Mutual Fund Share Classes: Different Ways To Get Paid For Fund Distribution

Mutual Fund Share Classes: Different Ways To Get Paid For Fund Distribution

Their are just the three classic types of mutual fund share classes.

First there were A shares, that paid an upfront commission to the broker who sold them. The payment came straight out of the fund’s NAV price, with breakpoints for larger dollar amounts.

Then there were B shares, which had the so-called “contingent deferred sales charge,” or CDSC, which was basically a surrender charge to recover commissions. Because B shares paid a similar commission to the broker as an A share, but it didn’t come out of the NAV up front. Instead, the fund advanced the commission to the advisor, and had an ongoing expense ratio that was higher to recover the commission over time. The broker might be paid 5% up front, while the fund charged an extra 1% per year to make up for it. After five years, the fund had made all its money back. If the client left within those first five years, the CDSC surrender charge recovered the unpaid amount. In other words, the broker got paid 5%, and if the investor left after three years, the investor had to pay a 2% penalty, which recovered the last 2% that was already paid as a commission to the broker but hadn’t been recovered by the fund company through the higher expense ratio.

Last, there were the C shares, which simply paid 1% a year, and had no upfront commission to the broker beyond the first 1% paid immediately. But the expense ratio was typically about 1% higher to compensate for it. That was the deal.

So to summarize, the options were: paid up front with A shares, paid up front but no upfront hit with B shares, or just the levelized commission of C shares.

In practice, B shares have largely wound down, due primarily to a lot of sales abuses. They’re still out there, but the problem was that since the upfront commission for A shares is reduced for large purchases investors receive at breakpoints, while B share commissions were generally fixed, some unscrupulous brokers sold B shares at higher commissions instead of A shares that would’ve paid lower commissions with breakpoints. And regulators caught on. Effectively, for what was otherwise the exact same fund, the client just got charged more for no reason, even or especially if they planned to hold for the long term. So brokers still have a choice to sell an A share with an upfront or a C share with levelized commission, but B shares have been getting squeezed out.

In addition to A, B, and C shares, it’s worth noting that most mutual funds also have some kind of institutional or advisory share class. These typically have no commission payments at all. They might include just the 25-basis point servicing fee portion of a 12b-1 fee. Although, that itself is optional. So currently, in addition to A, B, and C shares, most companies also have “I Class” shares for institutional funds.

American Funds calls them “F Class” shares. They’ve got the F-1 share class and the F-2 share class. The difference between F-1 and F-2 shares is whether they have the 25-basis point 12b-1 fee, that’s paid either to the advisor, or in some cases, to the platform that offers it. This 12b-1 fee is how a lot of platforms offer no transaction-fee-funds (NTF) no-load mutual fund purchases. Because the platform actually is getting 25 basis points of compensation in the form of the 12b-1 fee, that the client is paying for to get that “no transaction fee” purchase.

In addition to these share classes, American Funds actually recently introduced a new F-3 share class as well, similar to the F-2 share class with no 12b-1 fee, but it also has no sub-transfer agent (sub-TA) fee.

For those who aren’t familiar, Sub-TA fees are another kind of fee paid by the investors, through the mutual fund, to the investment platform. Technically, it’s to compensate the platform for all the work it has to do keeping track of investor purchases and sales, related recordkeeping, capital gain dividend distributions, and so on. All those things that have to be tracked when the investor doesn’t actually buy directly from a mutual fund company and instead buys through a brokerage platform. Fund companies often pay sub-TA fees, but the F-3 share class is now the cheapest of all for American Funds, because it strips out both the 12b-1 fees and the sub-TA fees.

American Funds is actually a good case-in-point example, because they’re advisor-sold and they have a lot of these advisor share classes. In addition to the A, B, and C, and F share classes, they also have a 529-plan version of A, B, and C, and F-1 share classes. They also have retirement account share classes (R-1 through R-6), which again, vary in the payments they provide either to the broker selling the funds, the plan to support recordkeeping, or just to incentivize the use of their funds.

I’m not trying to pick on American Funds in particular, at all. They’re just a good example here.

Because, if you add them all up… A shares, B shares, C shares, F-1, F-2, F-3, the alternative 529 versions of A, B, and C, and F-1, the R-1 through R-6 share classes… you end out with about 16 different share classes. For the same fund, for the same investment manager, for the same portfolio of securities! In fact, the only substantive difference across all 16 is the distribution cost – the amount of money that’s paid from the fund’s assets from the investor, either as a commission, a servicing fee to the broker, a servicing or transfer agent, recordkeeping, or some similar fee to either the retirement plan or the investment platform that the fund is being sold through or made available on.

And with the rise of DoL fiduciary, we’re actually seeing the emergence of a 17th share class – the T share. The T share is like a hybrid of A share and C shares. It’ll have a 2.5% upfront commission – like an A share, with breakpoints for larger purchases – but a 25-basis point 12b-1 fee on an ongoing basis. And then no other revenue sharing deals to platforms, to reduce some of the conflicts of interest that otherwise might run afoul of DoL fiduciary requirements.

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