Why No-Load Funds Trump Loaded Funds Every Single Time

by Kevin on October 22, 2008

Yesterday we talked about loaded funds and how poor of an investment choice they are. I wrote that I’d tell you why no-load funds are the superior investment choice today.

Why Pay for Something You Can Get for (Almost) Free?

We’re not talking about pirating movies or music. We’re talking legal investment choices. The Franklin Templeton funds we discussed have egregiously high expense costs. Costs that take money out of your pocket and put it into the pockets of the company that your funds are invested in. Money out of your pocket and into the hands of the “financial adviser” that sold you the fund.

None of these really high fees benefit you. Period.

Granted, you will always have some sort of expense ratio on a fund. Companies won’t invest for you for free… not by a long shot.

But there is a big difference between the following expense ratios: 0.07%, 0.21% and 1.83%. The first is for a Vanguard ETF (Exchange Traded Fund, similar to a mutual fund, we’ll talk about these in the future). The second is Vanguard’s Target Retirement 2050 fund. And the third is the example from two days ago — one of the Franklin Templeton funds my friend is invested in.

Which is the best investment? It depends. But I can guarantee you 10 times out of 10 it isn’t the one with the high expense ratio.

You can choose to invest in a fund with a load (front or deferred), or you can invest in a very similar fund without a load. Why would you choose to lose some of your investment when cheaper alternatives are available?

Embracing Average Returns

Most people, in their heart of investing hearts, instinctively want to chase high returns. Psychologically it makes a lot of sense. You see an ad in a finance magazine about this new hot fund with very high returns over the last year. “I better get in while the fund is still hot,” you think.

In the end you will be chasing returns, moving from hot fund to hot fund, wondering why your returns are dismal. Essentially you are buying near the peak of the fund.

We talked about this a while back with a post called Embracing the Beauty of Being Average.

The above chart is an example of what you might experience out of an actively managed fund. The blue line is what you might expect out the index… average returns. The red line represents the ups and downs of the fund over time. Some years it will out perform the index. Others it will lag that index.

However, over time, the fund will give you at best average returns. It is nearly impossible for actively managed funds to always outperform the market.

Another way to look at high expense ratios

Sometimes I prefer to explain it to people this way: let’s say you could get a similar index fund with 0.21% and the fund you are invested in charges you 1.5% instead. The fund team is essentially saying that they will outperform the index every year by 1.29%.

That may not seem like a huge hurdle. It’s just a bit more than 1%, right? Over the long run though that is a lofty goal.

In the end those loaded funds, or even just no-load funds with high expense ratios, will lag behind index funds. Stick with an investment plan, and invest in regular intervals. Set it and forget it, and get on with your life.

What do you readers think? Are you convinced that no-load funds are better than loaded funds?

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October 24, 2008 at 8:46 am

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Russ October 22, 2008 at 9:55 am

And here’s another perspective on ridiculously high fees . . .

Let’s say your fund of choice has an annual expense ratio of 1.5% (and there are many with much higher fees than this), in an average year of equity returns let’s say your fund earns 10% gross (before deduction of fees), that means you’re giving 15% of your total return away.

Finally, the expense ratio is the mandated public display of costs associated with a mutual fund, but it doesn’t tell the whole story.

You must also include the fund’s brokerage costs associated with buying and selling within the fund. These can typically be found buried in a funds SAI (Statement of Additional Information), and curiously, these SAI documents are notoriously buried within a mutual fund company’s website (in my experience.)

Mel October 25, 2008 at 9:32 pm

Very informative post! So I just learned my parents have a couple of these load funds in their IRA. Performance wise, they’ve done no better than other standard index funds. Given the state of the market right now, would it make sense to trade them in for no-load funds?

Kevin October 28, 2008 at 12:25 pm

@Russ: Excellent point.

@Mel: I would say yes it would make sense to sell them. They’ll get the side benefit of writing off up to $3,000 of the losses off of their taxes (and carry forward any extra losses). There are specific rules to follow — that is, the funds they buy cannot look just like the funds they sold. You couldn’t trade an S&P 500 index fund for another S&P 500 index fund. If you wanted to do that, they would have to wait 30 days. Look into the IRS rules for this.

Other than that, I would say any time is a good time to get out of high expense funds and into low expense funds.

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