The concept of pooling capital of individual investors into a common fund is at least as old as the Dutch investment trusts of the late 18th century. The modern mutual fund harkens back to 1924 with the institution of the Massachusetts Investor's Trust, forerunner to present-day MFS Investment Management. Today, investors have over $15 trillion invested in U.S. mutual funds, an amount nearly equal to a year's worth of GDP.
Yet many of those investors do not realize that how they buy their funds is nearly as important as which funds to buy. Returns from a great fund can be significantly impaired by owning the wrong class of shares with high expenses and sales charges. Understanding the different share classes and choosing carefully is critical over the long haul.
Mutual fund companies utilize a variety of marketing channels to sell their products, some more costly than others. The same investment product can be packaged into various wrappers and cost structures. Mutual funds sold by brokers generally fall into one of three classes.
Class A shares are subject to an up-front sales charge or "load," typically between 3 and 6 percent of the amount invested, to compensate the broker and the broker's firm. In addition, class A shares carry an ongoing annual marketing expense, called a 12b-1 fee, of around 0.25 percent per year. Class A shares generally involve the lowest ongoing annual expenses over time, but are only appropriate for long-term holders given the high up-front commission.
Most funds offer volume discounts on the front loads, reducing the sales charge if the initial or subsequent investment exceeds certain thresholds called breakpoints. Loads phase out entirely for very large investments.
Class B shares shift the front end load to the back, for a price. All the cash invested in B shares goes to work immediately, but any sales during a specified period (typically six years) will trigger a back-end sales charge that declines over time, much like a the surrender charge on a variable annuity. Once the stipulated period ends, B shares convert to A shares and may be sold at will.
B shares can be expensive to own, even if your holding period is long. The 12b-1 fees run around 1 percent per year and back-end sales charges can equal or exceed A share loads in the early years.
Class C shares are more appropriate for investors that anticipate shorter holding periods. With no up-front commission and very limited back-end loads (one year), C shares compensate the broker through higher annual 12b-1 fees than A shares (typically 0.75 percent) and so are costlier but offer greater flexibility in rebalancing an asset allocation portfolio.
Investors who feel comfortable selecting their own funds can bypass most of the sales charges by purchasing directly from the fund companies or by visiting one of the mutual fund supermarkets. These resellers offer thousands of funds with zero or very low sales loads and often with lower annual 12b-1 fees. Given the importance of keeping costs low, this option is best if you require very limited assistance.
Unlike brokers, registered investment advisers (RIA) do not receive commissions but instead charge an asset-based annual fee (0.75 percent to 1.5 percent is customary). Also unlike brokers, RIAs have a fiduciary duty to their clients, so fee-based advisers that utilize mutual funds favor no-load or low-load funds to minimize expenses. Some brokers are dually registered and can also do fee-based business with low-cost funds.
Keeping costs down is nearly as important as selecting the right fund (some say more so). Before you invest, understand the share classes and relevant expenses. It could make a big difference at retirement time.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. Advisors.