A mutual fund pools money from a group of investors and invests it in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds, which are managed by professional money managers. These professionals allocate each fund’s assets and attempt to produce gains or income for the investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus. Each shareholder, therefore, participates proportionally in the gains or losses of the fund.
Some mutual funds offer investors different types of shares, known as “classes.” Each class is part of the same portfolio of securities and has the same investment objectives and policies. Within an individual fund, however, each class has different shareholder services and/or distribution arrangements, and each class distributes fees and expenses differently to its shareholder. Because of the different distribution of fees and expenses, each class will likely have different performance results. A multiclass structure offers investors the ability to select a fee and expense structure that is most appropriate for their investment goals (including the time that they expect to remain invested in the fund).
All mutual funds charge fees and expenses, some of which may be paid up front, such as sales charges and redemption fees, and others that come out of the fund’s assets as ongoing expenses, like marketing and distribution costs. Also, some mutual funds, at their discretion, may waive fees for particular types of shares during certain time periods. These fees and expenses can vary widely from fund to fund or fund class to fund class. Even small differences in expenses can make a big difference in your return over time.
Cost Analysis
Expenses are generally broken into two areas: distribution and fund management. The distribution expense is related to the compensation to the brokers who place investors’ money in the funds. Think of it as two options: those brokers can either be paid up front or over time. Though there are compensation methods that are hybrids, it is best to think of them as brokers who get their commissions up front from the sale of the shares (usually in Class A shares) and those who are paid over a longer period of time (Class B shares).
The management fees are generally paid across all shares of funds but may be slightly lower in shares purchased by larger investors, such as institutional investors or aggregators of other funds including registered investment adviser firms. For these shares, the minimum purchase size is generally, but not always, much larger than is suitable for individual investors.
The provisions of each retail share class are determined by the mutual fund company. A significant factor for the structuring of share classes is the sales-charge schedule developed for distribution of the mutual fund among intermediaries. Mutual fund companies determine a sales commission fee structure for each share class that is presented in the fund’s prospectus. Each share class also has its own operating expense structure. Distribution fees, also known as 12b-1 fees, are often part of the operating expense of the fund and sometimes paid to intermediaries. Distribution fees are often different among share classes and typically are correlated with the sales charge schedule, requiring lower distribution fees on share classes with higher sales charge commissions. Mutual fund companies may report individual net asset values (NAVs) and performance returns for each share class. A share class’ returns will be more broadly affected by sales and distribution charges with less effect on returns from ongoing management type expenses.
Types of Shares
Mutual fund shares are usually termed by the fund as Class A, B, C, and I. Here are the most common differences among them.
Class A Shares. Class A shares typically charge a front-end sales charge at the time you purchase the shares. This fee often ranges from 3% to 7%, although it can be higher depending on the fund. When someone invests in a mutual fund, a specific percentage of that initial investment is taken out as a commission to compensate the placement agent, commonly known as the stockbroker, for the sale of the mutual fund to investors. Compared to Class C shares, a smaller amount of money is invested in Class A shares, since a percentage of that investment is taken out up front as commissions. This means a portion of the money involved is not invested in the underlying mutual fund and thus can make a difference in your performance over time. Thus, these funds are not optimal for investors with a short time-horizon.
Depending on the size of the purchase, the mutual fund might offer volume discounts, also called breakpoint discounts, on the front-end sales charge. This offer comes when an investor:
- Makes a large purchase.
- Makes a commitment for a large purchase over time.
- Already holds other mutual funds offered by the same fund family.
- Commits to regularly purchasing the mutual fund’s shares.
Sometimes, a fund company will offer “fee-waived” shares subtracting the up-front commission portion of the fees taken out of the amount to be invested. Doing so allows more of the investors’ assets to flow into the fund thereby putting more money to work while still owning what would otherwise be more expensive, and usually poorer performing, shares.
Class B Shares. Unlike Class A shares, Class B shares charge a load or sales fee but amortize that fee to the broker. These shares often carry a redemption fee, which is a deferred-load sales charge or a surrender charge. The charge decreases during the time invested if redeemed before a specific time. One must typically remain in the fund five to eight years to avoid this exit fee. Class B shares can convert to Class A shares usually only after a certain period. Higher ongoing management fees don’t necessarily make Class B shares less expensive to hold in a portfolio for the long term.
The B-shares have been disappearing from the mutual fund industry. There are several reasons for this, but chief among them is more regulatory focus on fees. The 12b-1 fees have been under attack, acting as a source of shareholder lawsuits against fund companies for alleged misuse. Many funds are dropping these fees and shrinking the class offerings to compete with exchange-traded funds (ETFs). ETFs themselves put pressure on Class B shares by providing a low-fee alternative for investors with limited investment capital. In short, Class B shares still exist, but they are a dying breed.
Class C Shares. Class C shares generally have neither an upfront fee nor a back-end fee. Instead, Class C share mutual funds charge a “level load” annually, which is usually 1%. This class works well for individuals who will be redeeming shares in the short term. Because this expense never goes away, C-share mutual funds are the most expensive for investors who are investing for long periods of time. They also don’t convert to less expensive shares.
Class I Shares. Class I shares, or institutional mutual-fund share classes, typically have the lowest expense ratios among all mutual fund share classes. They usually require a minimum investment and may require other specifications for investment. Institutional mutual funds can be purchased by more than just institutions. In some cases, individual investors may purchase these funds or asset management firms can often purchase these funds for individual investors.
In general, institutional-class mutual funds can be superior to other share classes because the lower expense-ratios across the board typically translate into higher returns for the investors. This is because the fund is not withholding as much money for the purpose of paying the operating costs of the mutual fund.
No Load/Investor Class. These are funds which generally do not charge a front-end or back-end load fee. This is made possible as this class of fund is sold without the assistance and/or expertise of a financial intermediary. These funds are sometimes designated as “Investor” shares, or else they simply do not have any type of class attached to them. These funds are sometimes a good choice due to their low costs, especially for veteran fund investors who follow their fund holdings and the industry on a regular basis.
Understanding How it Works
At Bowen Asset Management, we can be invested in any of these share classes at any time, but with a guiding principle of maintain the lowest possible fees while meeting the client’s liquidity needs. As a result, our choices change with each individual client.
There are numerous share classes to choose from for a specific fund within a family. Terms and conditions, as well as expenses may vary greatly from share class to share class and are complex but have definitive effects on investment performance. It is, therefore, very important for an investor to read the fund’s prospectus to understand not only how the money is being invested by the fund, but to also comprehend which share class is the best fit based on factors such as how much you have to invest initially and the length of time the investment will be held. As always, you should check with a financial adviser to determine which class is best for you.