Which Is the Right Fund Share Class for You?

Dear Christine,

Could you describe the typical differences between fund share types, and when to buy which: A shares, Z shares, etc. And why, even with big bucks to invest, am I sometimes restricted to which shares I can purchase?

Steve

Although they're typically labeled with letters, decoding mutual fund share classes isn't as simple as learning your ABCs. It's easy to get confused when you're attempting to select the right share class for your needs, and choosing the wrong one can end up costing you money. Here's a look at some of the factors you should bear in mind as you navigate the often-murky world of fund share classes.

We'll focus on the most common share class designations here, but there are many other share classes cropping up these days--American Funds, for example, now offers no fewer than 14 share classes for each of its funds. Many of these newer share classes are targeted at very narrow groups, however--such as investors in a particular 529 college savings program.

Broker-Sold Alphabet Soup
First off, you should know that most share classes exist to ensure that brokers or advisors get paid for their services. If you're a do-it-yourself investor, you should steer clear of share classes that require you to pay a sales charge. And even if you do want advice, it's possible--and in my opinion, preferable--to opt for a planner or advisor who charges you an hourly or flat fee, or a percentage of your assets on an ongoing basis, to provide investment advice. Such planners usually put their clients in no-load funds (i.e., funds that don't carry charges to buy and sell).

A shares typically carry front-end sales charges, or "loads." For example,  PIMCO Total Return's A shares (PTTAX) carry a 3.75% load. That means that if you invest $10,000, you'll pay $375 in sales charges right off the bat, and only the remaining $9,625 will be invested in the fund. Most, if not all, of that sales charge will go to the broker or advisor who put you in the fund. (The charge for this particular fund is on the low side--many offerings charge a 5.75% front load for their A shares.)

B shares typically carry deferred sales charges, often called "back-end loads." You won't pay anything upfront if you opt for the B shares, but you may pay a charge when you sell your shares, depending on how long you hold them.

That might sound like a good deal--after all, wouldn't you like to see your money compounding from the get-go? But B shares aren't usually the most economical option because their expense ratios--the fees that you'll pay year in and year out--are usually far higher than expense ratios for the A share class. That's because, instead of getting compensated by a front load, your broker or advisor is receiving an additional amount tacked on to the fund's expense ratio every year. (That additional amount usually comes in the form of a separate fee, called a 12b-1 fee, that's much higher than the 12b-1 fee for the A shares.) Returning to the PIMCO Total Return example, you'll pay 1.65% in annual expenses for the B shares , whereas the A shares of the same fund charge 0.90%. That's because the A shares charge a 0.25% 12b-1 fee, while the B shares charge a 1.00% 12b-1 fee.

If you plan to own a fund for a number of years, those extra ongoing fees can really add up. And if you don't hold your shares for a long period of time, you can get hit with the back-end load. This fee usually scales down with each year you hold the fund. The idea behind the back-end load is to make sure your broker or advisor gets paid if you sell the fund before paying out much in the extra 12b-1 fees that are supposed to compensate them. So, the longer you hold the fund, the less need there is for the back-end load. PIMCO Total Return's B shares charge a 3.5% back-end load for shares held less than one year, but the charge is eliminated for shares held more than five years and drops significantly each year in between.

B shares have one other critical feature--they typically convert to A shares if you hold them for more than a specified period of time. By swapping into the A shares, your ongoing expenses will be lower than if you had stuck with the B shares. If you're going to buy the B shares of a given fund, you should always look for a conversion feature, because that will greatly reduce your overall expenses if you think there's a chance you'll hold a given fund for a number of years. The length of the conversion period is also important--the shorter the better!  

You won't pay a front-end sales charge to buy C shares, commonly known as "level-load" shares, of a given fund. The maximum deferred sales charge you could be liable for--1.0%--is also much lower than it is for B shares, and it typically scales down much faster than the back-end loads of B shares. (You usually only pay a charge to unload C shares if you're selling them within 12 months of your purchase.) But as with the B shares, C shares are typically a poor option if you're looking to keep costs down--a worthy goal for every investor. That's because C shares invariably have higher year-to-year expenses than do A shares. Like B shares, C shares also typically levy a hefty 12b-1 fee. PIMCO Total Return's C shares (PTTCX), for example, charge an expense ratio of 1.65%. Moreover, unlike B shares, most C shares don't ever convert to A shares, so you pay the higher fees until you sell the fund.

