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2001. Reprinted by
permission of Dow Jones &
Company, Inc., via
Copyright Clearance Center,
Inc. © 2001 Dow Jones &
Company, Inc. All Rights
Reserved Worldwide.




How Funds Are Sold
Most mutual funds have an underwriter that has exclusive rights to distribute shares to in-
vestors. Mutual funds are generally marketed to the public either directly by the fund under-
writer or indirectly through brokers acting on behalf of the underwriter. Direct-marketed funds
are sold through the mail, various offices of the fund, over the phone, and increasingly, over
the Internet. Investors contact the fund directly to purchase shares. For example, if you look
at the financial pages of your local newspaper, you will see several advertisements for funds,
along with toll-free phone numbers that you can call to receive a fund™s prospectus and an ap-
plication to open an account with the fund.
A bit less than half of fund sales today are distributed through a sales force. Brokers or fi-
nancial advisers receive a commission for selling shares to investors. (Ultimately, the com-
mission is paid by the investor. More on this shortly.) In some cases, funds use a “captive”
sales force that sells only shares in funds of the mutual fund group they represent.
The trend today, however, is toward “financial supermarkets” that can sell shares in funds
of many complexes. This approach was made popular by the OneSource program of Charles
Schwab & Co. Schwab allows customers of the OneSource program to buy funds from many
different fund groups. Instead of charging customers a sales commission, Schwab splits man-
agement fees with the mutual fund company. The supermarket approach has proven to be pop-
ular. For example, Fidelity now sells non-Fidelity mutual funds through its FundsNetwork
even though many of those funds compete with Fidelity products. Like Schwab, Fidelity
shares a portion of the management fee from the non-Fidelity funds it sells.


4.4 COSTS OF INVESTING IN MUTUAL FUNDS
Fee Structure
An individual investor choosing a mutual fund should consider not only the fund™s stated
investment policy and past performance, but also its management fees and other expenses.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




108 Part ONE Elements of Investments


Comparative data on virtually all important aspects of mutual funds are available in the annual
reports prepared by Wiesenberger Investment Companies Services or in Morningstar™s Mutual
Fund Sourcebook, which can be found in many academic and public libraries. You should be
aware of four general classes of fees.

Front-end load A front-end load is a commission or sales charge paid when you pur-
chase the shares. These charges, which are used primarily to pay the brokers who sell the
funds, may not exceed 8.5%, but in practice they are rarely higher than 6%. Low-load funds
have loads that range up to 3% of invested funds. No-load funds have no front-end sales
charges. Loads effectively reduce the amount of money invested. For example, each $1,000
paid for a fund with an 8.5% load results in a sales charge of $85 and fund investment of only
$915. You need cumulative returns of 9.3% of your net investment (85/915 .093) just to
break even.

Back-end load A back-end load is a redemption, or “exit,” fee incurred when you sell
your shares. Typically, funds that impose back-end loads start them at 5% or 6% and reduce
them by one percentage point for every year the funds are left invested. Thus, an exit fee that
starts at 6% would fall to 4% by the start of your third year. These charges are known more
formally as “contingent deferred sales charges.”


Operating expenses Operating expenses are the costs incurred by the mutual fund in
operating the portfolio, including administrative expenses and advisory fees paid to the in-
vestment manager. These expenses, usually expressed as a percentage of total assets under
management, may range from 0.2% to 2%. Shareholders do not receive an explicit bill for
these operating expenses; however, the expenses periodically are deducted from the assets of
the fund. Shareholders pay for these expenses through the reduced value of the portfolio.

