01/12/2015 - The ABCs of Mutual Funds, Part I

Mutual Funds that have a "load," that is a charge associated with investing in the fund, are generally sold in three classes: A, B and C. They differ in the commission the broker is paid by the buyer for the sale, when it is paid, and the size and duration of annual fees taken by the fund company.

Class A funds are front-loaded. There is an up-front commission that is a percentage of the amount of the purchase. Annual fees, such as management fees and 12b-1 fees, are charged for fund maintenance, sales and distribution. No commission is charged on redemption, although there may be redemption fees charged.

The front-load percent may start out around 5.75 percent but the percentage decreases in steps as the size of the purchase goes up, dropping to zero percent typically at one million dollars. Legally the front-load can go as high as 8.5%.
Other ways to decrease the percentage of front-load fees are by owning other mutual funds offered by the same fund family, committing to regularly purchasing mutual fund shares, and having family members who hold funds in the same fund family.

The 12b-1 fees get their name from the SEC rule that governs them. Investors are not charged these fees directly, but fund managers are allowed to take these fees out of a mutual fund's assets to cover the annual costs of marketing and distribution. Since the fund assets are used to pay these costs, the value of a fund share is reduced and performance is adversely affected.

The current limit on 12b-1 fees is 0.75% per year, but there is no limit on how long a fund can pay these charges if it continues to make significant new sales to investors. As a result, shareholders may pay asset-based charges through the fund for as long as they own the fund.

Class B funds are back-end loaded. They charge higher expenses than Class A shares, usually for a period of four to eight years. Class B shares normally impose a contingent deferred sales charge (CDSC), which is the back-end load. You pay the CDSC if you sell your shares within a certain number of years, normally before the end of six years. Some Class B shares convert to Class A shares after a certain number of years. Class A shares typically have lower management and 12b-1 fees than Class B shares, so it's significant that the back-end commission goes away years down the road and the fees drop.

Class B funds have fallen under scrutiny lately. Purchase of large amounts of Class B funds lose the benefit of the breakpoints inherent in Class A funds, not to mention the higher annual fees generated over the first six to eight years. Large purchases of Class B funds tend to benefit the broker at the expense of the buyer so some broker/dealers cap purchases at $50,000. Several fund families have announced that they are planning to drop their B shares altogether.

Stay tuned for Part II, next week.
-Patti Spencer
(Initially published by LNP, 2013)