T Shares Are Best for Some Investors

There's a Catch (or Two) As discussed in last Friday's column, the T share class of mutual funds is coming to market. Invented after the Department of Labor issued its "Conflict of Interest" rule in spring 2016, the T share carries a maximum front-end sales charge of 2.5% and an ongoing 12b-1 fee of 0.25%. As Morningstar expects that all funds with an A share class will soon introduce a T share, the development would appear to be good news for fund investors. Pay 2.5% upfront for a T share, or double that amount for an A share, with both share classes having identical future performances? That seems like an easy call.

So, too, does buying T shares and holding them, rather than paying the standard 1% annual fee for no-load shares purchased through an advisory account. Within four years, if the T shares are not sold, they will be the better-performing of the two options. The math only improves over time. Consider a fund that gains 6% with its institutional shares. Its T shares, carrying the 12b-1 fee, make 5.75%. A $50,000 initial investment that is held for 10 years becomes $85,267 via the T shares, as opposed to $81,445 in the advisory account.

(The two amounts would be equal over the 10-year period if the annual advisory fee were 0.52%. For 20 years, the fee would need to be 0.39%.)

However, as a few readers reminded me, that analysis embeds certain assumptions.

For one, the T shares versus A shares cost comparison holds for smaller accounts but not necessarily for larger investments. Both share classes give volume discounts, but A shares do so more aggressively. Typically (the details vary among fund companies), the math converges for investments of several hundred thousand dollars. At $1 million, A shares will generally be the better deal—because most at that point waive their loads entirely, whereas T shares flatline at 1%. (A brokerage firm may waive that final 1%, if it so chooses, but the T share’s official fee schedule will not do so.)

Shares for the Slothful The T shares calculation also assumes no sellers' remorse. I learned from one well-placed reader that the major brokerage firms conduct "millions" of round-trip trades each year, wherein investors sell an A share fund, then shortly thereafter repurchase that fund. If those trades occur within a fairly short time period, that trade is load-waived for A shares. It would not be so with T shares.

Nor does my cost analysis incorporate the effects of long-term trades, including rebalancing. Investors who hold A shares may freely switch between funds of different asset classes, as long as they remain within the same family. With T shares, each such trade generates a new load charge.

In addition, there is the argument that all financial advisors’ services are not created equal. This is certainly true. Some give their views on investments only, while others opine on all matters financial. Some delight their clients; others displease them. However, I think this caveat is not very strong. Yes, financial advice should not be evaluated on price alone, but price surely is part of the analysis. The cost of T shares is such that if they come accompanied by good service, and held by the appropriate type of shareholder, they can be a compelling deal.

T shares are akin to illiquid securities. All things being equal, stocks that are difficult to move will have higher expected returns than those that trade easily, because those who value liquidity in their investments will look elsewhere. Lower demand for such stocks means lower prices, which in turn leads to better expected returns. That attribute attracts investors who are willing to sacrifice flexibility. They will happily give up that which is not important, in exchange for something that does matter to them.

The same, logically, will hold true for T shares. Investors with smaller accounts who buy funds, stash them away, and then largely forget about them will be served well by T shares. Not so those with larger accounts. Nor those who are frequently rebalancing, or conducting tactical allocation, or for any other reason turning over their portfolios. They will be better off with either A shares or advisory accounts.

Can We Simplify? If this all seems rather complicated, that's because it is. T shares have their benefits. They address the Department of Labor's fiduciary concerns by leveling the playing field with fund commissions, so that advisors won't face the temptation of choosing among investments that have different payout schemes. All funds with T shares will offer the same compensation. They also, as we have seen, will lower investor costs and thereby improve returns, under certain circumstances.

But they are messy. The introduction of T shares means, at least for the time being, even more choice for investors and advisors, even more trade-offs, even more analysis. Mutual funds have come a long ways from the days when they were available in only two flavors: no-load and front-end load. It would be difficult to argue that this journey has been entirely harmful. There are many sensible ways to purchase funds now, not just two. However, it would be equally difficult to argue that all the change has been positive. Were they still alive, the authors of the Investment Company Act of 1940, which governs mutual funds, would be asking themselves, "How on earth did we get here?"

The next column will answer that question. In addition, it will discuss a potential solution for clearing the underbrush, so that mutual funds can once again become the simple, easily understood investment that they were designed to be.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.