In mutual fund investing, the old adage that high costs indicate quality couldn't be further from the truth. There is no proof that if you pay a higher fee you'll get a higher return. If anything, the mutual fund manager of a high-cost fund might take more risks in the attempt to produce a higher return – and, of course, this higher return is not a sure thing. If the manager's risky moves don't pan out, you've not only forked out more money in costs, but you've also seen your portfolio value shrink from capital losses.
To avoid paying high fees only to suffer losses – and to maximize your investment return – it is important to consider which class of mutual fund shares is suitable for you and to know what kind of fees you will be paying when you invest in a mutual fund. Here we give an overview of these different classes.
While stock classes indicate the number of voting rights per share, mutual fund classes indicate the type and number of fees charged for the shares in a fund.
Although mutual fund companies can have as many as seven or more classes of shares for a particular fund, there are three main types of mutual fund classes: A, B and C (also known as A-shares, B-shares and C-shares). Each of these classes has various benefits and consequences. Let's examine each in turn.
Class-A shares charge an upfront sales fee, or front-end load, that is taken off your initial investment.
These shares are classified by their back-end or contingent deferred sales charge (a fee paid when you sell shares a specified period of years after the original purchase). These shares are typically good for investors with little investment cash and a long investment horizon.
Class C shares are a type of level-load fund, which charge an annual fee. This class works well for individuals who will be redeeming shares in the short term.
Although we've looked at all three classes, the middle class of mutual funds – the Class B shares – have been disappearing from the mutual fund industry. There are a number of reasons for this, but chief among them was more regulatory focus on fees. The 12b-1 fees as a whole have been under attack, acting as a source of shareholder lawsuits against fund companies for alleged misuse. Many funds are dropping these fees and shrinking the class offerings to compete with exchange traded funds (ETFs). ETFs themselves have put pressure on Class B shares by providing a low-fee alternative for investors with limited investment capital. In short, Class B shares still exist, but they are a dying breed.
Let's look at how the characteristics and pros and cons described above work in the following share classes of the hypothetical ABC Company Bond Fund.
|ABC Company Bond Fund, A Versus C Comparison|
|Class||Symbol||Front End||Back End||12b-1 Fees||Details|
|Source: Hypothetical bond fund, based on model from PIMCO|
In this example, you can see how these two different share classes are better for different types of investors and situations. If you plan on investing in this fund for retirement and your retirement is 20 years away, Class A shares would work best because they offer declining costs the longer you stay invested. Also, if you plan to invest just one lump-sum amount and it is enough to qualify for a breakpoint discount, Class A would be the best over time – you would get a discount on the initial load, and your yearly expenses (the expense ratio and 12b-1 fees) are very low, allowing your investment to grow.
Class C shares would work best if you are planning to invest for a limited period, optimally more than one year but less than three. In this way, you avoid both front- and back-end loads. Although your expense ratio will normally be higher than Class A shares, your full investment will gain interest while it is invested.
To show you how Class C shares work best for a shorter-term investment, let's compare the returns of a one-year investment of $10,000 in Class A and the same kind of investment in Class C shares:
Note the difference – you've made $378 more with Class C shares. Over a long period, however, Class A shares would be more optimal: The Class C's higher 12b-1 fee paid over the course of more than 10 years would eat into your returns to the point where Class A shares would provide you with a higher return.
When deciding which class of mutual fund shares to choose, remember to read the prospectus. In addition, you must take into account your investment horizon, the amount you have to invest initially, the frequency of your investments and the probability you will need to withdraw funds before you initially intend to do so.