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Many mutual fund companies offer different types — or “classes” — of the same investment fund. Every share class has the same investment objectives and invests in the same pool of securities. But each has different fees and expenses and, therefore, different performance results.
The term “class” is misleading. It’s easy to think that an A-class share is better than a B-class share, and so on. In reality, the letter designations have nothing to do with the quality of the fund. They only describe the fees you pay to invest in it.
Unfortunately, most investors don’t understand share classes and the different fees associated with them. As a result, many investors get taken advantage of by the financial services companies that sell these products.
How fees work
There are three types of fees associated with mutual funds that investors must pay:
- Expense ratios: All mutual funds have expense ratios, which range from 0.08% to over 2% of the amount invested every year. These fees pay the funds’ operating and trading costs and can also be used to pay financial services companies. The higher the expense ratio, the worse the fund’s overall performance for the investor.
- Commissions: These fees are paid to the broker and his or her financial services firm as compensation for recommending the product. A commission is separate from the expense ratio.
- 12b-1 fees: These fees are part of the expense ratio. They’re paid to the firm that originally sold the mutual fund as a supplemental fee, after the first year commission is paid.
Fee-only advisors generally recommend funds with no commissions, no 12b-1 fees and low expense ratios. Brokers who “sell” mutual funds often recommend investments with commissions and 12b-1 fees.
Types of mutual funds
A fund’s type can give you clues about the types of fees it will charge. Loaded funds pay commissions and ongoing marketing fees to the companies and salespeople that sell them. No-load funds don’t pay any commissions to the advisor, and most don’t have ongoing marketing fees. However, there are many sub-classes of mutual funds.
The following mutual fund share classes apply to retail investors:
Commissionable share classes (loaded funds)
- A-class shares have a front-end sales load, which is a commission that investors pay when they purchase fund shares. A 5% commission is common for equity funds and 3% commission is common for bond funds. That means if you invest $20,000 into an A-class equity fund, the broker and his or her firm may receive $1,000, and you’ll have $19,000 in your account.
- B-class shares don’t have a front-end sales load, but they do have ongoing fees that are higher than those charged by A-class shares. The first is a contingent deferred sales load (CDSL), which investors pay when they redeem the fund shares — although, if you hold a fund for long enough, the fees could eventually decrease to 0%. The second is the higher 12b-1 fee. Let’s say you buy $20,000 of a B-class fund. All $20,000 will appear in your account, but the fund company will pay an upfront commission to the salesperson. To make up for that commission, every year for the next 10 years, the fund company deducts higher expense fees from your account.
- C-class shares often have a first-year CDSL, plus the highest ongoing 12b-1 fees.
Non-commission share classes
- No-load funds are offered by many financial services companies, such as Vanguard, Dimensional Fund Advisors, T. Rowe Price and others. They have no commissions or 12b-1 fees.
- Class LW (load-waived) shares are A-class shares with waived commission. The 12b-1 fee still applies.
- Class F shares pay no commissions and can be either no-load or load-waived. These are more likely to be recommended by fee-only advisors than by salespeople.
There are a few other types of mutual funds. Class I shares are often utilized by institutional investors, and Class R and Class 529 shares often appear in 401(k) and educational 529 accounts. If you have a choice in these fund types, prioritize no-load and low expense ratio funds.
How fees impact returns
To better understand the different shares classes and fees, let’s consider American Funds’ Growth Fund of America, one of the company’s largest mutual funds. There are 18 ways to invest in this fund. Five share classes are for retail clients, eight are designed for retirement accounts, such as 401(k)s, and five are used in 529 education accounts.
Fees vary by as much as 4% between funds. This is the only difference between these funds — and it can have a huge impact on the amount in your account. Funds with the lowest expenses have the highest return and those with the highest expenses and commissions have the lowest returns.
The following chart shows how fees eat into investors’ overall returns for the five different retail share classes. In this hypothetical case, all fund types had an annual return of 8% every year over a 10-year period. All percentages are of the amount invested.
| Fund type | Expense ratio (%) | Front load (%) | Deferred load (%) | 12b-1 fee (%) | Invested amount ($) | 10-year balance ($) | Total fees to salesperson and firm ($) |
|---|---|---|---|---|---|---|---|
| No load | 0.43 | 20,000 | 41,490 | 0 | |||
| Load waived | 0.70 | 0.25 | 20,000 | 40,460 | 1,030 | ||
| A class | 0.65 | 5.75 | 0.24 | 20,000 | 38,312 | 3,178 | |
| B class | 1.40 | 5.00 | 1.00 | 20,000 | 37,897 | 3,593 | |
| C class | 1.45 | 1.00 | 1.00 | 20,000 | 37,719 | 3,770 |
Chart by Michael Chamberlain, using Morningstar fee data
Conflict of interest
Why would anyone pay commissions on a loaded mutual fund when the no-load offering provides higher returns?
Because the investor doesn’t choose which class of fund to buy; the broker does. Financial services companies say that the different share classes have different “pros and cons” and it is up to the consumer to select what is in their best interest. But brokers rarely present all the share-class options for the investor’s consideration. This is clearly a conflict of interest between what is best for the investor and what is best for the broker.
Consumer beware
As a fee-only advisor, I recommend only no-load funds. However, many brokers sell investments because they make higher incomes collecting commissions and marketing fees than they do giving objective investment advice.
Investors must be aware of the different share classes and the fees associated with each one, as well as the potential conflict of interest when a broker makes a recommendation that provides a commission. Simply put, investors are better off working with an advisor who provides objective advice and recommends no-load and low-cost mutual funds.
Should you need help finding the lowest-cost share class available, contact a certified financial planner who doesn’t sell any products. To find such an advisor near you, contact Garrett Planning Network or the National Association of Personal Financial Advisors.
Michael Chamberlain, CFP, is the owner of Chamberlain Financial Planning and Wealth Management, a fee-only firm with offices in Santa Cruz, Sacramento and Campbell, California.
Image via iStock.
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