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The Hidden Cost Of No-Transaction Fee (NTF) Servicesby Frank Armstrong Imagine the convenience when the early discount
brokers announced that they would hold no-load funds in their
accounts, and do trades for a modest transaction fee! The fund
supermarket was a big step forward. What had once been a long ordeal
was now a reasonably pleasant telephone call and trades settled
overnight. Ah, sweet progress! But, the next step was really brilliant. The
discount brokers would do the trades for free among certain
participating no-load funds. Well, free wasn’t quite the right word.
There was no direct charge to the investor. But, surely you don’t
think it was free? In fact, the brokers were charging the fund
companies 0.25% (now 0.35%) of net assets each year, for shelf space
in their supermarket. The brokers reasoned that they assumed
responsibility for many of the functions that the funds had to provide
such as prospectus delivery, customer support, and custody. The
brokerage house was only charging for services that they provided to
the fund. All true, but the reality was that the brokerage
houses soon became the primary distribution channel for the funds, and
that failure to participate could easily consign many small funds to
oblivion. On the other hand, participation and a little run of luck in
performance could propel even a tiny obscure fund to the top ranks in
gathering new assets. Funds clamored to join up. Do the various No-Transaction Fee (NTF) services
drive up fund expenses? The brokerage houses claim that the cost is
the same whether you use the service or not. They are deliberately
missing the point. It's true that if you buy the same class of fund
from a brokerage or the fund company directly, the cost will be the
same. But having to pay 0.35% per year is a major
expense. These costs must be included in a fund's operating expense
ratio. Some funds do not have total expense ratios that large. They
can obviously not afford to pay the brokerages without increasing fees
significantly. In some cases, the fund company creates a class
of shares with higher expenses simply to participate in the NTF
programs. Under what has been called the "hub and spoke"
arrangement some fund families issue the same fund shares at different
prices. The fund (hub) is the same, but shares are sold to different
investors with different prices (spokes). Many fund families feel compelled to participate
in the NTF programs. The brokerages are the 900 pound gorillas of the
mutual fund distribution game. Not playing may mean that a fund is
denied a key distribution channel. At the end of the day, the NTF
program is a prime factor in the escalating expense ratios of mutual
funds. It's also a giant part of the discount brokerage’s profits.
Just multiply 0.35% times a few hundred billion of funds that the
brokers hold in various NTF programs to see what kind of revenue the
program yields. On average, funds that participate have higher expenses
than funds that do not. We think you should buy funds with the lowest
expenses, and that the tradeoff between the NTF funds and the funds
that carry one-time transaction fees should be understood. Frank Armstrong, CFP, is the author of Investment
Strategies for the 21st Century, published here,
President of Managed
Account Services, Inc., a fee-only Registered Investment Advisor,
and Chief Investment Strategist of DirectAdvice.com. Note: The
featured writer is solely responsible for the content of this article.
The opinions expressed herein are not necessarily those of MFI or BES,
Inc. Get The Facts:
For detailed fund information, risk, rankings, and performance, click here.
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Just
a few years ago, if you wanted to sell one no-load mutual fund to buy
one from another company you had to write (that’s right-snail mail!)
to the first fund company to ask them to liquidate your shares and
send you a check. The mail took a few days, and the fund companies
took a few more days to open it. Then they sold your shares and a few
days later cut you a check. Eventually the check found its way back
through the snail mail to your home. Then you had to deposit it in
your bank and wait for it to clear before you could open an account
with company two. Of course, the check laid around in the mail and
during processing before the new account was set up and credited. All
in all, the process might take a month, and your money would be out of
the market somewhere in limbo.
