Despite the rise of other investment types such as ETFs, mutual funds remain the most popular type of investment for many individual investors today. But different mutual fund share classes can complicate the investment decision.
You usually have the option of purchasing any of several different share classes of the same mutual fund. Each class typically has a different fee structure.
Selecting the wrong share class for your personal situation can result in paying more fees than is necessary. Let’s take a look at some of the basics regarding mutual fund share classes.
Mutual Fund Share Classes
Mutual funds typically offer different “classes” of their shares to investors. The underlying investments of these mutual fund share classes are the same. However, the difference between the various classes lies in the expenses charged to the investor. The most common types of mutual fund share classes offered are “A”, “B”, and “C”. But there are others as well.
Before getting into discussion of the different mutual fund share classes, it’s important to understand some of the mutual fund expense terminology.
A load is basically a sales charge or commission that an investor pays directly or indirectly when investing in a mutual fund. The load is ultimately paid to the advisor or distributor of the fund.
It can be paid by the investor at the time of purchase (front end), or at the time of sale (back end). Load is usually also paid throughout the investment holding period via 12b-1 fees (see below).
These are fees that the mutual fund pays to the management company for managing the fund. The fund’s portfolio managers typically work for the management company.
Management fees are the same for the entire mutual fund, regardless of the class of shares in which you invest.
These are fees, also known as “level load”, that the mutual fund pays for marketing and distribution of its shares to investors.
The 12b-1 fees are capped at 1% of a fund’s average net assets per year.
Mutual fund investors do not pay management and 12b-1 fees directly as they do sales charges. Instead, the fund pays these fees. So the money comes out of the fund’s assets, which reduces the value of the shares in which you are invested.
The fund may also pay other expenses out of its fund assets. These may include custodial and transfer agent expenses, legal and accounting fees, and other administrative costs.
All the fees that the fund pays out of its own assets are called the fund’s operating expenses. The higher these operating expenses are, the higher the fund’s expense ratio. The expense ratio is calculated by dividing a fund’s total operating expenses for the year by its average net assets under management (AUM).
Front end and back end sales loads are paid by mutual fund investors directly. As such, they are not considered part of the fund’s operating expenses. They therefore are not used in calculating the fund’s expense ratio.
Class A Mutual Fund Shares
These are generally referred to as “front-end load” shares. The reason being that you pay a commission or sales charge up front when you purchase the investment.
Let’s say you invest $10,000 into class A mutual fund shares with a front-end load of 4%. Only $9,600 will be invested since $400 will be applied towards the commission.
This share class may be best for long-term investors who receive advice from an advisor and also will invest a large enough amount to qualify for discounts called breakpoints.
Sometimes discounts on the load or commission may be available for class A mutual fund shares. These discounts are called breakpoints. You may be eligible for higher discounts as your investment in the fund increases or if you make a large purchase. A discount may also be available if you purchase other funds from the same mutual fund company.
Always ask to find out what thresholds or other criteria must be met in order to potentially qualify for an available discount. Such information may also be available in the fund’s prospectus, which can usually be found online.
Class B Mutual Fund Shares
These shares do not have a front-end load charge. So if you invest $10,000, the entire amount is invested in the fund. However, these mutual fund shares typically have a contingent deferred sales charge (CDSC). This type of charge is also referred to as a “back-end load”.
With a CDSC, investors pay a sales charge if they sell their investment in the shares within a specified number of years. The potential CDSC is reduced each year you hold the investment, and is usually eliminated after about six years or so.
Class B fund shares also generally carry a higher proportion of the fund’s marketing or 12b-1 fees. This often results in a relatively higher expense ratio.
If you hold class B shares long enough, they often eventually “convert” to class A shares. As such, their annual expense fees typically go down. This conversion generally occurs within a couple of years after the CDSC is eliminated.
B shares may make sense for long-term investors who purchase through an advisor but don’t otherwise qualify for breakpoint discounts.
Class C Mutual Fund Shares
Class C shares also do not charge a front end load. Similar to class B shares, you may get hit with a commission if you sell your shares quickly after purchase. However, this CDSC charge is much smaller with C shares (usually a maximum of 1%). It can usually be eliminated if you hold for at least one year.
Class C shares, however, also carry a higher portion of the 12b-1 fees. But unlike class B shares, their slice of these fees does not go down over time. So the annual expense ratio will generally be higher than that of both class A and class B over longer holding periods.
This share class may make sense for short term investors who purchase from an adviser and plan to hold the fund investment at least one year.
Class A shares generally have relatively lower 12b-1 fees compared to classes B and C.
As a result, the total expense ratio of class A shares will generally be lower than the other mutual fund share classes within a specific fund family.
Class R Mutual Fund Shares
These fund shares are offered by employer sponsored retirement plans such as a 401k. They do not have a front end or back end load. However, they usually do incur 12b-1 fees, and their expense ratio may be higher than that of “load-waived” funds.
Class LW Mutual Fund Shares
These are generally A class shares which have the front-end load waived (LW). Like the R class, these fund shares are usually available inside employer sponsored retirement plans.
No Load Mutual Funds
No load funds or “investor class shares” do not charge a sales commission upon the purchase or sale of shares. They also must not charge a level load (12b-1 fees) of more than .25%.
Load funds are meant to compensate advisors for recommending the fund to you and providing related investment advice. If you are doing all the research and selecting the fund yourself, you are likely better off purchasing a no load fund. You can do so by investing directly through the fund company.
Class D or F Mutual Fund Shares
These are essentially no-load funds which are available via mutual fund supermarkets offered through discount brokers such as Schwab and Fidelity. However, many no-load funds purchased through fund supermarkets often incur a transaction fee.
Buying the right share class can make a big difference in your overall portfolio returns over time. So it helps to know what is available and how the fee structure for a particular investment is set up.
Always look at a fund’s prospectus before investing. These documents provide a wealth of information. Even if buying through an advisor, it can’t hurt to scan the prospectus and do some basic research of your own.
FINRA provides a Fund Analyzer tool which you can also use to research the cost of investing in different funds.
Armed with some knowledge and research, you can ask the right questions and discover key facts which can help in making a proper investment decision.