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To avoid confusion, know the ABCs of mutual fund classes.

Byline: Rochester Business Journal Staff

Nearly half of all U.S. households have investments in mutual funds. An estimated 100 million mutual fund investors include individuals from all age and income groups, with baby boomers accounting for a substantial portion. Yet, despite the enormous popularity of mutual funds, many investors do not understand the financial impact of a decision to purchase one share class over another.<br />The multi-class structure<br />Prior to the introduction of the "multi-class" mutual fund structure, choices for investors were limited to "load" or "no load" mutual funds. Compensation paid to a broker selling a "load" fund was readily apparenta commission was paid at the point of sale. The simplicity of these arrangements vanished with the introduction of the "multi-class" structure in 1988. Although this new structure provided more choices for investors purchasing load funds, the more complex pricing structure resulted in considerable investor confusion. Now, 30 years later, the pricing structure is still not well understood, and investor confusion abounds.<br />The "multi-class" mutual fund structure became commonplace as a result of two significant developments in the 1980s and 1990s. First, a rule adopted in 1980 allowed mutual funds to pass along to investors certain expenses relating to fund distribution. Second, a rule adopted in 1995 made it easier for fund sponsors to issue multiple share classes within a single fund. Each share class invests in the same portfolio of securities, but features a different expense structure. These different expense structures require careful study by the discerning investor because investment returns over time are directly related to share class selection.<br />Economics of retail share classes<br />As the industry moved into the more complex pricing structure, many funds took advantage of the new rules. Load funds re-designated their existing shares, which featured a "front-end" sales load, as "Class A" shares, and also added "Class B" and "Class C" shares. Because investors had been familiar with the front-end load structure for some time, the economics of Class A shares were readily understood. Moreover, mutual fund prospectuses featured a chart that illustrated breakpoints and broker compensation. The type and amount of compensation to be received by a financial intermediary in connection with sales of Class B and Class C shares is much less transparent to the retail investor.<br />Disclosure requirements for mutual fund prospectuses were changed in 2010 to require disclosure of the potential conflicts of interest attendant to payments made by a fund or related companies to financial intermediaries in connection with the sale of fund shares. Specifically, that disclosure directs investors to contact their financial intermediaries for more information. Despite these new disclosure requirements, investors remain confused, and regulators remain concerned that financial intermediaries may be recommending or selecting a particular share class without adequate disclosure to their clients about how they are compensated.<br />Class A Shares. Class A shares typically feature a front-end sales load, which is deducted at the time of purchase. The sales load typically declines as a percentage of the offering price as the size of the investment increases and "breakpoints" are achieved. In many cases, the front-end sales load is eliminated altogether for investments of $1 million or more, subject to certain "holding period" requirements. Certain classes of investors may be able to purchase Class A shares on a "load-waived" basis. The breakpoint discounts, which are specific to each fund, illustrate the importance of trade size as a consideration when choosing a share class.<br />Class B Shares. Class B shares, which are less popular today, are generally sold subject to a "back-end" or contingent deferred sales charge (CDSC) that declines year after year in accordance with a schedule, and is eliminated altogether once a specified holding period has been satisfied. If the Class B shares are redeemed prior to the expiration of the holding period, a CDSC will be assessed on the proceeds of the redemption. Because of the higher ongoing expenses associated with Class B shares (as compared to Class A shares), some fund groups permit the Class B shares to convert to Class A shares if the Class B Shares are held after the elimination of the CDSC. This conversion feature illustrates the importance of considering the anticipated holding period in choosing a share class.<br />Class C Shares. Class C shares are generally sold subject to a CDSC that typically expires 12 months after purchase. Like Class B shares, Class C shares are subject to higher ongoing expenses than Class A shares. However, unlike Class B shares, most Class C shares do not incorporate the "conversion" feature that would result in a lower expense structure subsequent to the expiration of the CDSC. The higher ongoing expenses of Class C shares and the absence of a conversion feature also illustrate the importance of considering the anticipated holding period in choosing a share class.<br />Eligibility for institutional<br />share classes<br />Some mutual funds also offer one or more institutional share classes (Class I shares or Class Y shares) in addition to the retail share classes (Class A, Class B, or Class C shares). Although Class I shares or Class Y shares may have lower overall expenses than the retail share classes, only certain purchasers are typically eligible to purchase them, e.g., institutional investors. Because institutional share classes customarily have no sales charge and no ongoing 12b-1 fees, they have lower expense ratios which results in better investment returns.<br />When the math matters<br />As an industry colleague is fond of saying, "It's better to be in command of the math than a victim of it." One useful tool that investors use to analyze the impact of costs over time is the Fund Analyzer found on the website of the Financial Industry Regulatory Authority at To illustrate, compare the hypothetical returns for two shares classes of a widely used U.S. large cap fund. Assuming an initial investment of $500,000 and 8 percent annual returns before expenses, the net rates of return to the investor over a ten-year period are 7.16 percent for the Class A shares in comparison to 6.52 percent for Class C shares. The C shares investor would have earned nearly $57,000 less over the 10-year period.<br />Both the mutual fund prospectus and the summary prospectus also provide useful information about the attributes of each share class and the effect of different share class expenses on investment returns over time. The table in the "Annual Fund Operating Expenses" section and the "Past Performance" section showing the performance of each share class over various time periods are particularly useful.<br />A caveat emptor approach is essential in connection with share class selection, and it's not that difficult to become an informed investor. Read the prospectus, do the math and ask your financial intermediary the relevant questions.<br />Patricia Foster is a securities law attorney who represents clients in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This column is a collaborative work by Patricia Foster and David Peartree. David Peartree is a registered investment adviser offering fee-only investment and financial planning advice. The information in this article is provided for educationalpurposes and does not constitute legal or investment advice.

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Publication:Rochester Business Journal
Date:Jun 8, 2018
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