Do you ever look at your investment statements and have no idea what they mean?
Investments should not be overcomplicated. You use your money to invest in a company or a project or a business. If it does well, you make money. If it does badly, you lose money. That is the Cliffs Notes version of investing, but the financial industry has spawned many different investment methods and vehicles to give greater choice and freedom. And a wider range of fees, commissions, and compensation structures to go with them.
In looking over your financial statements, you might notice that you are invested in one or more mutual funds. Nothing surprising about that, as passive investments like mutual funds and ETFs are rising in popularity and prominence. There are, however, different classes of mutual fund shares, and it is important to know the differences between them. The different shares of the same mutual fund will all grow at the same rate, but how much the fees are and when you have to pay them will differ, which will impact your overall return and what your strategy should be. Here is a quick rundown of the three main classes of mutual fund shares.
Class A shares are the most common type of share that I encounter when dealing with new clients, and should basically be thought of as an upfront commission. If you give a broker $10,000 to buy XYZ Class A shares, you will receive $10,000 worth of stock, minus a commission. The commission ranges from fund to fund, but is generally in the 3-7% range. Some Class A’s will also have a sales charge based on how long you hold it, but this is rare and is much less than the other two classes of shares.
Class B shares are less common and work on a deferred commission basis. This means that if you buy $10,000 of XYZ Class B, you will get $10,000 worth of XYZ. If you were to immediately sell the stock, you would receive $10,000 less the broker commission. This fee is typically reduced over the life of the asset, meaning that the longer you hold onto it the less you will have to pay. This can continue to the point where the shares are converted into Class A shares, which will lower the sales cost of the investment in the future. The sales charge on Class B shares is generally a few percentage points higher than with Class A shares, and they sometimes charge an annual percentage to ensure that the broker is compensated while you hold the stock.
Class C shares are not very common, and they derive most of their compensation from annual fees associated with holding them, generally 1% give or take a few basis points. They also generally charge you another percentage point if you sell them within the first year of owning the stock. Because the entirety of the commissions come from the ongoing annual fee, this class quickly becomes the least profitable investment the longer that you hold on to it.
For an even quicker summary, you can think of them in this manner; Class A shares you pay the commission up front, Class B you pay a commission when you sell, and Class C you pay an ongoing annual fee. Advanced, Belated, or Continuous fees.
Now that you know the difference, which is the best option for me?
Odds are, none of them are best for you. Why? Because there are mutual funds that come with no commissions at all. They’re called “no-load” mutual funds, and they are the ones used primarily by fiduciaries like us. Part of the allure of the different share classes stems from the old mantra of “you get what you pay for,” wherein mutual funds that you have to pay for should perform better than mutual funds that you don’t have to pay for. Furthermore, they should perform better by enough of margin to pay for the fees and then some. However, research shows that loaded funds worse on average than no-load funds, and that is before accounting for the extra fees and commissions involved. These loaded funds also tend to be more actively managed, which means that transaction costs for buying and selling securities further impede the ability earn strong returns.
It is for these reasons and more that fiduciaries tend to steer clients away from investing in loaded funds. They just aren’t worth it, and the commissions involved take a substantial bite out of retirement savings. So the next time your advisor is telling you to invest in a loaded fund, ask them why, and ask them how much commissions they expect to receive. The answers may or may not surprise you.