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Fund Expenses: Class Matters When Buying Multi-Class Shares

Fund Expenses: Class Matters When Buying Multi Class Shares Splash image
You've decided on a particular asset class, checked all the ratings, sorted through all the funds, and finally selected one mutual fund to invest in.

No more choices, right?

Wrong!

Some fund investors are confronted with an unexpected choice: What class of mutual fund shares should they invest in?

The share classes are for the same fund, but they carry different fees and expenses, and perhaps different shareholder services.

Which one is best?

There is no one best class for all investors, but choose the wrong class for your investment goals and the costs can be considerable.

Class Structure

Different fund families assign different letters to similar classes. However, you will most commonly find these typical fee and expense structures for the first three classes:

    Class A: These shares carry a high front-end load charge, perhaps as high as 5.75%, and a lower 12b-1 charge. Front-end loads are one-time sales charges levied against the initial dollar value of your investment. For example, a 5.75% front-end load on a $10,000 investment would result in a sales charge of $575 (0.0575 × $10,000) and a net investment of $9,425 ($10,000 - $575). The 12b-1 charge is a continuing sales charge levied over the course of each year on the market value of your investment. For example, if your mutual fund investment averaged $10,000 in market value for a year, a 0.30% 12b-1 charge would translate to a $30 (0.003 × $10,000) annual sales charge.

    Class B: These shares usually carry a contingent deferred sales charge, a back-end load, and a high 12b-1 charge. The contingent deferred sales charge is levied when you sell your fund and the charge is against the value of your original investment. These charges usually decline the longer you keep your fund, and may disappear after a set time period—six years, for example. If the deferred charge is 5% and the fund is sold in the first year, then on a $10,000 initial investment the charge would be $500 (0.05 × $10,000). Usually, each year you hold the fund reduces the charge by 1%: 5% if sold in the first year, 4% in the second year, and so on down to 0% if the fund is sold in the sixth year. Class B shares often automatically convert to Class A shares after the contingent deferred sales charge no longer applies. The 12b-1 charge, however, is usually much higher than on the A shares. For example, a 1% 12b-1 charge levied annually would be a charge of $100 on a $10,000 average market value of your mutual fund investment.

    Class C: Typically, these shares carry the highest continuing 12b-1 charges and either no front-end load or a smaller charge—1%, for example—along with a contingent deferred sales charge, for example 1%, that may disappear after 18 months.

Table 1. Mutual Fund Class Trade-Offs
Class A Class B Class C
Fee Expense Structure
High front-end load

No contingent deferred sales load

Low 12b-1 load

No front-end loa

High contingent deferred sales load

High 12b-1 load

No front-end load

Low contingent deferred sales load

High 12b-1 load

Tradeoffs
Large purchases can reduce or eliminate front-end loads

Low continuing annual load

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Money invested net of high load

If held for over five to six years, deferred load is eliminated

Low continuing annual load

All money initially invested

If held for one to two years, deferred load is eliminated

High continuing annual loa

All money initially invested

Investor Match

Best for:
- Long-term investors
- Investors who make large purchases

Worst for:
- Short-term investors
- Investors who make small purchases

Best for:
- Long-term investors
- Investors who make small purchases

Worst for:
- Short-term investors
- Investors who make large purchases

Best for:
Shorter-term investors
Investors who make large purchases

Worst for:
- Longer-term investors
- Investors who make large purchases

There are many more classes of shares but they tend to be unusual or pertain to few investors: I class for institutional share owners, D class for employees of the fund, Z class for funds that have grandfather provisions, and so on.

Some fund families also have different charges for the same class among the various funds they offer. For instance, Class A common stock funds may have higher costs than Class A bond funds of the same fund family.

Even for the same fund the front-end load charges for a Class A fund may decline as more of the fund is purchased, and the load may disappear entirely on a purchase of $1,000,000 or more of a fund's shares.

Class Choice

Now that you have a grasp of the potential nuances of the fund class alphabet, you can approach the fund class choice.

Table 1 will help you sort out the basic trade-offs of the usual Class A, B, and C shares.

Table 2. Comparing the Costs of Mutual Fund Classes
ASSUMPTIONS: $10,000 Initial Investment, 10% Annual Rate of Return
Class A: 5.75% load, 1.25% annual operating expense
Holding Period (Years) Fees/Forgone Earnings Investment End Amount
1 $762.09 $10,237.91
5 $1,851.31 $14,253.79
10 $4,380.87 $21,556.55
20 $17,971.57 $49,303.43
Class B: 5.00% deferred sales charge (1 year only), 1.25% annual expense
Holding Period (Years) Fees/Forgone Earnings Investment End Amount
1 $637.50 $10,362.50
5 $981.72 $15,123.38
10 $3,065.75 $22,871.67
20 $14,963.67 $52,311.33
Class C: 1.00% deferred sales charge (1 year only), 2% annual expense
Holding Period (Years) Fees/Forgone Earnings Investment End Amount
1 $320.00 $10,680.00
5 $1,547.37 $14,557.73
10 $4,744.66 $21,192.76
20 $22,361.67 $44,913.33
Source: Securities and Exchange Commission Web site (www.sec.gov); Mutual Fund Cost Calculator.

Table 2 puts numbers to the descriptions in Table 1. It assumes you have made a $10,000 initial investment, and earn a 10% annual rate of return. It was developed from the interactive tool, Mutual Fund Cost Calculator, on the Securities and Exchange Commission (SEC) Web site (click on Calculators under Investor Information.

The SEC Mutual Fund Cost Calculator allows you to compare various cost structures. The calculator lets you specify the type of load, front-end or deferred, the amount of your investment, the annual return expected on the investment, the number of years you intend to hold the fund, and the annual operating expense.

The annual expense ratio of the fund is given in the prospectus and includes the management fee, fund operating expenses, and the 12b-1 charge. Therefore, if the Class A shares have a 1.25% expense ratio and a 0.25% 12b-1 charge, the Class C shares with a 1.00% 12b-1 charge will have a 2.00% expense ratio.

The Mutual Fund Cost Calculator tells you what your investment would be worth at the end of the holding period after all expenses and loads-assuming the annual rate of return you selected. It also tells you how much in fees you would have incurred and how much in earnings you would have foregone-again, assuming the annual rate of return selected. Foregone earnings are what you would have earned on the money you paid as a front-end load or in expenses including the 12b-1 charge, if it had instead been invested.

The results?

Table 2 illustrates that the best cost structure to choose for any particular fund varies, depending on your holding period. The Class A shares were the worst for a one-year holding period and the Class C shares were the best. At 20 years the Class C shares were the worst and the Class B shares were the best. Had you put in sufficient money, however, to avoid a front-end load entirely, the Class A and Class B shares would have tied as best of classes. Higher rates of return assumed and longer time periods would have exaggerated these results.

Loaded Down

If the total cost of holding any of these classes over 20 years isn't shocking, then slap yourself to get your attention. High expenses and loads can devastate investment values over a lifetime. Take some time and play around with the numbers on the SEC Web site. If you are confronted with a fund class choice, make sure that you have the appropriate investment prerequisites or you may very well flunk this incredibly important exam.


Discussion

Neophyte Investor from CA posted 8 months ago:

Thank you for this article. I am learning from your website. I have a lot of questions that need to be answered.


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