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So Long Load Funds?

So Long Load Funds?

A new ETF from PIMCO and changes in fiduciary rules seem poised to push more advisors away from load funds.

During the past decade, the mutual fund industry evolved steadily. As advisors shifted to fee-based practices, assets in load funds declined while money moved to no-loads and ETFs. Now the pace of change is expected to accelerate in the next year. A new ETF from PIMCO and changes in fiduciary rules seem poised to push more advisors away from load funds.

The PIMCO fund could cause especially big waves. The company plans to introduce an ETF that will resemble PIMCO Total Return (Ticker: PTTAX), the giant fund managed by bond star Bill Gross. The ETF will be run by Gross and follow his proven strategy, which has topped the benchmarks for decades (although it has been underperforming peers recently). Up till now, prominent fund managers have shunned ETFs. But if Gross succeeds with his venture, other top professionals are likely to follow suit. The result could be a massive shift in assets away from traditional mutual funds and toward ETFs.

The odds seem high that PIMCO's new offering will attract a wide following. For many investors, the ETF will be cheaper to own than some of the flagship mutual fund's share classes. The ETF will come with an annual expense ratio of 0.55 percent, while the Class A shares of the mutual fund charge 0.85 percent. The new fund will have other advantages that ETFs typically enjoy. ETFs are transparent, disclosing their holdings daily. In contrast, the PIMCO flagship mutual fund only releases stale data on portfolio holdings. In addition, ETFs are easier to buy and sell. ETF shares trade constantly and investors can use limit orders or sell short. In contrast, traditional mutual funds are priced only once a day at the market close.

Will Fiduciary Rule?

Advisors who have long used the flagship PIMCO fund could be pushed to the ETF by changes in the fiduciary rules. In the next several months, the SEC plans to issue proposed fiduciary rules that would govern all financial advisors who provide advice to retail investors. Instead of recommending suitable investments, broker/dealers could be required to only use the best choices for clients. It is uncertain when a final rule will emerge, but some advisors are already anticipating the day when a rule goes into effect, says Paul Justice, director of ETF research for Morningstar. Figuring that the fiduciary standard could mandate the use of low-cost investments, the advisors are dumping load funds and shifting to ETFs. “If you want to use a load fund under the fiduciary standard, you would have to justify it,” Justice says.

Besides shifting away from load funds, advisors have also been moving to the cheapest share class of no-load funds, says Dennis Bowden, senior research analyst for Strategic Insight. Bowden says that in 2009, 72 percent of the assets in no-load funds came without 12b-1 fees. In 2010, that number increased to 83 percent. “Even in the fee-based programs, we are seeing a rapid movement toward the cheapest share classes,” he says.

Whether the fiduciary rule and the new PIMCO fund prove to be game changers, ETFs are likely to continue their assault on the traditional turf of mutual funds. During the past decade, ETFs have grown steadily. ETF assets totaled $1.1 trillion in July this year, up 23 percent from the year before, according to the Investment Company Institute, the mutual fund trade group. Much of the growth can be traced to advisors who have been enthusiastic users of ETFs. According to a study by Charles Schwab, 85 percent of the RIAs who custody at the discount broker use at least one ETF. Of RIAs who oversee $250 million to $1 billion in assets, 99 percent use ETFs, and the ETFs account for 8 percent of the assets in the portfolios.

Like RIAs, wirehouse advisors have been gravitating to ETFs. As advisors shifted from transaction-based practices to fee-based models, they have abandoned load funds and shifted to cheaper investments. In 2005, load funds had $2.4 trillion in assets, while no-loads had $3.4 trillion, according to the Investment Company Institute. By 2010 load funds had $2.6 trillion, compared to $5.1 trillion for no-loads. In recent years, the shift away from load funds has accelerated. During 2010, investors withdrew $87 billion from funds with front-end or back-end loads. At the same time, no-loads had inflows of $253 billion.

The shift away from front-end loads has been dramatic. According to a study by Strategic Insight, front-end load shares only accounted for 6 percent of sales of funds with multi-share classes in 2010, down from 9 percent in 2007. The size of front-end loads has also been dropping sharply in recent years. While some funds still charge front-end loads of more than 5 percent, the average load is only 1 percent, according to the Investment Company Institute.

The average figure has dropped sharply because of several factors, says Brian Reid, chief economist of the Investment Company Institute. First, many shares are now sold in wrap programs or other platforms where the loads are waived. The loads are also often eliminated when funds are used in IRAs and other retirement plans. In addition, loads can be discounted because of the system of breakpoints. Under a typical schedule, investors pay a maximum front-end load of 5.75 percent for investments of up to $50,000. The fee is reduced to 4.5 percent for purchases of $50,000 to $100,000. The loads are waived altogether for investments of more than $1 million. The breakpoints were set years ago, and they have not been adjusted for inflation and rising market prices. As a result, breakpoints provide bigger discounts as portfolio values rise.

Will load shares disappear altogether? No, says Reid. He says that there are situations where load funds are the best alternative for clients. Reid cites the example of a client who rolls $50,000 into an IRA. The broker recommends investing the assets in a target-date retirement fund with a 5 percent front-end load. That way the client would pay an up-front commission of $2,500 and no other sales charges in coming years. Reid says that the load fund could be cheaper than a no-load fund in a fee-based account. To use a no-load, the investor could face 2 percent annual charges, or $1,000 in fees per year. So if the account remained invested for three years, the client would be better off with the load shares in a transaction-based account.

Reid has a point. But all the signs suggest that load shares will continue to lose market share as more advisors turn to ETFs and no-load funds.

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