When it comes to buying mutual funds, individuals are increasingly seeking out professional investment advice, especially during difficult market periods. As a result, fund companies are rolling out share classes that have different cost structures to meet varying investor needs.
Depending on your financial situation and goals, one share class of a fund may make more sense than another. It's also important to understand what the different fund fees and expenses are - and how they factor into a fund's return figures. You need to know how much you are paying for your mutual fund in order to accurately assess how much you are making from the investment.
Types of loads
Most mutual funds are sold with some kind of a sales charge, or load, for the advice and service a client receives when purchasing the fund. There are three main types of sales charges: a front-end load, a back-end or deferred load, and a level load.
With fund share classes that charge front-end loads, you pay the load up-front when you buy the fund. If you buy into a fund with $10,000 and the front-end load is 3%, then $300 will be deducted for the sales charge and the remaining $9,700 will be invested.
With share classes that charge back-end loads, or contingent deferred sales charges, the percentage you are charged when you sell shares usually declines annually over the course of five to 10 years until the load is phased out entirely. However, there may be other higher expenses associated with these share classes.
Level loads, which are less common, involve paying a percentage of your return every year for a set number of years. A level load might make sense if you know how long you're going to hold the fund.
Does it make much difference which load you choose? It depends on your circumstances, and an advisor can help you evaluate them.
Mutual fund companies typically assign a letter of the alphabet to the different share classes of a fund. "A," "B," and "C" share classes are the most common. While there are no strict rules on which fee structure is associated with which share class, there are some general standards. "A" shares usually have front-end loads. "B" shares usually have back-end loads. "C" shares usually have no load but permanently higher annual charges.
Other letters are assigned to share classes as well, including ones for institutional investors, high-minimum investors, or investors using financial advisors.
Annual expense ratios
Regardless of which type of load you choose, the annual expense ratio is a key consideration in evaluating a fund. This ratio, listed in the fund prospectus as a percentage of assets, reflects almost all of the costs associated with the fund, except the loads. The expenses included in this calculation are deducted from earnings.
While multiple classes of a fund will experience the same investment performance because they share the same underlying portfolio of securities, the individual expense structure of each class will result in different net asset values for each class. The annual expense ratio might include advisor fees, administrative fees, transfer agent fees, and custodian bank fees, among others. These expenses are added up in dollars and divided by the average assets of the fund, which results in the annual expense ratio.
Annual expense ratios typically run from under 1%, for, say, an index fund, and up to more than 2% for an international fund.
The 12b1 fee often makes up a large part of the annual expense ratio. This fee pays for the distribution, marketing, and advertising costs of the fund and can be as high as 1% of assets. The allowable maximum 12b1 fee is .75% of assets, and the minimum fee for a fund that carries no sales charge is typically .25% of assets. Note, however, that many funds charge no 12b1 fee at all.
Some funds charge a redemption fee if you sell your shares after holding them for only a short period of time, usually for less than 90 days. Unlike back-end loads, redemption fees are paid directly back into the fund, not to the fund company or brokerage firm. These fees are put in place to discourage market timers.
How should an investor evaluate the many fees and expenses associated with mutual fund share classes? A good place to start is by looking in the fund's prospectus. It must include an SEC-approved method of calculating the long-term costs for each share class. But figuring out which share class is best for you can still be tricky. A portion of the fees charged by mutual funds goes toward providing investment advice - take advantage of it by consulting with an advisor.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.