Understanding Mutual Fund Share Classes (Or Why You Should Just Invest In Index Funds)

2011 October 4
by Kyle Bumpus
from → Mutual Funds And ETFs

Here at Amateur Asset Allocator, I advocate using low-cost index funds to meet your financial goals. One of the main reasons I prefer index funds, aside from their rock-bottom costs, is that they are so freakin’ simple. They are so simple, in fact, that even a relative novice could create a reasonable portfolio with them. You only need three: a Total Stock Market Index Fund, a Total International Stock Market Index Fund, and a Total Bond Market Index Fund (I prefer Vanguard index funds but Fidelity has excellent options as well). That’s it.

As for their relative proportions, that’s simple, too. To start, you’ll want to invest your “age in bonds,” meaning a 40 year old should have 40% of her portfolio in the Bond fund, a 55 year old should allocate 55% of her portfolio to the bond fund, etc. Then, just split the rest of the portfolio equally between the total stock market and the total international stock market funds. That’s it! You’ve just created a simple three-fund portfolio that will out-perform the majority of the pros on a risk-adjusted basis. You really don’t need to do any other research if you don’t want to. And as for portfolio maintenance, all you really need to do is spend 15 minutes each year rebalancing your portfolio back into its starting allocation (making sure to increase your bond allocation as you age, of course). Easy, right?

It’s Not So Easy With Many Active Funds

While the top mutual fund companies such as Vanguard, Fidelity, T Rowe Price, and a few others all offer primarily no-load mutual funds, most other fund families are not so generous. Their funds are sold through brokers and brokers have mouths to feed (a few thousand mouths judging from the size of the commission checks). Choosing between active funds isn’t as simple as just visiting Morningstar.com and choosing a few of the best-performing funds (although you should definitely sign up for a free Morningstar account to gain access to their excellent mutual fund database and portfolio tools if you haven’t already). That’s because past performance is not a guarantee of future results and experience shows us performance chasing rarely works.

Costs Matter, But What Are The Costs?

Here we come to the crux of the matter. In investing, costs matter more than anything else. They matter so much that cost is by far the single best predictor of future fund performance. So how do you figure out the costs? Sure, you could log into Morningstar.com and look at each fund’s expense ratio, but that’s not always enough. You see, fund companies have come up with a few sneaky ways to get you to pay the commissions they owe to their sales force in the form of loads. Some funds charge loads on your initial purchase, some charge when you sell, some charge on-going 12b-1 fees (which basically means they are making you pay their marketing and distribution costs), and some even obscure their additional fees by rolling them into the expense ratio!

Common Mutual Fund Share Classes

How do you know which share class is going to charge you the lowest total expenses and when you will be expected to pay? While the following conventions sometimes change from fund company to fund company, these are the industry “standards” so-to-speak. You should definitely double-check this information on any specific fund you intend to buy, though.

Share Class A – A class shares usually (almost always) charge an up-front sales load, meaning you pay a sales commission every time you buy a fund. Front-end sales loads on class A funds usually range from around 1% to 5%, although they can go higher. For example, if you invest $1000 in a mutual fund with a 5% front-end sales load, you will end up only owning $950 worth of the fund after the transaction. The other $50 goes directly to the broker who sold you the fund. Class A shares usually have the lowest on-going expense ratio of the retail fund share classes, however, so if you plan to make one large purchase and then hold the fund for a long period of time, A shares might be the cheapest long-term choice (although still many times more expensive than most index funds).

Share Class B – B class shares usually carry back-end loads (also called contingent deferred sales charges) payable when you sell shares. They are pretty much the opposite of A shares and usually charge a higher annual expense ratio to boot. On top of that, class B shares often charge 12b-1 fees as well, ranging as high as 1%.

Share Class C – C class shares usually charge 12b-1 fees (again, up to 1%) and charge about the same annual expenses as class B shares. However, class C shares generally do not charge a sales load, either up-front or on the back end. Some naive investors might be tricked into thinking the lack of sales loads makes class C shares the cheapest to own, but it’s usually quite the opposite. That’s because 12b-1 fees and the high expense ratio are charge every year for as long as you own the fund while sales loads are only charged once. Class C shares only make sense if you don’t intend to hold the fund for a long period of time (which is an unwise strategy, but that’s another topic).

Share Class F – F class shares are similar to A shares except they usually charge an annual asset-based fee instead of a load in order to compensate financial planners for their services. Yes, financial planners can be quite expensive.

Share Class I – Also called Institutional Shares, I shares sport annual expense ratios as low as or lower than class A shares but without any sales loads or 12b-1 fees, making them ideal if you have enough cash to qualify (if you’re reading this, you probably don’t).

Is trying to figure out which share class is best for your specific situation making your head spin? Mine too! That’s why I just invest in index funds instead.

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2 Responses
  1. 2011 October 6

    Please reconsider the above dangerous concept. First, you are advocating putting a great deal of money in bonds when they are at their riskiest point in the last 50 years! A 30 year bull market in bond prices have brought the yields to historical lows that make bonds a HIGH RISK investment. Secondly, index mutual funds work well in bull markets only. Those who have invested in index funds the last decade have suffered poor returns.
    Investors should now underweight bonds and overweight high quality dividend paying stocks. I realize it is not as “simple”. But this is not the time to be lazy!
    I have written an article illustrating this concept titled “Sell Bonds and Buy Best Dividend Paying Stocks” for anyone interested at:
    http://blog.arborinvestmentplanner.com/2011/08/sell-bonds-and-buy-best-dividend-paying-stocks

  2. 2011 October 6

    Hmm, I have invested in index funds over the last decade and my returns have been far from poor. My returns have been in the 6-7% range which, while below the historical average, is certainly not poor considering the economic climate (and much higher than the vast majority of active investors, I’ll bet). I do not agree with your argument that bonds are currently risky investments. Perhaps if you are holding only 30 year bonds, but the average short- to intermediate-term bond fund will not suffer a huge amount if rates spike significantly. And even if they did, it would only be temporary since those funds would quickly reinvest at higher rates. Rates have spiked before without a catastrophe: how is this time different?

    Besides, stocks don’t do well when interest rates rise sharply, either.

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