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 an 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:
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 charge 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, suppose 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 already purchased $1,000 a few weeks before investing $20,000, they could reduce the LOI amount to $4,000. However, backdating does not extend the LOI period. If the LOI is backdated by 3 months, the investor has only 10 months remaining to complete the shortfall. If the investor doesn’t complete the required purchases, the fund retroactively charges the higher sales charge.
An LOI can’t be satisfied through asset appreciation. Even if the investment grows in value, the investor still must make the additional purchases promised in the LOI.
However, funds may offer rights of accumulation, which allow an investor’s existing holdings in the fund to count toward breakpoints 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 (using the schedule above), the registered representative must explain how the customer could reach the next breakpoint (they’re only $1,000 away). The customer’s options include:
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 a financial incentive for a representative not to help a customer reach a breakpoint, because the firm earns more when the sales charge is higher. Using the same example:
That’s a $290 difference. If the customer isn’t informed about the breakpoint opportunity, the representative commits a violation called a breakpoint sale. Breakpoint sales can lead to FINRA-imposed fines and/or suspensions. The representative must act as a fiduciary, putting the customer’s interests ahead of their own compensation.
Breakpoints are available to 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. For example, if you invest $10,000 through each of five different broker-dealers in the same fund, the fund treats that 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 best for long-term investors who are 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 shares. This is also called a contingent deferred sales charge (CDSC). The CDSC typically declines the longer the investor holds the shares. A typical schedule looks like this:
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 rewards longer holding periods with lower sales charges. 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 the example above, 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 who are 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 doesn’t charge a front-end or back-end load, 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 cost for Class C shares is usually the 12b-1 fee. This is a marketing fee intended to help reduce a fund’s expense ratio by attracting more investors.
Many mutual fund expenses are relatively fixed regardless of assets under management. For example, suppose a fund has $100 million in assets and $1 million in annual operating expenses. The expense ratio is 1%. If the fund grows to $200 million in assets while expenses stay at $1 million, the expense ratio falls to 0.50%.
12b-1 fees are used to grow 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 reduce investor returns over time. Because of this, a fund that charges 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 paying an ongoing marketing fee indefinitely. So even if many Class C shares don’t charge a front-end or back-end load, they generally can’t be advertised as “no-load” due to their higher 12b-1 fees.
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. Even though 1% may sound small, it’s charged 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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