A Secret About Buying Funds Through an Online Broker

No question: Online brokers have built a much more convenient way for investors to buy and sell no-load mutual funds without paying any transaction fees. But the service comes with hidden costs. What's worse, all investors in no-fee funds -- not just those using fund supermarkets -- wind up paying those costs.

First consider the advantages of fund supermarkets. When you want to buy or sell a fund, you simply log on to your brokerage account or call your broker. In a matter of minutes, you can sell one fund and invest the proceeds in another.

Compare that to the old days. You had to call (or write) one fund company to request that your shares be sold and a check mailed to you. When the check finally arrived, you had to run it through your bank, then mail it to the new fund company. While you were waiting, it always seemed the market was rising -- and you weren't invested. The only way to hasten the process was to pay to have your money wired.

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But while online brokers don't charge you, the investor, directly for the convenience of buying and sell funds, they do charge the funds. A fund must pay a broker roughly 0.30% to 0.40% annually of the amount investors hold through the broker in that fund.

That's a lot of money considering that the average no-load fund (excluding money-market funds) charges total expenses of just 0.90% annually. But the system seems fair: The fund pays money to the brokerage, which helps it attract assets by offering its funds to investors without a transaction fee.

The rub: Online brokerages, almost uniformly, insist that a fund participating in a no-transaction-fee program charge all fund investors the same expense ratio. Consequently, even investors who invest directly with a fund and don't use no-transaction-fee programs often end up paying higher fees than if the fund didn't participate in such a program.

Every once in a while, a fund firm bucks the system. Selected American Shares and Selected Special Shares, run by the Davis fund company, decided it wasn't fair to charge direct investors the same fees as those who used no-transaction-fee platforms. They launched "D" shares for direct investors, to go along with existing "S" shares, which would still be sold for no fee through brokers. The new D shares levy a lower expense ratio.

First Schwab and then Fidelity, the two biggest players in this arena, balked. Both refuse to offer Selected's S shares to new investors. They don't want investors saving money on the same funds by foregoing their no-transaction-fee platforms. Says a spokesperson for Schwab: "Mutual fund shares offered via OneSource [Schwab's fund program] must represent the lowest share class available anywhere, including when purchased directly from the fund company itself."

What's an investor to do? You shouldn't automatically avoid funds sold through a broker with transaction fees. If your broker's transaction fees are too high -- and Schwab's run between $49.95 and $164.95 a trade -- switch to a broker that charges less. For instance, OptionsXpress, our top-ranked online broker, charges just $14.95 to buy or sell a fund. Apparently, we’re not the only ones to question Schwab’s high fund transaction fees: The San Francisco-based firm just announced it will charge a flat fee of $49.95 for online trades on all funds with transaction fees, effective July 1. That’s a huge improvement, though $49.95 is still a lot to pay to trade a fund.

Here's the secret: Many of the best funds, including many of the ones Kiplinger's recommends, don't sell their funds through no-transaction-fee programs. Why? First, their expense ratios are often so low that the payments to the brokerage would eat up all their profits. Second, they're so good -- and so popular -- that they don't need no-fee programs. In the case of many of the funds you can buy and sell through no-transaction-fee programs, the sad truth is that you may get what you pay for.

--Steven Goldberg