What is a Sales Charge?
Also called commission or a load, a sales charge is a fee paid to purchase or sell a specific investment. It is expressed as a percentage of the amount invested. The term is most often used when discussing mutual funds.
How Does a Sales Charge Work?
In general, there are two kinds of sales charges: front-end loads and back-end loads. A front-end load is a fee paid to purchase an investment, and a back-end load is a fee paid to sell an investment (it may also be called a contingent deferred sales charge, an exit fee or a redemption charge). A no-load fund is a mutual fund that does not charge any fees of this type.
Let's assume you are interested in making a $10,000 investment in the Company XYZ mutual fund. If the fund has a 4% front-end load, then of the $10,000 investment, $400 ($10,000 x .04) is a sales charge paid to the fund company, and $9,600 is actually invested in the fund as a result. Ideally, the earnings from the investment should more than make up for the front-end load. In this example, the front-end loaded fund must return 14.6% in one year to reach $11,000 in value.
If the fund instead has a 4% back-end load, then you must pay a $400 sales charge upon the sale of the investment. Again, the earnings from the investment should ideally more than make up for the back-end load. In this example, the back-end loaded fund must therefore return 14% in one year to reach $11,000 in value after the sales charge.
Clearly, the size of the sales charge affects the size of the investor's return. In our example, if the Company XYZ fund is a no-load fund, then in order to reach $11,000 in value after one year, it needs to generate only a 10% return.
Sales charges vary widely and may apply to reinvestments of dividends, interest or capital gains. Front-end load mutual funds often are referred to as A Shares. When looking at mutual fund trading information, front-end loaded mutual funds will have ask prices that are greater than the fund's net asset value (or bid price). The ask price equals the fund's net asset value plus the front-end load.
Back-end loads are commonly assessed on the beginning value of the investment, although some companies calculate the fee on the ending value if the share price is lower than the original purchase price. Back-end load mutual funds are often referred to as B Shares. Generally, back-end loads are reduced for each year the investor holds the investment. If the investor holds the investment long enough, many fund companies waive the sales charge. For example, a back-end fee might be 5% in the first year, 4% in the second year and so forth until the sales charge is zero.
Frequently, investors are able to pay reduced sales charges if they make large investments. The amount that qualifies for a reduced load is called the breakpoint and varies from investment to investment. Some funds many have more than one breakpoint. In some cases, an investor can sign a letter of intent with the investment company, promising to invest a certain amount over time in order to qualify for the reduced sales charge from the outset.
Why Does a Sales Charge Matter?
Sales charges discourage investors from frequently trading their mutual fund shares, an activity that requires funds to have considerable amounts of cash on hand rather than invested. Generally, however, a sales charge is considered payment for the broker's expertise in selecting the right fund. Notably, there is considerable controversy about whether load funds perform better or worse than no-load funds.
Sales charges are most often associated with mutual funds, but annuities, life insurance policies and limited partnerships also may have them. Mutual funds must disclose loads and other fees in their prospectuses, and it is important to understand that a load is only one of several types of fees that may be charged. Thus, when comparing investments, investors should be careful to evaluate all fees associated with an investment, not just the size of the sales charge. Additionally, the nature of the investment, the investor's risk tolerance and the investor's time horizon should always be considered when evaluating any investment.