12b-1 charges The Securities and Exchange Commission allows the managers of so-
called 12b-1 funds to use fund assets to pay for distribution costs such as advertising, promo-
tional literature including annual reports and prospectuses, and, most important, commissions
paid to brokers who sell the fund to investors. These 12b-1 fees are named after the SEC rule
12b-1 fees
that permits use of these plans. Funds may use 12b-1 charges instead of, or in addition to,
Annual fees charged
front-end loads to generate the fees with which to pay brokers. As with operating expenses,
by a mutual fund to
investors are not explicitly billed for 12b-1 charges. Instead, the fees are deducted from the
pay for marketing and
distribution costs. assets of the fund. Therefore, 12b-1 fees (if any) must be added to operating expenses to ob-
tain the true annual expense ratio of the fund. The SEC now requires that all funds include in
the prospectus a consolidated expense table that summarizes all relevant fees. The 12b-1 fees
are limited to 1% of a fund™s average net assets per year.1
A relatively recent innovation in the fee structure of mutual funds is the creation of differ-
ent “classes”; they represent ownership in the same portfolio of securities but impose differ-
ent combinations of fees. For example, Class A shares typically are sold with front-end loads
of between 4% to 5%. Class B shares impose 12b-1 charges and back-end loads. Because
Class B shares pay 12b-1 fees while Class A shares do not, the reported rate of return on the B


1
The maximum 12b-1 charge for the sale of the fund is .75%. However, an additional service fee of .25% of the fund™s
assets also is allowed for personal service and/or maintenance of shareholder accounts.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




109
4 Mutual Funds and Other Investment Companies


shares will be less than that of the A shares despite the fact that they represent holdings in the
same portfolio. (The reported return on the shares does not reflect the impact of loads paid by
the investor.) Class C shares do not impose back-end redemption fees, but they impose 12b-1
fees higher than those in Class B, often as high as 1% annually. Other classes and combina-
tions of fees are also marketed by mutual fund companies. For example, Merrill Lynch has in-
troduced Class D shares of some of its funds, which include front-end loads and 12b-1 charges
of .25%.
Each investor must choose the best combination of fees. Obviously, pure no-load no-fee
funds distributed directly by the mutual fund group are the cheapest alternative, and these will
often make the most sense for knowledgeable investors. However, many investors are willing
to pay for financial advice, and the commissions paid to advisers who sell these funds are the
most common form of payment. Alternatively, investors may choose to hire a fee-only finan-
cial manager who charges directly for services and does not accept commissions. These ad-
visers can help investors select portfolios of low- or no-load funds (as well as provide other
financial advice). Independent financial planners have become increasingly important distri-
bution channels for funds in recent years.
If you do buy a fund through a broker, the choice between paying a load and paying 12b-1
fees will depend primarily on your expected time horizon. Loads are paid only once for each
purchase, whereas 12b-1 fees are paid annually. Thus, if you plan to hold your fund for a long
time, a one-time load may be preferable to recurring 12b-1 charges.
You can identify funds with various charges by the following letters placed after the fund
name in the listing of mutual funds in the financial pages: r denotes redemption or exit fees;
p denotes 12b-1 fees; and t denotes both redemption and 12b-1 fees. The listings do not allow
you to identify funds that involve front-end loads, however; while NAV for each fund is
presented, the offering price at which the fund can be purchased, which may include a load,
is not.


Fees and Mutual Fund Returns
The rate of return on an investment in a mutual fund is measured as the increase or decrease
in net asset value plus income distributions such as dividends or distributions of capital gains
expressed as a fraction of net asset value at the beginning of the investment period. If we de-
note the net asset value at the start and end of the period as NAV0 and NAV1, respectively, then
NAV1 NAV0 Income and capital gain distributions
Rate of return
NAV0
For example, if a fund has an initial NAV of $20 at the start of the month, makes income dis-
tributions of $.15 and capital gain distributions of $.05, and ends the month with NAV of
$20.10, the monthly rate of return is computed as
$20.10 $20.00 $.15 $.05
Rate of return .015, or 1.5%
$20.00
Notice that this measure of the rate of return ignores any commissions such as front-end loads
paid to purchase the fund.
On the other hand, the rate of return is affected by the fund™s expenses and 12b-1 fees. This
is because such charges are periodically deducted from the portfolio, which reduces net asset
value. Thus the rate of return on the fund equals the gross return on the underlying portfolio
minus the total expense ratio.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




110 Part ONE Elements of Investments


Cumulative Proceeds
TA B L E 4.2 (all dividends reinvested)
Impact of costs on
Fund A Fund B Fund C
investment
performance
Initial investment* $10,000 $10,000 $ 9,200
5 years 17,234 16,474 15,502
10 years 29,699 27,141 26,123
15 years 51,183 44,713 44,018
20 years 88,206 73,662 74,173

*
After front-end load, if any.
Notes:
1. Fund A is no-load with .5% expense ratio.
2. Fund B is no-load with 1.5% expense ratio.
3. Fund C has an 8% load on purchases and a 1% expense ratio.
4. Gross return on all funds is 12% per year before expenses.




