Hedge funds get a lot of grief over punitively high fees and low returns, with good reason. Among the most hated are so-called “gated” funds, those with rules that lock up investor money for specific periods of time.
The gate is there to protect other investors, and often that includes the manager. If one large investor decides to leave the fund the manager has to sell something to generate cash. Selling under pressure can get ugly.
From the point of view of the departing investor, of course, things look different. Like those late-night TV commercials put it, “I want my money and I want it now!”
Few retirement investors have this problem, since few of us have the kind of money it takes to consider owning pricey hedge funds.
That doesn’t mean you don’t run the risk of having to pay to leave a fund. In fact, it happens all the time.
A new client recently came to my firm, Rebalance, seeking advice on how to invest and, of course, to lower their cost of investing.
Part of what we do is help clients get out of high-fee mutual funds. We then use the cash to buy low-cost, index-style ETFs.
The reason we do that is simple: Lower costs lead to higher returns over time and, consequently, more money for retirement.
Yet when we went to sell the funds on our client’s behalf we noticed some surprisingly high exit fees in some cases, adding up to more than $1,000!
A costly farewell
The companies we found in the account included three MFS funds with as high as 4% exit charges and two Ivy Investments funds that charged up to 5%. The funds were MFS Growth Allocation (MBGWX), Massachusetts Investors Trust (MITBX), MFS Mid Cap Value (MCBVX), Ivy Balanced (IBNBX), and Ivy Asset Strategy (WASBX).
Needless to say, the client was shocked and angry. We were told that a previous advisor had failed to mention the exit fees, also known as contingent deferred sales charges (CDSC) or back-end loads.
These fees can be quite high, up to 6% in the first year then gradually falling by 1% per year. By year seven, usually, you can leave without paying the exit toll.
Think about that: On a portfolio of $100,000, a charge of 6% means $6,000 out of your pocket. You get just $94,000 of your money back.
Back-end charges discourage emotion-driven selling. Investors tend to cash out of funds when the stock market is falling.
A prudent advisor discourages selling in a down market. It’s often the time to buy, not sell. So I understand the argument for exit fees.
What’s wrong is how such fees get hidden in the fine print and go unmentioned by stock brokers and advisors, only to reappear when the client needs to make a change. We had to dig into a 356-page prospectus to turn up some of these fees.
Not many investors bother, and advisors know that. Often, too, the advisor is quietly paid on the side to propose the fund in the first place. There’s a built-in conflict.
Conflicting loyalties
When you choose whole-market investments such as index funds, the problem of “inopportune” selling is virtually erased. The sheer liquidity of index funds means it’s easy and cheap to get in and out.
Naturally, as portfolio managers, we discourage trading for trading’s sake. But when it comes time to rebalance our clients’ portfolios, it’s nice to be able to do that important work in as frictionless and low-cost a manner as possible. There are no secretive commissions, no conflicting loyalties.
Meanwhile, it’s surprisingly hard to find out how many mutual funds have these toxic back-end loads built into them.
In the late 1980s one in five funds nationwide had such fees, according to The Wall Street Journal. That number is probably lower today but, as my client’s recent experience shows, exit loads are still alive and kicking (you, in the you-know-where)!
What’s the takeaway? It’s important to ask before buying: “What fees will I have to pay for this fund, now or later?” An honest advisor won’t hesitate to give you that information in writing.
