What Is The Best Mutual Fund Class For You?

I’ve said before that the devil of the financial world is in the details. And in my opinion, the real devil is assuming that you understand the details, when really you don’t.
 
A few weeks ago, a new client came in to our office to meet with Susan Roman and me, let’s call him Adam. We began digging through Adam’s portfolio, looking at how his broker has him positioned, for the most part, in mutual funds, when I asked why he has C shares. Now, in the past, I’ve had folks not even know there are different mutual fund share classes, and I was half expecting Adam to respond in that way. Instead, he said something worse.
 
“Well, it’s because of the fees,” he responded. Susan and I just looked at him, and then looked at each other, before he said what we were afraid he would say, “There are no upfront fees for the C shares, so I was told they’re cheaper.” He continued to look back and forth between Susan and me. “Right?”
 
Hmm. Wrong.
 
This is a good example of my theory, mentioned above. Not understanding the different types of mutual fund share classes is dangerous but, in my opinion, thinking that you understand and assuming the wrong thing is even worse.
 
So, whether you know or think you know about mutual fund share classes, please stay with me here because I want to start from the beginning.
 
Remember what Susan and I always say; we don’t look at any investment vehicle as good or bad, only as either appropriate or not. In the case of mutual funds, there is a seemingly endless amount of share classes, including A, B, and C classes. Then there are the funds that offer Institutional shares (I shares), and American Funds that offer “F Class” shares, with F-1, F-2, and so on. Overall, there are about 16 share classes, including “T shares” being created as a combo of A shares and C shares.
 
Is your head spinning yet?
 
For our discussion today, let’s keep things simple and just address what we commonly see from the retail side of the financial services industry. The retail side traditionally uses just A, B and C share classes, so let’s dig down to discuss the differences between those. Understanding the differences will help you to determine which, if any, are appropriate for your strategy.
 
On its website, FINRA (Financial Industry Regulatory Authority) explains that “A single mutual fund, with one portfolio and one investment adviser, may offer more than one ‘class’ of its shares to investors. Each class represents a similar interest in the mutual fund’s portfolio.” The differences in the classes are the fees and expenses that you will pay for each.
 
For Class A shares, you typically pay a front-end sales fee. This is the “upfront fee,” also known as a commission or “front-load fee.” Adam’s broker was using American Funds, specifically the AMCAP fund. The AMCAP fund’s class A shares carry a 5.75 percent upfront commission on any purchase of fund shares. This fee is taken from the client’s money and is not invested.
 
Class A shares also typically pay a 12b-1 fee, usually anywhere from .25 to 1 percent per year. These fees are typically explained as fees used to advertise the fund. Wikipedia further breaks down this 12b-1 fee for us by explaining, “Back in the early days of the mutual fund business, the 12b-1 fee was thought to help investors. It was believed that by marketing a mutual fund, its assets would increase and management could lower expenses because of economies of scale. This has yet to be proven. With mutual fund assets passing the $10 trillion mark and growing steadily, critics of this fee are seriously questioning the justification for using it. Today, the 12b-1 fee is mainly used to reward intermediaries for selling a fund’s shares. As a commission paid to salespersons, it is currently believed to do nothing to enhance the performance of a fund.” I explained to Adam that these commissions and fees are above and beyond the 1 percent advisory fee often paid to a broker.
 
Also, with A shares, if an investor makes a large purchase of mutual funds in the same fund family, or regularly purchases a fund’s shares, he or she can often receive break point discounts on the front-load fees.
 
Things get a bit more convoluted with B shares, which don’t usually charge on the front end but instead often times have significantly higher 12b-1 and administration fees than you’d pay for class A shares. Also, with B shares, typically, if you sell your shares within a certain time (which can be up to six years), you have to pay a deferred sales charge. This charge will often slowly decrease the longer you hold the shares. After the deferred sales charge period has expired, those B shares can usually be converted into A shares, and therefore subject to the lower 12b-1 fee instead. While B shares don’t have the charge at the time of purchase, like A shares do, they typically are subject to fees that, for large enough purchases, end up costing more than A shares would over time. And in this case, Adam is paying the higher 12b-1 fee and the 1 percent advisory fee to his advisor.
 
Now let’s talk about the “super simple” C shares—the ones that Adam thought were the cheapest. There’s no front-end sales charge, he was right about that. Everything that you pay for your shares actually gets invested. However, if you sell your shares within one year, there’s often a charge, around 1 percent. But there are usually higher 12b-1 and administration fees than you’d see from A shares. Also, you are not able to convert C shares into those lower cost A shares, like you can with B shares, so they continue to be more expensive over time. If you hold these funds for a long time, they almost always are significantly more costly than A shares and B shares. And again, these fees do not include the 1 percent advisory fee Adam pays his advisor.
 
Share classes are confusing, I know. But with the upcoming shift in the industry toward all professionals having a fiduciary responsibility to clients, we will likely see the options of share classes reduced to one simple question: which is the cheapest and, more importantly, which is in the clients best interest?
 
You see, class C shares were not the cheapest in Adam’s case but they were suitable. Adam asked Susan and me why his broker would put him into C shares instead of A shares. Susan took that one, and simply said he would have to ask him. But, if every financial professional is soon forced to act only in their clients’ best interest, as we independent advisors have for years, it’s a simple mathematical analysis to determine which is the cheapest, in each situation, and that will be the recommendation. The fees won’t likely change but the advice you receive will.
 
In this case Adam was vigilant and he stayed alert, because he deserves more.
 
Have a great week!