Understanding mutual fund classes

Tina Haapala |

By Gary Silverman, CFP®

Recently, I got a series of questions from a financial reporter for a major business publication. I didn’t have time to respond—not a big problem as he probably had 1000 responses to his question—so I didn’t read it until recently. Frankly, the questions surprised me. After all, this was a financial reporter yet the questions showed a profound ignorance concerning mutual fund classes. So I figured if he could be that confused, readers like you, who are probably not financial reporters, might need a bit of a refresher, too.

I did a quick internet search on the various sub-topics the reporter was addressing and those that I thought should be added to the subject to round it out a bit. When I read the first half-dozen or so articles from each search, I found glaringly incomplete answers which would result in the reader learning lessons way off the mark; lopsided discussions biased by the entities producing them; or downright wrong information. Now, this wasn’t all of them. I’d say about 2/3, enough to matter. Plus, how would you know which was which?

This will take more than one week to straighten out. Get out the scissors and start saving this series. (Please put the scissors down if you are reading the electronic version.)

First, let’s look at the initial big divide between different types of mutual funds: Loaded vs. No-load funds. To get started here we need to define what a Load is. While there are several ways loads are charged they share one characteristic: They are sales commissions. Now, to those from the no-load camp (and to most of the fee-only advisers like myself), any form of commission is considered evil. But last I saw, most salespeople in this country make a commission and most of those I have met are not evil. But that discussion can wait for another day.

One of the first questions the reporter asked was whether it even makes sense to pay a load. The answer is yes. Remember a load is a commission, so one reason to pay a load on a fund is because your chosen financial adviser earns her or his living through commissioned sales. I have chosen to run my firm through the charging of fees instead, but there is nothing inherently wrong with commissions. Trust me, fee-only and commissioned advisers both make money and we both can do a good or bad job by you.

Now, if you were working with me, I’d never recommend a loaded mutual fund. It would make no sense to pay a commission to a fund company when I am the one helping you manage the investment, not the company.  Likewise, if you do your own investing and do the research and buying yourself you should also not use a loaded mutual fund because the fund company isn’t going to pay you a commission either. So, only use loaded mutual funds if your adviser gets compensated that way.

Of course if that’s how he or she is compensated, that’s the only type of fund they are going to recommend.

Last week we looked at Load vs. No-load funds and defined loaded funds as those that charged a commission. Brokers that make their living through commissions are likely to recommend loaded funds. That’s how they make a living. First, we’ll  look at two of the three main types of loaded mutual funds: A and B.

Way back in the beginning days of mutual funds, this first type, A, didn’t have a name. It was only later, once the B and C classes of funds came out that the first became known as an ‘A’ share. In those days, almost everyone did their investing through a stock broker. And back then almost every stock broker earned their living from commissions charged when they bought or sold a stock. So it was natural for the first mutual funds to charge a commission. However, the commission was only charged when the fund was purchased, not when it was sold. Why?

Because with a mutual fund, someone is managing that fund for a fee (called, nicely, a management fee). Of course, the fund managers like to keep money in the fund so they didn’t want to reward brokers who made people leave the fund. So they designed the funds to pay a decent commission (8.5%) when the broker sold the fund to a client, but no reward if they sold it. For example, if you put in $10,000 into an A-share fund and looked at the value of your account the next day if would be $9,150 (assuming no market movement). The other $850 went to the person who sold you the fund and the management. The commission is what gives the load fund its name so this A-share is also known as a front-end loaded fund.

The B fund grew out of the no-load fund era. You see, no-load funds, sold directly to the public, began growing in number. Some financial reporters who weren’t beholden to the financial industry began to sing their praises and people took note. Why should they be paying a commission as high as 8.5% when they could instead buy a no-load mutual fund and pay nothing? (While there are reasons for this, we’ll ignore them for now.)

The load-fund industry, seeing their market share start to erode, created a new type of fund…the B-share. Generally this is exactly the same as a front-load share except no commission charge comes off the front. In other words, if you put $10,000 into the fund and looked at it the next day you’d still have that $10,000 plus or minus whatever the market did to you. Oh, and your broker still got the commission.

Seems great! But there’s more to it than that as you might guess.

Are you following so far? Here’s a summary:

Loaded funds are sold with a commission to compensate your adviser; no-load funds don’t have a commission built into them. A-share mutual funds charge their commission up-front (which is why they are also called front-load funds). So if you bought an A-share that had a 5% load, $9,500 got into your account while the other $500 would be used to compensate your adviser and management.

The B-share doesn’t have this front-end load. However, it still pays a commission to your adviser’s team (for our example we’ll assume 5%). Sounds like a winner. You get all your $10,000 working for you and your broker is happy. But wait, what about the mutual fund company? Aren’t they out the $500 that your broker got? They wouldn’t like that. Not-to-worry. They are the ones who designed the fund in the first place. Here’s what they did to make sure they don’t lose money…

First, the fund company adds a little fee, above and beyond the normal management fee, usually about 1% a year. After several years (how long depends on the up-front commission the fund paid to your broker) the B-shares magically become A-shares that don’t have this additional fee. (And no, they don’t charge you a front-end load on the conversion to A-shares.)

