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 we’ll focus on:
Class A shares assess a front-end load, which is a sales charge collected when you purchase shares. This share class is also 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 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 (pledging 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 prior purchases. For example, if the investor had purchased $1,000 a few weeks before investing $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 customer still has a total of 13 months of coverage - meaning they now have only 10 months left to make the shortfall deposit. If the customer doesn’t make the required deposit, the fund will retroactively assess the higher sales charge.
LOIs can’t 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 tell customers when they’re 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’s options include:
There’s a potential conflict of interest here: higher sales charges can mean higher compensation to the firm. Using the same schedule:
That’s a $290 difference. If the customer isn’t informed about the breakpoint opportunity, the financial professional commits a breakpoint sale, which is a violation. Breakpoint sales are subject to FINRA-imposed fines and/or suspensions. The representative must act as a fiduciary by putting the customer’s interests first, which includes explaining 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 through five different broker-dealers in the same fund, it would still count as a $50,000 purchase for breakpoint purposes.
Investors can also use the combination privilege, which allows purchases across a single 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. Front-end loads can be substantial, so selling too soon can make the sales charge a large drag on returns. With a longer holding period, the investor has more time for returns to potentially outweigh the initial sales charge.
Class B shares assess back-end loads, meaning the sales charge is paid when the investor sells shares. This type of back-end load is called a contingent deferred sales charge (CDSC). Typically, the longer the shares are held, the lower the CDSC.
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 when shares are redeemed, 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 sold 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 breakpoint schedules.
Class C shares are best known for ongoing marketing fees, which create level loads. This share class typically does not impose a front-end or back-end sales charge, although some funds impose a one-year CDSC. In that structure, investors avoid the back-end sales charge if the shares are held 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 more investors and potentially lower a fund’s expense ratio by spreading fixed 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 assets grow to $200 million while expenses remain $1 million, the expense ratio falls 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, the maximum annual 12b-1 fee is 1%.
Each share class typically has a different 12b-1 fee level:
Regulators recognize that ongoing 12b-1 fees reduce investor returns over time. Because of that, a fund charging more than 0.25% in 12b-1 fees can’t market itself as a “no load” fund. Otherwise, an investor might buy a fund expecting low costs while still paying an ongoing marketing fee.
Class C shares are generally suitable for short-term investors. Because 12b-1 fees are ongoing, long-term investors typically avoid this share class. Even though 1% may sound small, it’s charged repeatedly. 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.
Sign up for free to take 10 quiz questions on this topic