Mutual Fund Classes

Today I want to talk about mutual fund share classes because as part of my job, I am constantly charged with making sure that clients purchase the types of shares that are best for their particular situation.

First of all, I want to clarify that mutual fund share classes have nothing to do with the investment mix of a particular fund. By "investment mix," I'm referring to a mutual fund's investment choices – whether a fund holds mostly foreign securities vs domestic securities, big established companies vs start ups, stocks vs bonds, etc. Mutual fund classes are basically about the fee structure of the fund, and there are different structures for different time horizons and objectives - even within the same actual fund.

So. Here we go.

The share class that most people think of then you talk about mutual funds is Class A. Class A shares have an upfront sales charge. There are no load and low load funds, but for the purposes of this discussion, we'll say that a Class A fund has a load of 4-5%. That means that if you invest $10,000 into a fund with a 5% load, you're going to pay $500 just to buy the fund. You can add that $500 to the top so that you end up with a net investment of $10,000, or you can have the fee taken out of the $10,000 and your net investment - money that will begin to work for you - will be less than $10,000.

Now, the load on a fund may not be the only fee you'll pay when you invest in A shares. There may be annual fees based on the amount invested, called 12b-1 fees, but it won't be much because of regulatory restrictions. Class A shares also might have "breakpoints," which are investment amounts at which you get a discount on the front end charge you have to pay. Most of the time you can combine all of the assets you invest (say, the funds you have in your name, your kids' custodial accounts, your spouse's IRA) with the same fund family (company) in order to hit breakpoints.

Class A shares are beneficial if you are investing large amounts of money and can take advantage of the breakpoint since the annual fees are lower. Even if you can't invest large dollar amounts, some people prefer A shares because they just want to get the fee out of the way.

Class B shares are back end load funds. Remember "B for Back End." What that means is that you don't pay a fee when you purchase the fund, but you may pay one when you sell it. The annual fees on Class B shares will typically be higher than for Class A shares, and there are no breakpoints with B shares. You pay the same back end load regardless of your investment into the fund. After a certain amount of time, the shares convert into Class A shares, which means the annual fee goes down, and the back end fee goes away.

If you are going to invest a smaller amount of money that would make you ineligible for Class A share breakpoints and know that you are going to hold them for a long time, Class B shares may be the way to go. If you are uncertain of your ability to hold the shares long term, just be aware that you may have to pay to get your money back. Some people don't like these types of shares because they feel "trapped." The NASD pays particular attention to them because they want to make sure that investors are aware of the back end fees and also of the possible breakpoint benefits of Class A shares that you can't get with Class B's.

Class C shares don't have a front or back load, although they may have a penalty if you sell within a year. The way Class C shares make money for the rep and the fund company is through higher annual fees. There are no breakpoints with Class C shares, and they generally don't convert to anything else. For this reason, it would be very difficult to think of a reason why large dollar amounts should be invested in Class C shares for a long term time horizon. Very hard from the client side, anyway - from the broker side, they get paid a fee every year for as long as the client holds the fund. Very unethical.

Class C shares do serve a purpose, though. If you know you only have a couple of years to invest - say, for example, you're putting $10,000 from an inheritance into a fund for your 16 year old who will go to college in two years - they could be perfect. If their fees are .5% per year and you're only in the fund for two years, you're only paying 1% of your investment in fees. If you went into A shares, you'd have perhaps 5% lopped off the front, and off the back if you went with B shares.

If you'd like to play around with some numbers, you can use the NASD Mutual Fund Expense Analyzer. Compare different classes for the same fund (for example, American Funds, New Perspective Fund - A, B, and C shares) so that you don't have differences in investment mix or company fees muddying the picture. Do a comparison of a $10,000 investment with maybe a 10% return and a 2 year return - you should see that the C shares produce the highest return. Then do a comparison of 10 years, and then 20 years.

Then try it all again, but change your investment amount to $100,000 for 2, 10, and 20 years. Yes I know, probably very few of us here have $100,000 to plop into a fund right now - it's an example. You should see that the percentage charged for the upfront Class A shares goes down with $100,000 investment.

Different share classes were created to meet client needs - different investment amounts, time horizons, and fee preferences. There isn't a "good" or "bad" judgment that should be attached to any of the classes, just "appropriate" or "inappropriate."

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