Before committing one’s savings to a fund, it is highly essential to have a thorough understanding of how the fee structure works. This is important because broker compensation directly impacts an investor’s returns. In a typical fund, especially in mutual funds, there are three main forms of broker compensation schemes. These are front end load, back end load, and level load. The specific focus of this article will be on the second category.

From all forms of broker compensation, the back end load remains the most elusive to investors, which pushes the need for it to be clarified to all market participants, especially beginners.

In this article, we uncover the mystery shrouding these hidden costs, in order to help fund investors gain a clear picture of the investment returns, and subsequently make informed decisions.

What Is a Back End Load?

A back end load is a form of a broker fee that is incurred when an investor sells off or redeems his or her investment from a mutual fund.

In the standard back end load definition, the load, or fee, is described as being back ended because it materializes at the end of an investment, rather than upfront.

Typically back end fees have an expiration date after a number of years, and diminish with each subsequent annual period. In essence, these are designed to incentivize long-term investment, which enhances the liquidity position of the fund.

The load would be a fixed percentage fee that is applied on the maturity value of the investment, and thus is directly proportional to the gains made by the fund. Such back end fees are relevant to funds that are not traded on public exchanges.

Understanding Back End Load

Back end load is also referred to as contingent deferred sales charges (CDSC) because they are fundamentally a charge applied on the sale of security back to the fund. The charge creates a contingent liability for the investor at the moment of the sale.

This fee structure is appealing to brokers because they provide an immediate commission on an already appreciated capital amount. They are managed by fund distributors to pay off brokers and come at the expense of the investors of the fund.

It is important to note that these back end fees come in addition to other upfront fees disclosed, and add to the obligations of the investor. That is why understanding the specifics of each fund’s terms is so important to each investor.

Back End Load vs Front End Load

It would be useful to take a step back and draw a juxtaposition between the front end load vs back end load. Unlike the back ended load, the front end one is an upfront charge levied against the initial investment amount.

The focal difference between the two fee structures lies primarily in when each is incurred. Front end loads are charged upfront, when the commitment to investment is being made, whereas the back ended load takes place at the time of redemption.

Similarly, the purpose of front end load is to act as compensation for the brokers and fund management and is explicitly defined. On the back end, however, the fee is more of an incentive to ensure long-term investment and is less prominent.

4 Benefits of Back End Load

Back end load comes with a range of benefits that are quite compelling to many investors of different backgrounds. Primarily, there are four main benefits to this brokerage fee class, which are listed below as follows:

• Incentivizes long-term investments

  All forms of back ended loads are great ways to encourage long-term investments in mutual funds. This benefits both the investors and the fund distributors, which can allow funds to remain invested till maturity.

• Tax advantage

  In most financial jurisdictions, back-end fees are treated as a deductible expenses and are thus removed from taxable income. As a result, investors’ tax burden is reduced. This is especially useful for giant institutional investors.

• Reduction of upfront costs

  Many investors are not very favorable toward upfront costs as they prefer to invest the entirety of their savings.

  Through back-end fees, the costs are transferred to the end of the investment period, when the burden of brokerage costs can be afforded.

• Delivers compensation to financial advisers

  Back-ended loads contribute to the sustainability of the mutual fund industry because they provide a way for financial advisors and the overall management team to be compensated for their services to the fund.

Disadvantages of Back End Load Funds

Despite the strengths listed above, many often criticize the back end or hidden loads, as being vehicles to exploit investors, and adding to the disrepute of the mutual fund industry. The key disadvantages of these loads are as follows:

• Adversely impacts investment returns

  Back ended loads are deducted from the redeemed capital, and thus reduce investment return. When accounting for this, the effective return is lower than what would have been earned were it not for this hidden fee.

• Places double cost burden on investors

  Often investors have to incur both front-end and back end fees, which doubles their cost burden. Due to this, many criticize the load as being an inefficiency in transaction fees that does not lead to value creation.

• Conflict of interest

  Because back-ended load funds have a direct compensatory advantage to brokers, they would be incentivized to recommend these funds over those without hidden loads, despite potentially having lower returns.

• Complexity

  Another criticism of back ended loads is their complexity, which can dissuade beginner investors. Many point out that these are deliberately structured in this manner, so these costs are incurred by investors.

When Back End Load Funds are Appropriate

There are specific instances where back ended load funds are actually appropriate to certain investors, despite the criticism it faces. These instances are usually as follows:

• Long-term investment horizon

  In the event that an investor has a long-term horizon spanning several years, back ended load funds may be appropriate. This is because the investment period may outlast the back ended load expiration.

• Ongoing brokerage and advisory support

  Similarly, back ended loads are great in the case where an investor seeks consistent support, in terms of brokerage and advisory services from the fund.

  Back end fees are a great way to compensate the relevant parties of the fund in a sustainable manner. This would also incentivize these parties to deliver quality services to the investor to maximize their own compensation, indirectly.

• Low expense funds

  When a particular fund has minimal upstart funds and low management fees, one way to ensure its sustainability would be through back ended loads. This not only incentivizes fund performance but delays immediate cost burdens on investors.

How is a Back End Load Used?

The way back ended loads work are essential as exit fees, and they differ across various mutual funds with distinct holding periods.

Similarly, the back end feature is observed in instances where a particular fund offers different share classes to investors. The A class shares would come with front-end loads, whereas the class B shares would have back end load within them.

Often, class B shares that have an exit fee or sales deferred charge can convert into the class A category, if held long enough. This further plays into the role of incentivizing long-term holding of the stock.

Example of Funds with Back End Load

To contextualize what we have just learned about back end fees on mutual funds, we take a look at a real-world example, by turning to the American asset management company, Franklin Resources Inc. (NYSE: BEN)

The company functions as a fund, and offers a range of equity facilities to investors, spanning across distinct classes. For its long-term fixed-income funds, it charges 1% as a deferred sales charge upon the sale of a security.

The vesting period of the share is 18 months, and the back ended load amounts to 1%. This is in addition to the broker’s commission of 0.5% and the service fee of 0.25% it charges to investors for this class of security.

How Back End Load Work

In normal cases, the way funds and asset management companies structure their back end fees are through fixed percentages which undergo a decrease as time elapses.

For instance, a back ended load could be 7% for 7-year security, which would decline by 1% for every year that passes. This is a clear example of incentivizing complete holding, to fully eliminate the cost burden of the exit fee.

However, the specifics of the back end load calculator could differ from fund to fund, depending on the objectives of the fund distributors and management, who may prioritize different areas based on their investment approach.

Conclusions

Back end load is a consistent part of reality seen across mutual fund industries, and helps incentivize long-term holding periods. Unlike upfront, front end loads, these are more elusive and less transparent at first.

Despite being criticized by certain investors as being an inefficient transaction fee that reduces investment return, they serve an important purpose and help align the interests of investors and fund management.

There are certain instances where these broker compensation schemes are more appropriate than others, which is why investors must carefully analyze the terms of each fund, and determine whether it aligns with their investment goals.

FAQs

How do you calculate back end load?

Back ended loads are calculated by applying the specified percentage with the investment redemption amount when the security is being sold. This rate typically diminishes with time, on an annual basis.

Which is better: front end load or back end load?

Whether an investor prefers front end or back ended loads are dependent on their individual strategy, goals, and circumstances. Most prefer the front end for the upfront payments, whereas others prefer to pay out towards the end.

What is a back end load in insurance?

A back ended load in insurance is the sales charge incurred when policyholders surrender their insurance agreement before its maturity.