Q: Why do you provide analyst coverage of mutual funds that are off limits to people who don't have $1 million to invest in a single fund? The audience of Morningstar subscribers who will benefit from having read this review is minimal.
A: Many readers question why Morningstar analysts cover the institutional share class of mutual funds, whose investment minimums can be hundreds of thousands or even millions of dollars.
You may be surprised to learn that many times, the institutional share class is the most widely held share class of a particular fund strategy. And, according to the Investment Company Institute, the "vast majority" of assets in institutional shares classes are held by retail investors.
Who are these millionaire individual investors, and why aren't they inviting us out on their yachts?
A Quick Rundown on Share Classes
A mutual fund can have multiple share classes, depending on the channel through which it's sold. The terminology may differ slightly from fund company to fund company, so if you don't know what a particular share class letter means, it could pay to do some investigation on the fund company's website. (For example, Vanguard provides a helpful rundown of its different fund share classes.)
The main thing to understand is that the lower the investment minimum, the higher the expense ratio usually is. The reasoning is that it's more difficult to maintain many accounts with low balances than fewer accounts with lots of assets. So although the strategy and investment portfolio (and investment manager, if applicable) are the same across all share classes, the expense ratios will differ. See the different share classes of Vanguard Total Stock Market Index (VTSMX), for example.
The share class information, including expense ratios and minimum investment, are available on the "Purchase" tab of a fund's Morningstar quote page, in the middle section labeled "Review Other Share Classes."
So in the case of Vanguard Total Stock Market, if you are a retail investor who started out with the VTSMX share class but your balance grows to $10,000 or beyond, you would benefit by taking advantage of the lower expense ratio by switching into Admiral shares. (The share class conversion can be a taxable event in certain types of accounts, so be sure to figure that into the equation.)
How Can I Get Access to Lower-Cost Share Classes?
You may be wondering, who are all these investors that have access to Vanguard Total Stock Market for 3 basis points or less? There is over $200 billion invested in share classes with minimums of at least $5 million (and as high as $5 billion!).
Through an Employer-Sponsored Retirement Plan
Many investors have access to ultralow-cost institutional share classes, which strip out 12b-1 distribution charges and typically don't charge sales loads, through an employer-sponsored retirement plan such as a 401(k), 403(b), or 457. The money invested in the company retirement plan in aggregate meets this high minimum investment--each individual in the plan would likely have a much smaller balance and smaller, regular ongoing contributions. Because institutional share classes are often used in 401(k)s, many times the bulk of assets in a particular fund will be in its institutional share class; hence, Morningstar analysts may choose to cover that share class of a particular fund.
If your 401(k) invests in a fund share class with a high expense ratio, check the fund's Purchase tab on Morningstar.com to see if there are lower-cost institutional share classes available. If you find a lower-cost share class listed, ask your plan administrator why your 401(k) doesn't invest in that one instead. It's possible that your plan isn't large enough to qualify--there are no accepted guidelines for what makes a share class "institutional," except that it has a higher minimum investment and a lower expense ratio. Sometimes the minimum-balance requirement is $100,000, but it can be much higher than that--upward of $1 million in some cases. But it doesn't hurt to investigate whether the fees borne to investors in the 401(k) plan are as low as they could be. (Brightscope.com offers research and ratings on many companies' 401(k) plans.)
Through Discount Brokerages
Some investors can also get access to lower-cost share classes with lower minimum investments if they invest via an online brokerage such as Fidelity or Schwab. (This also applies to sales loads in many cases, by the way; for example, the American Funds F1 share classes allow retail investors to bypass the load.)
Institutional shares classes aren't usually offered on discount and no-transaction-fee brokerages, however. These platforms often offer share classes that include a 12b-1 fee. This charge is bundled into the fund's expense ratio, and it's normally around 0.25% but sometimes as high as 1.00%. 12b-1 fees were originally intended to help funds to grow quickly so they could ultimately pass on savings to fundholders in the form of lower expenses. Unfortunately, 12b-1 fees failed in that original mission.
The definition of the 12b-1 fee has become somewhat murky, and there's little clarity or agreement about what they pay for and, thus, how to define them. In some cases, though, the 12b-1 fee is used to buy shelf space at fund supermarkets.
If you're considering purchasing a specific share class and want to see the underlying components of the expense ratio--the management fee, whether there's a 12b-1 fee and how much it is, etc.--check out a fund's "Expenses" tab on Morningstar.com. To see how a certain share class stacks up against other share classes of the same fund, click on the Purchase tab.
Through an Advisor
Sometimes an advisor will bundle clients' accounts into a larger "omnibus account" to meet the higher minimum investment on lower-cost shares; other times it is simply waived by the fund company for investors purchasing though an advisor. For example, fund companies such as AQR and DFA will waive their high minimum investments for investors purchasing through an advisor.
"In some cases, advisors can give access to institutional class shares with smaller or no minimums," said financial planning expert Michael Kitces, author of the Nerd's Eye View financial planning industry blog. "In other cases, there are 'advisor-class' shares that have at least similar costs to institutional shares, even if it's not exactly the institutional share class. The advisor-class shares are basically ones where the 12b-1 fees (and any other commissions) are eliminated, as the advisor is expected to be charging a separate fee."
But Kitces also notes that many of the different share class structures that represent all of the ways that advisors get paid to distribute mutual funds could be headed toward extinction as the Department of Labor's fiduciary rule takes effect.
"With the rise of DOL fiduciary … and a shift to consumers paying advisors directly, most of these share classes will become irrelevant and fade away," Kitces said. "Similarly, the very nature of a 12b-1 fee--a levelized commission for sales and servicing--becomes moot when advisors are paid directly by clients, raising the question of whether the 12b-1 fee may soon be gone as well," Kitces said.
Karen Wallace, CFP® does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.