Mutual funds with sales charges (loads) are typically grouped into share classes. The key difference is how and when the sales charge is collected. Here are the three share classes covered here:
Class A shares assess a front-end load, meaning the sales charge is collected when the investor buys shares. This share class is also subject to breakpoint schedules, which reduce the sales charge as the investment amount increases.
Here’s an example of a breakpoint schedule:
ABC Fund Class A Breakpoint Charge
| Volume | Sales Charge |
|---|---|
| $0 - $24,999 | 8.5% |
| $25,000 - $49,999 | 7.0% |
| $50,000 - $99,999 | 5.5% |
| $100,000+ | 4.0% |
Breakpoint schedules reward larger purchases with lower sales charges. Funds must offer breakpoint schedules if they assess the maximum sales charge of 8.5%.
If a customer doesn’t currently have enough money to reach the next breakpoint, they can sign a letter of intent (LOI). An LOI is a pledge to invest the additional amount (the shortfall) within the next 13 months. Signing the LOI lets the customer receive the lower sales charge immediately.
Using the breakpoint schedule above, assume a customer has $20,000 to invest. They could sign a $5,000 LOI (agreeing to invest the additional $5,000 within 13 months) and receive the 7.0% sales charge today instead of 8.5%.
LOIs can also be backdated up to 3 months to include recent prior purchases. For example, if the investor had purchased $1,000 a few weeks before investing the $20,000, they could reduce the LOI amount to $4,000.
Backdating does not extend the LOI period. If an LOI is backdated by 3 months, the investor has only 10 months remaining to complete the shortfall deposit. If the investor fails to complete the LOI, the higher sales charge is assessed retroactively.
LOIs cannot be satisfied through asset appreciation. Even if the investment grows in value, the customer still must make the shortfall deposit.
However, funds do offer rights of accumulation, which can reduce sales charges on future purchases. For example, if a customer already has $40,000 invested in a fund and wants to invest an additional $10,000, the new purchase qualifies for the $50,000 breakpoint.
Financial professionals must inform customers when they are close to a breakpoint. For example, if a customer wants to invest $24,000 in ABC Fund, the registered representative must explain how the customer could qualify for the next breakpoint (they’re only $1,000 away). The customer could:
Either option would qualify the customer for the 7.0% breakpoint. The customer can also choose to do nothing and accept the higher sales charge.
There can be an incentive for a financial professional not to help a customer reach a breakpoint, because the firm earns more when the sales charge is higher. Using the same schedule:
That’s a $290 difference. If the customer is not notified of breakpoint options, the financial professional commits a violation called a breakpoint sale. Breakpoint sales are subject to FINRA-imposed fines and/or suspensions. The representative must act as a fiduciary by placing the customer’s interests ahead of their own, which includes presenting available ways to qualify for a lower sales charge.
Breakpoints are available to all individuals and some groups. Many funds offer householding, which allows family members living at the same address to combine purchases to qualify for lower breakpoints.
Breakpoints also apply regardless of where the fund is purchased. If you invested $10,000 in the same fund through five different broker-dealers (firms that help investors trade securities), the fund would treat that as a $50,000 purchase for breakpoint purposes.
Investors can also use the combination privilege, which allows purchases across multiple funds in the same fund family to be combined for breakpoint purposes. For example, an investor buying $10,000 of the ABC Stock Fund, $10,000 of the ABC Corporate Bond Fund, and $5,000 of the ABC US Government Bond Fund would qualify for a $25,000 breakpoint.
Class A shares are generally most suitable for long-term investors investing larger amounts. Because the front-end load can be substantial, selling soon after purchase can make the sales charge a large drag on returns.
Class B shares assess a back-end load, meaning the sales charge is paid when the investor sells (redeems) shares. This type of back-end load is called a contingent deferred sales charge (CDSC).
A CDSC typically declines the longer the investor holds the shares. Here’s a typical schedule:
ABC Fund Class B CDSC Schedule
| Years of ownership | Charge |
|---|---|
| 1 year | 8% |
| 2 years | 6% |
| 3 years | 4% |
| 4 years | 2% |
| 5+ years | 0% |
If a CDSC applies at redemption, the fund deducts the charge from the redemption proceeds before paying the investor.
Most CDSC schedules eventually reach a point where no sales charge is due. In the example above, shares held for 5 years or longer can be redeemed with no CDSC. Many fund companies convert Class B shares to Class A shares once the CDSC period ends.
Class B shares are generally suitable for intermediate- to long-term investors investing smaller amounts. Investors with larger amounts to invest often benefit more from Class A breakpoints.
Class C shares are best known for ongoing marketing fees, which create a level load (a continuing cost rather than a one-time sales charge). This share class typically does not impose a front-end or back-end sales charge, although some funds impose a one-year CDSC. Under that structure, the investor avoids the back-end charge by holding the shares for at least one year.
The most significant expense for Class C shares is usually the 12b-1 fee. This is a marketing fee intended to attract additional investors and, in theory, reduce a fund’s expense ratio by spreading operating costs across a larger asset base.
For example, assume a fund has $100 million in assets and $1 million in annual operating expenses. The expense ratio is 1% ($1 million ÷ $100 million). If the fund grows to $200 million in assets while expenses remain $1 million, the expense ratio falls to 0.50% ($1 million ÷ $200 million).
12b-1 fees are used to grow a fund’s assets in hopes of lowering expenses on a per-investor basis. There are two components:
Together, the maximum annual 12b-1 fee is 1.00%.
Each share class typically has a different 12b-1 fee level:
Regulators recognize that ongoing 12b-1 fees reduce investor returns over time. For that reason, a fund charging a 12b-1 fee of more than 0.25% cannot market itself as a “no load” fund. Otherwise, an investor might buy a fund expecting low costs while still paying an ongoing marketing fee.
Even though many Class C shares don’t have a front-end or back-end sales charge, the fund company still cannot market them as “no-load” if the 12b-1 fee exceeds 0.25%.
Class C shares are generally suitable for short-term investors. Because 12b-1 fees are ongoing, long-term investors typically want to avoid this share class. A 1% annual fee may sound small, but it applies year after year. If an investor holds Class C shares for 10 years, they pay the 1% annual fee ten times!*
*Technically, 12b-1 fees are assessed quarterly, although the fee is expressed as an annual percentage. For example, assume an investor owes an annual 12b-1 fee of $100. The fund would charge $25 per quarter instead of a one-time $100 fee.
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