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, which is a sales charge collected when an investor purchases shares. This share class is subject to breakpoint schedules, which reduce the sales charge as the investment amount increases. Here’s an example:
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 an LOI lets the investor 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, pledging to invest the additional $5,000 within the next 13 months. That would qualify them for the 7.0% sales charge today (instead of 8.5%).
LOIs can also be backdated up to three months to include 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 three months, the investor has only ten months remaining to complete the shortfall deposit. If the investor fails to complete the deposit, the fund retroactively applies the higher sales charge.
LOIs cannot be satisfied through asset appreciation. If the investment grows in value, that growth doesn’t replace the required shortfall deposit.
However, funds may 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 the ABC fund, the registered representative must explain how the customer could qualify for the next breakpoint (they’re only $1,000 away). The customer’s options include:
There can be an incentive for a financial professional to avoid helping 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 representative fails to notify the customer about the breakpoint opportunity, it’s a violation called a breakpoint sale. Breakpoint sales are subject to regulator-imposed fines and/or suspensions. The representative must act as a fiduciary by putting the customer’s interests ahead of their own.
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 invest $10,000 in the same fund through five different firms, it’s treated as a $50,000 purchase for breakpoint purposes.
Investors may also use the combination privilege, which allows purchases across multiple funds within 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 too soon can make the sales charge a large drag on returns. A longer holding period gives the investment more time to potentially earn returns that outweigh the initial sales charge.
Class B shares assess back-end loads, meaning the sales charge is paid when the investor sells (redeems) shares. This type of back-end load is also called a contingent deferred sales charge (CDSC).
A CDSC typically declines the longer the investor holds the shares. Here’s a common 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% |
A CDSC schedule reduces the sales charge for longer holding periods. 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 this example, 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 shares because breakpoint schedules can reduce the front-end load.
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 Class C shares impose a one-year CDSC. With that structure, investors avoid the back-end charge if they hold the shares for at least one year.
The most significant expense for Class C shares is typically 12b-1 fees. This is a marketing fee intended to lower a fund’s expense ratio by attracting more investors.
Many mutual funds have operating expenses that don’t change much as assets grow. For example, assume a fund has $100 million in assets and $1 million in annual operating expenses. At that level, the expense ratio is 1%. If the fund could double assets to $200 million while keeping operating expenses at $1 million, the expense ratio would fall to 0.50%.
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, these create a maximum annual 12b-1 fee of 1%.
Each share class typically has a different 12b-1 fee level:
Regulators recognize that ongoing 12b-1 fees can reduce investor returns over time. Because of that, a fund charging more than 0.25% in 12b-1 fees cannot market itself as a “no load” fund. Otherwise, an investor might buy a fund expecting low costs while paying an ongoing marketing fee that doesn’t go away. So even if many Class C shares don’t have a front-end or back-end sales charge, they generally can’t be marketed as “no-load” due to their higher 12b-1 fees.
Class C shares are generally suitable for short-term investors. Because 12b-1 fees continue year after year, long-term investors typically want to avoid this share class. Even though a 1% annual fee may sound small, it’s charged repeatedly. If an investor holds Class C shares for ten years, they will 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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