Pros, Cons of Discount Brokers’ No-Fee, No-Load Sales

A small revolution is in the works that could make it exceedingly tempting for investors to buy no-load mutual funds through a discount broker.

Charles Schwab & Co., the nation’s largest discounter, says it will soon let investors buy and sell selected no-loads free of any transaction costs.

A smaller rival, Jack White & Co. of San Diego, has already adopted a similar no-commission program on a few funds to stay competitive with Schwab.

At first blush, you might ask what makes all this such a great deal from the investor’s point of view.

After all, no-loads by definition don’t charge any sales commissions if you deal with the fund company directly.

The answer is that it’s often more convenient to hold funds through a discount brokerage.

“You get a consolidated statement listing all your funds, and there’s a local office you can go to,” says Tom Taggart, a spokesman for Charles Schwab in San Francisco.

Up to now, anyone wanting to buy or sell no-loads through a discounter has had to pay commissions ranging from about $25 to $30 on up.

Now, investors enjoy the opportunity to trade at least some no-load funds free of commissions.

However, it’s not yet clear whether investors will get a totally free lunch. Here’s why:

The fund companies will compensate the brokerages by paying them a 0.25% yearly fee on the assets they handle, and it’s possible that some funds might pass that expense along to shareholders rather than absorb it themselves.

Taggart concedes that this is a possibility, although he predicts that most fund companies will pick up the 0.25% tab. “The whole idea of the program is to make it as clean as possible,” he says.

And even in cases where shareholders had to pay for this cost, they wouldn’t necessarily face higher overall expenses, says Jack White, head of the brokerage that bears his name.

The reason: These funds would likely reap savings on behalf of shareholders elsewhere.

“This might just mean shifting an expense from one area to another,” White says.

For example, a fund perhaps could reduce its staff of telephone reps or clerks because the brokerage would be handling some shareholder-servicing duties.

In any event, fund managers would see their overall advisory-fee income rise as assets increased. Advisory income, rather than loads or commissions, are the main way fund-management companies make money.

Taggart says there’s no definite timetable for Schwab’s no-fee service, but he predicts that it will start this summer.

So far, eight families with about 80 funds have signed on. They are Berger Associates, Dreyfus Corp., Federated Investors, Founders Funds, Invesco Funds Group, Janus Group, Neuberger & Berman and Stein Roe Mutual Funds.

Jack White & Co. is already up and running, with 18 portfolios in three families: Dreyfus, Blanchard Funds and Selected Funds.

On other no-load funds (and all load portfolios) available through the brokerages, some commissions or transaction fees would still apply.

Both brokerages hope to add more no-load families, but it’s likely that a good number of companies won’t go along.

“The no-load industry will split on this issue,” White says. “Some firms don’t feel it’s the proper way to present themselves.”

But on those funds that do participate, investors will have a chance to consolidate and simplify their portfolios. They won’t have to call or correspond with as many fund groups or track as many statements.

And in some circumstances, they will be able to buy shares more quickly and receive redemption money sooner.

The no-commission plans aren’t designed for everyone. For example, Schwab plans to impose limits on short-term traders.

Even more important, investors seeking recommendations will be disappointed because discounters don’t provide this type of assistance.

Anyone who needs help deciding which funds to buy, when to sell or other such advice should go with a full-service brokerage or financial planning firm.

Still, the no-load, no-fee idea may fill a void for people who want more convenience than they get dealing directly with individual fund companies, at a lower cost than they face at full-service firms.

Other Brokerage Benefits Besides quicker service and consolidated account statements, investors can receive the following benefits and services when purchasing no-load funds through a discount broker:

* Reduced IRA fees. If you consolidate your mutual fund retirement holdings in a single brokerage account, you can wind up paying less in annual trustee fees. Charles Schwab & Co., for instance, charges no IRA fees on more than $10,000 in combined fund holdings.

* Margin purchases. This is a way to boost your investment position using money borrowed from the brokerage. Regulatory guidelines allow you to margin $1 for every $1 you own, which means that you could add $5,000 in borrowed fund shares if you already hold $5,000. The use of margin increases both your potential return and risk.

* Selling short. If you’re pessimistic about the stock market or selected industries, some discounters will let you sell short. With this strategy, you unload the fund today in hopes that it will subsequently fall, allowing you to purchase the shares later at a lower price and thereby close out your position.

“Short selling is an aggressive strategy for sophisticated investors,” says Donna Morris, a senior vice president in charge of brokerage marketing at Fidelity Investments, the No. 2 discount brokerage.

Not only must you pay interest on the borrowed money, but you’re theoretically exposed to unlimited losses if the fund’s price keeps rising.

Still, shorting can be an effective way to hedge your portfolio.

Fidelity and Jack White & Co. both allow shorting of some funds.