If you invest in mutual funds through a broker or advisor, you're likely to encounter fund share classes. Each broker-sold fund typically comes in several varieties, or share classes, which differ in how you pay the sales charge associated with them. Most load funds have at least three share classes, differentiated by letters; some, such as the American Funds, have considerably more.
It's understandable to feel bewildered by all this, but never fear. The essentials of mutual fund share classes are not hard to grasp, as long as you keep a few basic ideas in mind. In addition, there are tools that can help untangle the specifics and help you figure out which share class is right for you given your goals and time horizon.
Before we get into tips for using and evaluating fund share classes, it will be helpful to briefly outline the major types. Those wanting more detail can read this article by Christine Benz, which describes the various share classes in some depth. It also discusses share classes in no-load funds, which we won't deal with here; these are for different classes of investors or distribution channels, and a given investor usually doesn't have a choice about which one to buy.
The share classes we're concerned about here are for broker-sold funds, or load funds. They arise because such funds are generally available only through advisors or other intermediaries, and anyone buying those funds is charged a load designed to help pay those intermediaries. The major load-fund share classes, usually known as A, B, and C shares, allow investors to pay the load in different ways, and which of these classes you choose can have a significant effect on your returns. Many load funds, especially from the big shops, have more than just these three share classes, but these are the essential ones to know about.
* A shares are front-load shares, where you pay the whole sales load up front. A handful of funds have maximum front loads as high as 8.5%, but 5.75% is the most common amount. That load generally goes down the more money you put in the fund (or in the fund shop as a whole) and becomes zero if your investment is big enough.
* B shares have back-end loads, or deferred sales charges. That means you pay nothing up front, but you may have to pay a load when you sell the fund. The good news is that this load is generally less than in A shares and goes down over a period of years until it becomes zero and the shares convert into A shares. The bad news is that B shares tend to have much higher expenses than A shares, sometimes twice as high, because of their higher 12b-1 fees. Some fund shops have done away with B shares because they're not a great deal for long-term investors.
* Finally, C shares are known as level-load shares. Like B shares, they don't charge a front load, and the back load they charge is smaller and goes away sooner--it's typically just 1% and goes away after a year. However, C shares do not convert into A shares, even though they typically cost about the same as B shares. Thus, you're stuck with the higher expenses, which is not good if you plan to own the fund for a long time.
So, how is an average investor supposed to cut through all this clutter and figure out which share class is best for them? Here are a few tips for evaluating the share classes of load funds.
Investigate Load-Waived Shares
One important thing to do is to see if you're eligible to buy A shares where the load is waived or reduced. As we saw above, A shares usually have much lower expenses than B or C shares, but the presence of the front load eliminates most of that cost advantage in the short term; thus, if you're able to avoid paying the load, it's always a good idea to do so. The fund's prospectus will list who is eligible for load-waived A shares. In the case of Davis New York Venture (NYVTX), one of the best load funds out there, this list includes employees of Davis Funds and firms involved in distributing the funds, various institutions, employee benefit plans, and wrap accounts offered by certain brokers and advisors.
Investigate Load Breakpoints
If you can't get the load waived, see if you can invest enough to get the front load reduced. As noted above, the load on most A shares goes down with bigger investments and is eventually waived altogether if your investment is large enough. The A shares of Davis New York Venture charge a load of 4.75%, but that load drops to 3.50% once your investment passes $100,000, and it keeps going down in increments until the $1 million level, when it disappears altogether.
Often you can combine the accounts of all family members for this purpose, and some fund companies, including the Davis funds, will charge a lower load if you sign a Statement of Intention promising to invest the appropriate amount in the company's funds over some future period, such as a year. For example, if you plan to invest at least $100,000 in A shares of Davis New York Venture over the next 13 months, you can get the lower 3.50% front load even if you don't have that money right now.
Compare A, B, and C Shares
Suppose you can't buy load-waived or reduced-load A shares, and you're not an institution. Which option is best in that case--A, B, or C shares? For the most part, that will depend on your time horizon. If you're only expecting to hold a fund for a year or two, B or C shares might make sense, because the absence of the front load will usually offset the higher annual expenses. If you're a long-term investor, though, A shares are generally the way to go. The load will take a bite out of your investment up front, but savings from the lower annual expenses will really add up over time.
Each fund's prospectus will generally include a table showing the projected expenses for each share class over one-year, three-year, five-year, and 10-year holding periods. (You can also find such projections in each fund's Fees & Expenses page on Morningstar.com, but there you can't compare different share classes directly.) These tables can be helpful in choosing a share class if you know how long you plan to hold the fund. For example, the table in the Davis New York Venture prospectus shows that if you invest $10,000 and sell the shares after one year, the C shares will be the cheapest; your total estimated cost will be $264, versus $558 and $569 for the A and B shares, respectively. If you sell after three or five years, the C shares are still the cheapest. Over a 10-year holding period, though, the A shares are the best bargain, with total costs of $1,474, versus $1,648 for B shares and $1,911 for C shares. (All these numbers assume a 5% annual return for the fund.)
Use Cost Analyzer
Premium Members at Morningstar.com can also compare share classes using the Cost Analyzer tool, which you can find here. Enter your initial investment, expected annual return (10% is the default), and the ticker for each share class you want to compare. (If you don't know a share class' ticker, type the fund name into the Quotes box in the upper left of the page, and a list of that fund's share classes should show up.) When you click on Submit, you'll see a list of the share classes you entered along with the total costs and annualized return for each class.
This tool not only lets you enter any amount of initial investment, it automatically takes into account reduced loads for large investments. So, for example, suppose we enter the A, B, and C shares of Davis New York Venture (tickers (NYVTX), (NYVBX), and (NYVCX)) with a $10,000 initial investment, 10% expected return, and one-year time horizon. The projected costs are $559.61, $472.83, and $167.67, respectively. The C shares are cheapest, just as in the similar example from the prospectus, because the front load on the A shares took such a big bite up front. If, however, we up the initial investment to $1 million while keeping everything else the same, the results are very different, because the load on the A shares is waived on investments of $1 million or more. Now the A shares have a total cost of $8,883.18, versus $47,283.27 for B shares and $16,766.58 for C shares. If we extend the time horizon to 10 years, then the A shares are the cheapest option whether you're investing $10,000 or $1 million.
Such projections inevitably involve some guesswork, but they're a good foundation on which to base a decision. If you're buying a load fund, you're probably working with a broker or advisor who can give you advice on this point. Even so, it's a good idea to figure out what makes sense for you, given your resources and time horizon, so that you can make suggestions and ask the right questions. After all, the ultimate decision is up to you.
A version of this article appeared on this site on Oct. 7, 2008.
David Kathman, CFA, Ph.D. does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.