Textbook
1. Introduction
2. Investment vehicle characteristics
3. Recommendations & strategies
4. Economic factors & business information
5. Laws & regulations
6. Wrapping up
2.3.2.4 Share classes
Mutual funds with sales charges (loads) are typically categorized by class. How and when sales charges are imposed defines their differences. In particular, we’ll cover these three share classes:
Class A shares assess a front-end load, a sales charge collected when customers purchase shares. This share class is subject to breakpoint schedules that determine the load based on the amount of money invested. 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% |
As you can see, breakpoint schedules allow for lower sales charges when an investor purchases more. Funds must offer breakpoint schedules if they assess the maximum sales charge of 8.5%. A customer without the required funds for a lower breakpoint can sign a letter of intent (LOI), a pledge to make an additional deposit for the shortfall in the next 13 months. By doing so, they can obtain the lower sales charge right away.
Using the breakpoint schedule above, assume a customer had $20,000 to invest. They could sign a $5,000 LOI pledging to make the shortfall deposit sometime in the next 13 months to obtain the lower sales charge of 7.0% today (vs. 8.5%).
LOIs can also be backdated up to three months to include any previous purchases. Using the previous example, the investor could reduce their LOI to $4,000 if they had made a $1,000 purchase a few weeks before the $20,000 investment. However, backdating the LOI does not increase the time it covers. If an LOI is backdated three months, the customer only has ten months to make the required shortfall deposit. If the customer fails to make the necessary deposit, they will be retroactively assessed the higher sales charge.
LOIs cannot be met by asset appreciation. If the position grows significantly in value, it does not exempt the customer from making their shortfall deposit. However, funds provide rights of accumulation, which results in lower sales charges for future purchases. For example, if a customer had $40,000 invested in a fund and wished to make a new $10,000 purchase, they would qualify for the $50,000 breakpoint on the new purchase.
Financial professionals must inform customers when they are approaching a breakpoint. Assume a customer requests to purchase $24,000 of ABC mutual fund with the breakpoint schedule referenced earlier. The registered representative is responsible for informing them how to obtain a lower breakpoint (they are within $1,000 of the next breakpoint). The customer has a few options: deposit the $1,000 shortfall now or sign an LOI. Either option will give them the lower 7.0% breakpoint. Alternatively, the customer doesn’t have to do anything and can simply accept the higher sales charge.
There’s an incentive for financial professionals to avoid helping their customers attain lower sales charges. If a customer purchases $24,000 of the fund previously referenced, the firm will make more money on the sale. Let’s look at the numbers:
As you can see, an additional $290 is charged if they don’t inform their customer of the next breakpoint. If the customer is not notified, the financial professional engages in a violation called a breakpoint sale. Breakpoint sales are subject to regulator-imposed fines and/or suspensions. If a customer is close to the next breakpoint, it’s the representative’s responsibility to provide them with options for attaining it. The representative must act as a fiduciary by placing their customer’s interests before their own. This requires providing the best potential options rather than prioritizing their paycheck.
Breakpoints are available to all individuals and some groups of people. Many funds provide householding, which allows families living under one roof to add their purchases together for lower breakpoints. Also, breakpoints apply no matter where or how many different brokers the fund is purchased through. If you spent $10,000 at five different financial firms on the same fund, it would be viewed as purchasing $50,000 of the fund (for breakpoint purposes).
Investors can also utilize the combination privilege, allowing multiple purchases made within one fund family to be added together for lower breakpoints. 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 most suitable for long-term investors with large amounts to invest. The more money invested, the lower the breakpoint. Front-end loads can be substantial, so it is only suitable to liquidate (sell) shares after a long holding period. Otherwise, the investor would lose significant money on the sales charge alone. The longer invested, the better the chance they have to obtain returns that exceed their sales charge.
Class B shares involve back-end loads, which are sales charges assessed when an investor sells their shares. This load type is also called a contingent deferred sales charge (CDSC). The longer an investor holds their shares, the lower the sales charge assessed. Here’s what a typical CDSC schedule looks like:
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% |
As you can see, CDSCs award shareholders if their shares are held long-term. If a back-end load applies during a redemption, the fund will remove the charge from sales proceeds before making payment. Most CDSC schedules have a point where no sales charge is due. In our example, shares held for 5 years or longer can be liquidated with no CDSC. Most fund companies convert these shares to Class A once the CDSC period ends.
Class B shares are suitable for intermediate to long-term investors with smaller amounts to invest. Longer-term investors with larger amounts to invest should consider Class A shares because of their breakpoint schedules.
Class C shares are primarily known for assessing ongoing marketing fees, subjecting investors to level loads. This share class typically does not impose a front or back-end sales charge, although some impose a one-year CDSC. In this structure, investors avoid a back-end sales charge if the shares are held for at least a year.
The most significant expense for class C shares is 12b-1 fees. This is a marketing fee that aims to lower a fund’s overall expenses by bringing more investors into the fund. Most mutual funds maintain a relatively static expense ratio regardless of the amount of assets under management. For example, let’s assume a fund with $100 million of current assets assesses $1 million in annual operational expenses. At this asset level, the expense ratio is 1%. If the fund could double the size of its assets under management (to $200 million) while maintaining the same expense ratio ($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 a fund’s expenses on a per-investor basis. There are two components of this type of fee. Distribution fees pay for marketing and promotional services, including advertisements and payments to brokers that place customers into these funds. The maximum distribution fee that may be assessed is 0.75%. Service fees pay representatives to answer questions and discuss attributes of these funds as all advertisements include contact information (e.g., “Call us if you have questions!”). The maximum service fee that may be assessed is 0.25%. Combining the distribution and service fees results in a 1% maximum annual 12b-1 fee.
Each share class assesses a unique 12b-1 fee. These are the typical fee structures:
Regulators keenly know that ongoing 12b-1 fees eat away at investors’ returns. Therefore, relevant regulations do not allow a fund charging a 12b-1 fee of more than 0.25% to market itself as a “no load” fund. Otherwise, an investor may purchase a fund thinking it is efficient (low fees), while being assessed an annual marketing fee that never goes away. Although many Class C shares don’t maintain a front or back-end sales charge, the fund company could not market shares as “no-load” because of their high 12b-1 fee structure.
Class C shares are suitable for short-term investors. With the ongoing costs that 12b-1 fees present, long-term investors want to avoid this share class. Although a maximum 1% fee may seem low, these fees are continuously imposed. If an investor held 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.
Sign up for free to take 18 quiz questions on this topic