To see how expenses can affect rate of return, consider a fund with $100 million in assets at
the start of the year and with 10 million shares outstanding. The fund invests in a portfolio of
4.1 EXAMPLE stocks that provides no income but increases in value by 10%. The expense ratio, including
12b-1 fees, is 1%. What is the rate of return for an investor in the fund?
Expenses and
The initial NAV equals $100 million/10 million shares $10 per share. In the absence of
Rates of Return
expenses, fund assets would grow to $110 million and NAV would grow to $11 per share, for
a 10% rate of return. However, the expense ratio of the fund is 1%. Therefore, $1 million will
be deducted from the fund to pay these fees, leaving the portfolio worth only $109 million, and
NAV equal to $10.90. The rate of return on the fund is only 9%, which equals the gross return
on the underlying portfolio minus the total expense ratio.




Fees can have a big effect on performance. Table 4.2 considers an investor who starts with
$10,000 and can choose between three funds that all earn an annual 12% return on investment
before fees but have different fee structures. The table shows the cumulative amount in each
fund after several investment horizons. Fund A has total operating expenses of .5%, no load,
and no 12b-1 charges. This might represent a low-cost producer like Vanguard. Fund B has no
load but has 1% management expenses and .5% in 12b-1 fees. This level of charges is fairly
typical of actively managed equity funds. Finally, Fund C has 1% in management expenses,
no 12b-1 charges, but assesses an 8% front-end load on purchases.
Note the substantial return advantage of low-cost Fund A. Moreover, that differential is
greater for longer investment horizons.
Although expenses can have a big impact on net investment performance, it is sometimes
difficult for the investor in a mutual fund to measure true expenses accurately. This is because
soft dollars of the common practice of paying for some expenses in soft dollars. A portfolio manager
earns soft-dollar credits with a stockbroker by directing the fund™s trades to that broker. Based
The value of research
services brokerage on those credits, the broker will pay for some of the mutual fund™s expenses, such as data-
houses provide bases, computer hardware, or stock-quotation systems. The soft-dollar arrangement means
“free of charge” in
that the stockbroker effectively returns part of the trading commission to the fund. The ad-
exchange for the
vantage to the mutual fund is that purchases made with soft dollars are not included in the
investment manager™s
fund™s expenses, so the fund can advertise an unrealistically low expense ratio to the public.
business.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




111
4 Mutual Funds and Other Investment Companies


Although the fund may have paid the broker needlessly high commissions to obtain the soft-
dollar “rebate,” trading costs are not included in the fund™s expenses. The impact of the higher
trading commission shows up instead in net investment performance. Soft-dollar arrange-
ments make it difficult for investors to compare fund expenses, and periodically these
arrangements come under attack.


<
2. The Equity Fund sells Class A shares with a front-end load of 4% and Class B Concept
shares with 12b-1 fees of .5% annually as well as back-end load fees that start at
CHECK
5% and fall by 1% for each full year the investor holds the portfolio (until the fifth
year). Assume the rate of return on the fund portfolio net of operating expenses is
10% annually. What will be the value of a $10,000 investment in Class A and Class
B shares if the shares are sold after (a) 1 year, (b) 4 years, (c) 10 years? Which fee
structure provides higher net proceeds at the end of each investment horizon?

4.5 TAXATION OF MUTUAL FUND INCOME
Investment returns of mutual funds are granted “pass-through status” under the U.S. tax code,
meaning that taxes are paid only by the investor in the mutual fund, not by the fund itself. The
income is treated as passed through to the investor as long as the fund meets several require-
ments, most notably that at least 90% of all income is distributed to shareholders. In addition,
the fund must receive less than 30% of its gross income from the sale of securities held for less
than three months, and the fund must satisfy some diversification criteria. Actually, the earn-
ings pass-through requirements can be even more stringent than 90%, since to avoid a sepa-
rate excise tax, a fund must distribute at least 98% of income in the calendar year that it is

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