Many broker-sold fund shops also carry D shares. These are usually no-load shares that are available through mutual fund supermarkets such as Schwab or TD Waterhouse. You won't be charged a front-end or a back-end load to buy a firm's D shares, and expenses may also be reasonable. (PIMCO Total Return's D shares , for example, charge 0.75% per year.) But it would be a mistake to call D shares "free." That's because you often need to pony up a charge--often called a transaction fee--to buy into one of these share classes.

No-Load and Institutional Share Classes
In general, the world of no-load funds--i.e., those that don't carry sales charges to buy or sell--is infinitely less complicated than the broker-sold fund arena. The typical no-load fund doesn't carry any letters after its name, though no-load share classes are sometimes tagged as "Retail" or "Investor" shares. You'll also occasionally run into no-load funds with Z or S share classes. These are usually former no-load share classes that have closed to new investors; if you want to buy into one of those funds for the first time, you'll have to go through a broker and opt for the A, B, or C share class. Funds from Scudder, Franklin Mutual Series, and the Columbia Acorn families of funds are prominent examples of funds with S or Z share classes. These closed share classes are typically cheaper than their broker-sold counterparts.

Many fund shops also offer institutional share classes of certain funds--often tagged as I or Y shares. Such offerings are usually only available to investors who have big bucks to invest--usually $1 million or more--and invariably have the lowest expenses in the mutual fund world. If you participate in a retirement plan at work and your employer is a good-sized company, there's a good chance you invest in the institutional share class of a given fund. But you needn't rule out an attractive institutional fund simply because you're a smaller investor, because some institutional funds are available through fund supermarkets. If you go this route, you may pay a small charge to buy a given institutional fund, but lower expenses may offset that levy.

How to Choose the Right Share Class
So which share class is the right one for you? Well, at least one thing is simple: If you don't want or need investment advice, you shouldn't buy the A, B, or C shares of a fund, because you'll be paying for something (advice) you're not using. You'll want to opt for the no-load or institutional share class instead. If you're a no-load investor who is determined to buy a fund that's primarily broker-sold, go through a supermarket and opt for the D shares.

If you are using a broker or planner, the decision about whether to opt for the A, B, or C share class boils down to your own time horizon and, to a lesser extent, how much you're investing. If you plan to invest for the long haul--say, 10 years or more--the A shares will invariably make more sense for you than the B or C shares. That's because A shares' lower ongoing expenses will offset the higher fee you'll pay to get in. At Morningstar, we believe in long-term investing, and that's why we tend to recommend A shares over B or C shares; if you're a Morningstar.com Premium Member, you'll notice that our  Analyst Reports of broker-sold funds typically apply to the A shares, too.

So should you ever use B or C shares? Possibly, if you expect to hold a given fund type for a short period of time. If you plan to own a fund for just a year or two, for example, you may want to opt for C shares, and if your time horizon is in the neighborhood of five years or fewer, B shares may be the way to go. Morningstar's  Cost Analyzer tool can help you determine the correct share class given your anticipated time horizon and the amount of money you have to invest. (Cost Analyzer is available to Premium Members of Morningstar.com; for a free trial membership, click here.)

Protect Yourself: Know Your Rights and Ask Questions
Many brokers and planners work hard to select the correct share class for their clients, but you should also be aware of unscrupulous practices in this area. B and C shares carry higher expenses, and part of those fees, called 12b-1 fees, go straight to the broker each year. Thus, some brokers might be inclined to recommend B or C shares even if they're not the best deal for their clients. Some fund shops--including Franklin--have stopped selling B shares altogether.

To help ensure that you get into the right share class for your needs and time horizon, it never hurts to ask your broker why he or she is recommending a certain share class of a given fund. What assumptions is he or she making about your holding period? Does he or she have a financial incentive to recommend one share class over another?

Also be sure to ask whether your total investment with a given fund family qualifies you for a discounted sales charge. These breakpoints often kick in when your total investment across the fund family reaches $25,000 or more, and they can save you substantial amounts of money. And even if you don't meet the minimum asset level yet, you may still be able to qualify for the discount if you sign a "letter of intent" that states you plan to invest enough money to qualify for the discount within a specified period of time (usually one year). Some brokerage firms have recently gotten into trouble for failing to provide these bulk discounts, so your broker should be well aware of the issue and able to tell you whether you qualify.