in some cases, a small 12b-1 fee. However, given that the 12b-1 is included in the expense ratio, it is accounted for. Load funds, in this study, included any fund with a front end, a deferred load, or a 12b-1 fee greater than .25%.

Let's start with a comparison of total annualized pre-tax return over the three year period from 2000-2002 (see Figure 2). Load-adjusted returns (for load funds) were utilized in this study, meaning that the returns were adjusted to account for front loads and deferred loads.

Very simply, no-load funds uniformly outperformed load funds. Of course, during this particular time frame (2000-2002) the "winners" are those funds which did less poorly! The margin of superiority among no-load funds (using style category averages) was as small as 10 basis points and as large as 430 basis points. Superior no-load performance was most notable in the small cap category, however, no-load funds outperformed load funds in each of the nine Morningstar style categories over this particular three year period.

Figure 3 reports the three year annualized returns for the same funds after considering the impact of taxation. The after-tax results reported in Figure 3 were obtained by using what Morningstar refers to as "Return After Taxes on Distributions and Sale". This figure reflects the effect of both taxable distributions by a fund to its shareholders and any taxable gain or loss realized by the shareholder upon the sale of fund shares. As can be seen by comparing these results with those in Figure 2, the no-load advantage was trimmed among seven of the nine categories by an average of 60 basis points. For instance, among large-cap value funds, the no-load pre-tax advantage of 150 basis points was trimmed to 110 basis points after considering the full impact of taxation. Among small-cap growth funds, a 430 basis point no-load advantage was lowered to 340 basis points after considering taxation. These results suggest that load funds are moderately more tax-efficient than no-load funds.

One possible explanation (at least in part) for the higher tax-efficiency of load funds is turnover ratio (Figure 4). Higher portfolio turnover has the potential to create greater tax liability. From the data in Figure 4 we observe that load funds tend to have lower turnover ratios compared to no-load funds. The margins of difference are not enormous, but relatively consistent across the 9 style categories. In seven of the nine categories load funds have a lower turnover ratio. One category (mid cap value) the ratio is essentially the same, and among small cap blend funds the no-loads have a slightly lower ratio. Thus, for whatever reason, load funds generally have lower turnover which shows up fairly consistently in the form of better tax efficiency.

Finally, the expense ratio issue. As shown in Figure 5, no-load funds had lower average expense ratios than load funds in each of the nine categories. In fact, no-load fund had expense ratios which, on average, were about 37 basis points lower than the average load fund. Recall that the average no-load fund had a 3 year annualized return which averaged about 200 basis points higher (see Figure 2) than the average pre-tax return among load funds. Thus, the lower cost structure of no-load funds was only partly responsible for their superior performance.

A significant component of the expense ratio for many funds, both load and some "no-load" funds is a 12b-1 fee. NASD guidelines prohibit this fee from exceeding 1%. Over 82% percent of the 684 load funds in this study had a 12b-1 fee. For load funds with a 12b-1 charge, the average fee was .47%. Nearly 44% of the load funds which assess a 12b-1 charged exactly .25%. Among load funds, only 16 out of 684 were funds where the 12b-1 was the only load (in which case it was in excess of .25% otherwise it would have been considered a no-load fund). In other words, nearly 98% of the time it was a front or deferred load which caused a fund to be categorized as a "load fund", rather than simply a large 12b-1 fee. Nearly 60% of the load funds had a 12b-1 fee of .25% or lower.

By comparison, among the 813 no-load funds in this study, only 192 had 12b-1 fees (representing just under 24% of the sample). Of that total, 162 funds had a 12b-1 of exactly .25%. The average 12b-1 fee among no-load funds was .23%. Therefore, most funds - whether load or no-load - have a 12b-1 fee which is very near .25%. It should not be surprising to recall that NASD guidelines prohibit a mutual fund from calling itself a no-load fund if the distribution fee (i.e. 12b-1) is greater than .25%.

In summary, over the three year period from 2000 to 2002, the presence of a load did not make funds stronger, at least as measured by pre-tax or after-tax return. Perhaps Nietzsche's insight doesn't pertain to the performance of equity portfolios, but rather the people that invest in them.

Figure 1. Sample Size

Figure 2. 3 Year Annualized % Return (2000-2002)

Figure 3. 3 Year Load-Adjusted, After-Tax Return (2000-2002)

(Assuming taxation on distributions and sale)

Figure 4. 2002 Turnover Ratio (%)

Figure 5. 2002 Expense Ratio (%).