But what if you pull your money out “early,” that is, before the mutual fund company gets enough to make up for the commission they paid? In that case they charge you a fee known as a “back-end load” as you leave. Here’s how that works:

Let’s say that you put in your $10,000 and then after a month decided it wasn’t for you and pulled it out. Assuming the market didn’t move you’d probably only get $9,500 back. Where did the other $500 go? It stayed with the fund company to compensate them for the $500 they gave the broker when you bought the fund. This back-end load slowly decreases over the years (after all, each year they are getting that other 1% fee).

Finally, we come to the C-share funds. They come with no front load, and only have a small 1% back-end load (the one if you sell it early) that goes away after one year. However, the mutual fund company keeps that 1% extra internal fee going forever. The payout to your broker is a bit different here as well. Instead of getting an up-front commission like in the A or B shares, they get part of that ongoing fee each year.

There, now you know the ABCs of loaded mutual funds. But we’re not done yet. If you remember, this review of the types of loaded mutual funds began because of some questions I got from a reporter that reminded me there’s a lot of ignorance in this area.

 Up to now we’ve looked at mutual fund “loads”. Let’s summarize:

No-load funds pay no commissions and therefore there are no commission charges (loads) built into them.

A-share funds have a front-end load where a commission charge is taken from your funds when you buy them. Your broker gets paid when they sell you the fund.

B-share funds have a higher internal fee for several years. If you sell off the fund during this time you’ll pay a load on the way out of the fund. Your broker gets paid when they sell you the fund.

C-share funds have a higher (usually 1%) ongoing fee inside the fund that lasts as long as you own it. Your broker gets paid a part of this every year.

Now, with that behind us,  we can start with the reporter’s questions. First, he asked which class of fund you should buy. He wondered if paying a load would be better if it resulted in a lower expense ratio.

Whoa! As you now know, a load is a way for a mutual fund to get the money from you that it uses to pay the financial professional for selling you the fund. If you are doing your own investing and not using the services of a commissioned adviser, then you shouldn’t be buying a fund that takes money from you to pay an adviser. So, it seems to reason that you should not buy a loaded mutual fund yourself. You, the individual investor who is making your own fund choices and doing all the work yourself should only be buying no-load mutual funds. Period.

Now, if you work with a financial adviser of some sort, then you might be buying some loaded funds. It depends. Some of us (like me) work for a fee. My clients pay me for my advice directly. So it would make no sense for us to use loaded mutual funds with them. If we did, they’d be paying twice: once to us and then a load to the fund. So advisers like me have our clients use no-load funds.

But a whole bunch of other advisers (most of them) are compensated by commissions generated by the investments they sell. With them you are not going to be given the choice of no-load funds and there’s nothing wrong with that. After all, do you expect them to work for free? In that case you’ll want to discuss with your adviser which share class makes the most sense for your particular situation. I can think of situations where any of them (A, B, or C) can make sense.

While we are at it though, I’d like to go inside the mutual funds in a little more detail and discuss the other fees that exist. We’ll cover that next week.

Over the last four weeks we’ve defined load vs. no-load funds and explained the three main types of load funds out there, namely A (front-end), B (back-end), and C-shares. Today I want to complete the discussion by talking about mutual fund fees.

Realize that there are more mutual fund share types than just the four mentioned above. First there is the I-share class that is open only to institutional investors. This class has no load charge and lower expenses than its sister funds. However, to get in them there are some steep minimum purchase amounts. I’ve seen minimums as low as $10,000 and as high as $10 million. The key to these and any other share class (or mutual fund in general) is to read the prospectus. What’s nice is that fees are found in the first couple pages of the booklet.

For example, in the prospectus for the Oppenheimer Developing Markets Fund (this isn’t a recommendation…just the first prospectus I found lying around) they list the fees and expenses of the fund on page 3. This fund actually has 6 classes: A, B, C, R, Y, and I. We’ll ignore R & Y today.

Only Class A has a Sales Charge (Load), in this case 5.75%. Remember that class A shares are front-load, so the mutual fund recoups the commission it pays out to your adviser through a charge on the sell. Class B & C shares show a Deferred Sales Charge. That’s the back-end load I’ve talked about. Note that the back-end load only occurs during the first few years you own the fund (to find out how long, you’ll have to read deeper into the prospectus).

Further down you’ll find something called Distribution and/of Service (12-b-1) Fees. This is where that additional expense comes in for the B and C shares, in this case 1%. Note though that the A shares also has one of these 12-b-1 fees of .25%. That’s very common, and is even common for many no-load mutual funds. This is a fee that compensates the mutual fund for fees it pays to the brokerage firm, such as Schwab, for handling your trades in the fund or for your commissioned adviser for ongoing services they provide.

On top of all that you have Management Fees and “Other” Expenses which are the same regardless which share class you purchase. That’s because this is the money the fund earns to pay its own expenses and make a profit for itself.

What you won’t find here is the costs the fund has to trade securities. Mutual funds, after all, are pools of money used to buy other securities whether they be stocks, bonds, commodities, real estate, or just about anything else. Buying and selling those costs money. An indication of how much this costs can be estimated by looking at the Portfolio Turnover rate (the percentage change in what the fund owns over a year).

As we’ve discussed over the years, all things being equal, you want to own funds with lower expenses. But, of course, all things are seldom equal.

This post was from a series of articles published in Wichita Falls Times Record News in October  and November 2016.