Mutual Fund Class Warfare - TheStreet

Mutual Fund Class Warfare

Fund investors can get burned for buying the wrong class of shares. Here's what you should know.
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What do Marxists, high school students, frequent flyers and mutual fund investors have in common? Answer: They all want a world without classes.

Sorry for the cheap joke, but there aren't too many mutual fund jokes out there, and unfortunately, it's a cheap joke about a very expensive and sore subject to mutual fund investors. Especially those investors burned in the past for purchasing the wrong class of shares simply because they were unaware of the difference between fund classes.

So now that we've exhausted all the possible humor on the subject, here's a quick tutorial on fund classes:

A single mutual fund may offer more than one class of its shares to investors. The primary classes are catalogued as A, B or C shares, although there are other types out there with corresponding letters. If your broker is showing you anything from a D on down, you are probably far too gifted and talented for this particular class, or you should change brokers immediately.

In a nutshell, the principal differences among the three primary classes are the fees and expenses the mutual fund will charge you. Or, to paraphrase Led Zeppelin, no matter what class you buy into, the fund remains the same.

All the information regarding the fees associated with a particular mutual fund can be found in that fund's prospectus. Unfortunately, many times, prospectuses are more difficult to read than calculus textbooks. Therefore, it may be worthwhile to go online and check the

SEC's

Mutual Fund Cost calculator to get a clearer understanding of the fees you will be paying.

Class A Shares

It's a bit of a misnomer in our grade-grubbing society, but buying Class A shares does not mean you are buying first-class shares, or a fund with a high rating from an agency like Moody's or S&P. Class A Shares have nothing to do with quality. Once again, the fund remains the same, it's the fees that determine the class.

Class A shares generally nail you at the door with a front-end sales charge. This front-end load, as it is often called, is taken right off the top and usually goes to the broker selling you the fund. So whatever percentage of your hard-earned inheritance you decide to put into Class A shares of a fund, a portion will not be invested.

For example, if you invest $100,000 in Class A shares with a 5% load, only $95,000 gets invested, while $5,000 goes to the broker or financial adviser who sold it to you.

If that same fund has a 2% annual expense ratio -- a mutual fund's expense ratio measures the fund's total annual expenses expressed as a percentage of the fund's net assets -- then the fund will cost you a total of $6,900 for the year in fees alone ($1,900 in expenses plus $5,000 for the front-end load). In order to make that back in the first year, the portfolio manager needs to return a minimum of 7.3%. That's not an easy feat.

So what's the upside on Class A shares if the vigorish is high and there's no difference in quality? Breakpoints.

A mutual fund may offer you discounts, called breakpoints, on Class A shares if you:

make a large purchase;

already hold other mutual funds offered by the same fund family; or

make a deal to regularly purchase the mutual fund's shares.

Finally, Class A shares may also charge 12b-1 fees, which are asset-based and pay the marketing costs of a fund. (Usually, the 12b-1 fees associated with A shares are lower than those charged in B and C shares. But more on those in a moment.)

There you have it folks, everything you ever wanted to know about Class A shares except the most important thing: When should you buy them?

Most financial advisers would probably recommend purchasing Class A shares only if the fund has an amazing track record (we're talking Willie Mays numbers here) and if you are investing enough bucks to hit a serious breakpoint. Otherwise, stick with a no-load fund.

Class B Shares

Class A shares charge you on the way in, Class B shares charge you on the way out. Class B shares are back-end loaded, or in SEC speak, the exit fee is termed a "Contingent Deferred Sales Charge." The SEC refers to it as a contingency-based fee because it is dependent on how long you hold the fund. The fee percentage will be higher if you redeem, or sell, the shares within the first couple of years, and slide down to zero by the sixth or seventh year.

Class B shares also tend to have a higher expense ratio, and higher 12b-1 fees than Class A shares. Are there breakpoints for Class B shares? No.

So if you can't get a reduced price for buying in bulk, and the fees are generally higher, when should you buy Class B shares? Buy Class B shares if you are going to hold your fund for a very, very long time. Held long enough, Class B shares eventually convert into Class A shares.

In other words, buying Class B shares gives you squatter's rights: You didn't pay on the way in and you won't pay on the way out as long as you stick around for a long while.

Please note, however, that there has been skepticism about the performance of B shares when compared to A or C shares even after long holding periods. An S&P study published in October states that the higher fees associated with Class B shares caused it to underperform comparable A shares over three-, five- and 10-year periods.

Finally, please don't confuse the back-end loads of Class B shares with redemption fees. Redemption fees are generally short term, often no more than 30 days and are meant to discourage market-timing and frequent trading. For more on redemption fees, please check out Beverly Goodman's article

"What's the Difference Between Back-End Loads and Redemptions?"

Pop Quiz

You want to know why understanding the difference between A and B classes of mutual funds is important? Check this out. Last month,

Morgan Stanley

(MWD)

settled with the SEC because its brokers did not inform its customers of higher fees associated with large purchases ($100,000 and higher) of Class B shares of certain proprietary funds. Basically, Morgan Stanley brokers earned more money by selling their customers B shares than A shares because the fees were higher.

Because its brokers did not explain the value of "breakpoints" to their clientele, or put the clients in the proper class of shares in the first place, Morgan Stanley is paying fines totaling $50 million.

Prior to the recently unearthed market-timing scandal, most SEC cases involving mutual funds revolved around brokers' unscrupulously selling B shares to clients instead of A shares.

Class C Shares

Class C shares are level-loaded shares in which the load is paid annually as long as you own the fund. Class C shares cannot be converted to Class A or B shares.

Although the lack of a front- or back-end load might seem the most cost-effective of all possible worlds, in actuality, the never-ending load usually causes long-term Class C shareholders to have the highest expense costs.

So when should you buy Class C shares?

Class C shares make sense for investors looking to hold the fund for a year or two. Hold a Class C share too long and the fees eat away at your return. Hold it for too short a time and you might get hit with a redemption fee.