Reasons to Fire Your Mutual Fund Company: Alphabetical Group of Sales Charges
BusinessIf most people cannot easily explain how they are charged for services, you can almost always count on a scam among you. Such is the case with many mutual funds and their “fund classes.” Just like when a corporation offers shenanigans like “supervoting” stocks, grab your wallet.
Take this. The same organization with the same portfolio and the same manager can have class “A”, class “B” and class “C” shares. In some extreme cases they can also have “D”, “E”, “Z” and more, but these are rare and we will not discuss them here.
“A” shares generally refer to shares that have an initial “charge” or sales charge. It is typically in the 3-5 percent range. This means that 3 to 5 percent of your investment leaves the cap even before it is invested. Your $ 100k investment just turned into $ 97k with a 3% sales load. This sales charge is often split between the financial advisor, the mutual fund supermarket, or another intermediary who placed you in this fund. Loading funds, often maligned, are not always the worst possible solution. In many cases, the ongoing management fee charged each year is typically lower for “A” shares. If you intend to hold the fund for a long period of time, this might be the cheapest way to do it. More on this later.
The “B” shares forgo the initial charge, but instead employ a contingent deferred sales charge (CDSC) or ending charge. In simple terms, this means that you will not be charged upfront, but if you redeem your shares in the fund, you may face a sales charge. The most common CDSCs are those that are gradually reduced or phased out over time, say seven years. If you hold the fund for seven years or more in this example, you don’t pay any initial or final charges. Why the complexity? The aforementioned brokers likely want your vigor up front, so the fund forces them, but you want to make sure they get your money back. The imposition of these onerous restrictions allows the fund to cover at least your out-of-pocket costs to hire you. Again, “B” shares may be the cheapest alternative for a specific fund if it has a long-term horizon.
Actions “C” have no initial or final charge. However, it is likely that if a fund has this alphabet soup in the first place, the ongoing management fee will be higher than the “A” or “B” shares. So while every penny of your investment goes to work immediately, over a long investment horizon, you may be paying more.
What class is right for you?
With very few exceptions and for various reasons, the answer to this question is that none of these classes is right for you. In fact, if you are presented with these fund options, your investment advisor is likely holding you back. The reason these classes exist is so that fund companies and advisers, two trustees who are bound to have your best interests first, can organize how to divide your money. I am a firm believer that, in that circumstance, your interests will not come first. In general, funds that employ these practices have a higher than average total expense ratio. I will always return to the principle that the most reliable way to adjust the performance of your mutual fund is to select funds with low expenses and low turnover.
Most fund companies that use this method also have in-house brokerage or advisory services. Surprise surprise. The real reason they love this method is that selling expenses make immediate money for them. In theory, they are correct in saying that long-term horizons will make uploaded funds cheaper. However, let me be clear on this point, because I myself come from this culture. In a few months or years, they will call you again to advise you to change funds and they will call you again. Me sick. Actually.
There is a better way
For me, there are three superior approaches to buying class-laden funds, and only one of them involves blatant self-promotion. 🙂 First, there are dozens of well-managed, low-cost, and actively managed funds. Your advisor won’t mention them, because they don’t pay you to sell them to them. Second, I keep coming back to indexing and index funds. They are mostly low-cost, low-turnover, and classless. The principle mentioned above explains why I prefer this method to the first. Third, folio investing offers the benefit of zero cost, a long holding period, a tax advantage, and a social assessment. The First Sustainable program allows investors, in effect, to create their own mutual fund, based on their long-term needs and social criteria.