The A,B,C’s of Mutual Funds

by Jeffry Marzina, CFP

Several years ago there was much debate in the press about whether individuals should invest in “load” mutual funds or “no-load” mutual funds. The term “load” was negative slang invented by the no-load mutual fund families to refer to the words “sales charge” or “commission.” The reality is, that once upon a time all mutual funds had an up-front sales charge, sometimes as high as 8.5%. This changed during the last great bear market of 1973 and 1974 when the Vanguard Group decided to eliminate its commission in order to retain its share of the market. As mutual funds gained in popularity and more mutual fund families came into existence, the load vs. no-load debate became louder and louder.

In my opinion, the entire debate could have been settled by simply stating that no-load funds were for do-it-yourselfers, and funds that had sales charges would be used by those seeking the advice of a professional advisor. After all, the sales charge was the way that the investor paid the advisor. Instead, what ensued was a sort of price war. Investors wanted professional help but since the no-load fund families were doing such a good job marketing, investors did not want their money invested in load funds. This created quite a problem with financial advisors because in essence what they were being told by investors was “We want your advice, we need your help, we just don’t want to pay you.”

Many of the fund families that had sales charges went back to the drawing board. They knew that advisors did the majority of the marketing for their funds and they wanted to keep that relationship. So how do load mutual funds compete against no-load funds and still compensate advisors? Simple. Create a new class of shares that masks the up-front sales charge. Hence, the “B” share was created.

Then the brokerage “supermarkets”, companies like Charles Schwab, came into the picture. These companies made agreements with some no-load mutual fund families whereby the fund company would pay the brokerage firm a portion of the fund’s management fee and the advisor would market the funds.

Now investors had the ability to invest in several different mutual fund families and have them all show up on one statement. This also made it possible for investment advisors to use no-load funds for their clients and charge a flat asset-based fee on an ongoing basis. The concept was a tremendous success for all parties involved. Today, more and more advisors (including Bill Few Associates) work on a fee basis rather than on a commission basis.

Once again the load fund families faced a dilemma. How could they maintain a relationship with the advisors that worked with them in the past, but now wanted to be compensated on an asset-based fee rather than the old commission structure? The solution was the “C” share. Other classes of shares were also created allowing investors to invest in their mutual funds without any sales charge as long as the assets were held in a fee-paying account.

So what are the A,B,C’s of mutual funds? They simply are different classes of shares of a particular mutual fund. In most cases, the investments are the same; it is how you pay for them that is different. Usually, Class A shares have an up front sales charge. For example, if the sales charge is 5.75% and you make an investment of $10,000, then $9,425 would actually go into your account and the remaining $575 is paid out as a commission from the fund company to the brokerage firm.

With Class B shares, the commission is still paid up front to the selling broker and the full $10,000 is invested in your account. What is different here is that if you redeem your shares within a certain number of years, then you are assessed a “deferred sales charge.” Typically the deferred sales charge starts at 5 percent and is reduced by 1 percent per year. The catch is, that the annual expenses of the fund are slightly higher than in the Class A shares. This is how the mutual fund company recoups the up-front commission that it paid to the broker. Class C shares have no front end or deferred sales charges, although some funds will charge a 1% redemption fee if the account is redeemed in the first year. They simply pay the advisor a flat annual fee for advising the client. This fee is added to the expense ratio of the mutual fund.

Ironically, some no-load mutual fund families are changing their tune and adding sales charges to their funds. They no longer want do-it-yourselfers investing in their funds, but would rather have an advisor involved. Financial advisors deserve to be paid and as you can see there are many ways to pay for advice.

However, the fee needs to be fully disclosed to the investor before investments are made. For anyone to say that “B” shares are no-load simply because there is no up-front sales charge is wrong. The fee discussion between client and advisor should be open and honest. Remember that the advisor has been compensated in some way for their professional advice. So do not be afraid to ask your advisor up-front how you are paying them.

Jeff Marzina is a Certified Financial Planner and a senior consultant at Bill Few Associates, Inc. He advises high net worth clients on investment management issues. Please feel free to contact Jeff by email at jmarzina@billfew.com, or by fax at (412) 801-4911.