What's the Difference Between Back-End Loads and Redemptions? - TheStreet

Beverly,It seems to me that both "no-load" funds and load funds have added significant loads to short-term trades to prohibit short-term trading. However, it was done in reaction to the market-timing activities in the news. If an investor leaves Putnam or Janus and goes into a "no-load," how do they know they are not going from the frying pan and into the fire? An investor could end up paying another fee even with a "no-load" fund if they redeem, too.Thank you,Paul F.

Let's clear up a few issues regarding load and redemption fees. Loads are sales charges -- like commissions, they are essentially the fee that you pay for the privilege of purchasing a fund through a broker. If you invest $10,000 in a fund with a 2% load, you've paid $200 to the broker and actually invested $9,800. No-load funds don't charge any additional fees -- if you invest $10,000 in a fund, that's the amount that goes into the market. You can generally buy no-load funds directly from the investment company or through a broker.

Of the increasing number of funds that are charging loads, there are a variety of fee structures. Different share classes come with different loads, although there's no hard-and-fast rule as to how share classes are structured. Indeed, the options offered by many fund companies are unique and difficult to decipher.

Generally speaking, though, Class A fund shares carry an initial sales charge -- what's known as a front-end load. Discounts on front-end loads are available for large purchases of Class A shares -- the so-called breakpoint.

Class B shares do not have an upfront sales charge. Rather, they become subject to a "contingent deferred sales charge" (or "back-end" load) only if they are redeemed before the end of a specified holding period -- the load diminishes over time, and usually disappears after you've held a fund for five years. And because we wouldn't want fund executives being paid like, say,

teachers

, Class B shares mitigate this diminishing sales charge by increasing the 12b-1 fees. (The higher 12b-1 fees on Class B shares is ostensibly to defray the costs of distribution of the fund.)

So as a result, brokers typically earn more on Class B shares than they do on Class A shares -- and that means that long-term mutual fund shareholders often pay higher sales charges if they hold the B shares. That's particularly true if they would have been eligible for a breakpoint discount on A shares.

Funds' failure to alert investors to this discount is of some concern to the

Securities and Exchange Commission

. The SEC has brought three enforcement actions (against

Morgan Stanley

( MWD) and

Prudential Securities

, included) involving the sales of Class B shares to investors who were not made aware by their brokers that they could purchase Class A shares of the same fund at a discount.

(For the record, fund companies offer share classes bestowed with any one of the 26 letters or even another title altogether. But another common share class is the C-class, or level-load, in which the load remains the same for the length of time you hold the fund. A level load may seem lower than the percentage quoted for A or B shares, but can amount to far more in dollar figures if you hold the fund for a long time.)

None of this is to be confused with the idea of redemption fees, though. Back-end loads are simply sales charges paid when a fund is sold, rather than when it's purchased. It is still, most certainly, a sales charge that the investment manager collects and then pays to the broker on your behalf.

Redemption fees, however, are implemented to mitigate the transaction costs that a fund incurs when investors pull out of a fund shortly after entering it. Unlike load charges, redemption fees get paid

directly into the fund

. Many funds (including no-load funds) have long had redemption fees to discourage early withdrawal from a fund -- for reasons entirely separate from the recent market-timing debacle.

Funds that are illiquid -- because they hold small stocks, foreign companies, are highly concentrated or simply have limited assets -- often impose a redemption fee on short-term investors since frequent buying and selling wreaks havoc on their portfolio management. (For more on how frequent buying and selling can damage a portfolio's management, see

Unraveling the Mysteries of Market-Timing.)

Redemption fees exist solely to compensate the investors who remain in the fund, so they don't suffer because of other investors' premature exits. But redemption fees are generally very short term -- often no more than 30 days -- after which time an investor can sell without penalty. The SEC is considering implementing a mandatory 2% redemption fee for all funds (save money market accounts) that would expire after five days. Such a short redemption fee period is aimed purely at discouraging market-timers.

So while it's true that by exiting one of the maligned funds and investing in a more stalwart (and no-load) company like

Vanguard

an investor could end up in a fund with a redemption fee, that would only be an issue for those who plan to exit the fund in fairly short order. And even with a redemption fee, that move can hardly be considered going from the frying pan into the fire -- companies that sell no-load funds such as

American Century

,

Fidelity

,

T.Rowe Price

(TROW) - Get Report

,

TIAA-CREF

and Vanguard generally charge much lower fees overall and have a more investor-friendly overall investment strategy.