Mutual Funds

Understanding Mutual Funds – Share Classes and Their Costs

To the unsuspecting investor, all mutual funds might look the same. In fact they are not. With over 25,000 mutual funds now available in the marketplace, it’s important to understand how one fund might vary from its peers. Mutual funds come in all shapes and sizes and often represent distinct categories of the market. This article will focus on the differences in cost structure from fund to fund, and their impact on you, the investor.

Before we jump into this discussion, it’s important to note how many financial advisors get paid. Brokers are often paid by commissions (front end, back end or some blend of both) plus trailing commissions. Brokers can also claim future commissions on any new dollars deposited to the funds, whether or not the broker actually had a direct hand in the process. Certain mutual fund companies either pay the brokers a direct commission, or they recoup these “marketing” expenses from the shareholders by inflating their annual expense ratio.

By way of background, every mutual fund has annual operating expenses. Fund operating expenses vary widely depending on the type of fund. The largest component of operating expense is the fee paid to a fund’s investment manager/advisor. Other costs include recordkeeping, custodial services, taxes, legal expenses, and accounting/ auditing fees. Some funds have a marketing cost referred to as a 12b-1 fee, which would also be included in operating expenses. Monitoring the costs of the underlying investments within the portfolio is critical to your financial success. The higher the expense of the fund, the less profit you keep, and so these fees should be controlled by the investor.

Investors can buy mutual funds with distinct “share classes”, many of which contain sales loads. Savvy investors should only consider funds without sales loads, by buying “no-load” funds, often available by buying them directly from the fund company or at a discount broker (ie. Schwab, e-Trade, etc.). Let’s find out what these share classes mean:

  • AA class shares typically require upfront commissions, usually between 1% and 5%, commonly referred to as a “sales-load.” These shares generally have the smallest annual expense ratio, but tend to have temporary 12b-1 fees (or marketing expenses) embedded in the cost.
  • BB class shares commonly carry contingent deferred sales charges (CDSC), also called “back-end loads,” payable on the sale of the shares. B class shares generally have higher expense ratios than A shares. On top of paying higher yearly expenses, 12b-1 fees are also present. After an initial investment period, usually between 5 to 8 years, B shares customarily convert to A shares.
  • CC class shares, like B shares, generally charge a 1% 12b-1 marketing fee and have higher expense ratios. While there are no up-front and back-end fees, C shares ultimately may be the most expensive for many investors because 12b-1 fees are subtracted each year,for as long as the investor owns the shares.
  • FF shares are similar to A shares, but with an asset-based fee, usually 1% to 1.5%, directly billed to investors by financial advisors.
  • II shares, often called “institutional shares,” are usually sold to a broker’s largest customers and are sold without upfront loads, CDSC or 12b-1 fees. They carry expense ratios similar to A shares. These are often your best bet, but require big deposits or access through advisors.
  • RR shares, often called “retirement shares,” are similar to I shares, but add additional payments to financial advisors and record-keepers into the expense ratio. These are typically found in corporate retirement plans.

When it comes to investing in funds, costs matter. If you’re buying a mutual fund using a full-service broker’s advice, there’s high probability that you’ve just bought a fund with high costs and commissions. So, before your take the plunge either as it “do-it-yourself” investor or as the client of an “advisor”, do your homework. You can find the expense ratios and loads of mutual funds at websites such as Morningstar’s.

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