HUMBERTO CRUZ Fund Watch

September 6, 1998 | HUMBERTO CRUZ Fund Watch

Today I’ll address questions about mutual fund loads and fees. Many of you seem to have the same misconception as this reader:

Q: My broker told me it is possible to buy load mutual funds and not pay any commissions. You do this by buying the B shares of the fund. You ought to mention this in your column.

A: You didn’t quite understand, or you didn’t get the whole story.

When a broker sells you a mutual fund, you are going to pay a commission. It may not be the usual upfront charge or load, and it may not look or feel like a commission.

But a commission it is. How else is the broker going to get paid?

Today, many load mutual funds offer you a choice of A, B or C shares.

Whichever class of shares you buy, your money is invested in the same stocks, bonds or other securities. The portfolio is identical. What changes is the commission you pay — how you pay it, how much and for how long.

And how much you pay, in turn, helps determine how much you get to keep. That’s why different shares classes of the same fund show different rates of return.

With no-load funds, as a rule, there are no share classes. You don’t need to pay a broker because you buy directly from the fund company.

But when you receive advice from a broker, each share class represents a different way of paying for that advice.

Some brokered funds have only one share class — usually called Class A — while others offer all three.

And a few funds offer a fourth, usually Class D, or use different names or letters, such as Class Y or Z. But the concept is the same.

Class A shares impose a sales charge or load when you invest, often ranging from 2.5 to 6 percent. That’s a commission, plain and simple.

But most of the time, in addition to the commission or load, you also pay an ongoing 12b-1 fee for marketing and distribution, which is another way of saying compensation to the broker.

That’s usually 0.25 percent a year on the value of your investment — in other words, you pay more the more your account grows. You should note here that many no-load funds, but not all, also charge 12b-1 fees to pay for marketing and advertising.

With Class B shares the sales charge is deferred, or back-loaded. You pay it only if you sell the shares within a certain number of years. Typically, this back load declines each year and disappears after five or six years.

But with Class B shares you usually pay a 12b-1 fee of 1 percent a year on the value of your investment, at least until there is no longer a back-end load. Some funds then lower the 12b-1 fee to the 0.25 percent charged by the A shares, but others keep charging the 1 percent a year.

Depending on how long you plan to keep the fund and on the fee structure, an upfront commission or load on the A shares may be the best choice.

For investors who intend to stay in a fund many years, it costs more if they pay a 1 percent annual fee than a 5 percent load the first year on the principal, said Thomas A. Haunty, a certified financial planner in Madison, Wis.

Class C shares, sometimes called level-load shares, don’t charge an upfront or back-end load, unless you sell soon, usually within a year. But you usually must pay a 1 percent 12b-1 fee each year for as long as you own the fund, again on the value of the investment, not just what you put in.

So which option is better? It depends on how long you intend to stay in the fund and, in some cases, on how much you invest.

In general, Class A or B shares are better — and B shares did slightly better — if you intend to stay in the fund for several years, typically seven, according to a study published in the summer issue of The Journal of Financial Research. It depends, of course, on how much each fund charges and for how long.

Let’s say you invest $1,000. With the A shares, you might pay a 4 percent upfront charge of $40 and an annual 0.25 percent 12b-1 fee for the remaining $960, or $2.40. Assuming no growth in your investment, you would have paid a total of $64 after 10 years.

But with Class C shares, you would have paid a 1 percent 12b-1 fee each year for 10 years, or $100.

Of course, you would expect the value of your investment to go up over time. Let’s say after 10 years your shares are worth $2,000. In that case you would pay $5 in 12b-1 fees during the 10th year with Class A shares but $20 a year with Class C shares.

If you intend to invest only a short time, Class C shares may be best. The article in The Journal of Financial Research, based on a study by finance professors Miles Livingston of the University of Florida and Edward O’Neal at Auburn, calculated that A and B shares become the better deal than the C shares after about seven years.

Class A shares also can make more sense the larger your investment. That’s because many funds reduce or even waive the upfront sales charge if you invest enough money — typically at least tens of thousands of dollars or, in some cases, $1 million or more.

Q: Is it true that a load mutual fund must outperform a no-load mutual fund by the amount of the load to be on a par?

A: Actually no. Assuming everything else is the same, the load fund must go up by more than the amount of the load to break even and, therefore, to outperform the no-load fund.

Don’t think so? Say you invest $1,000 in a fund that charges a 5 percent upfront commission or load. You are left with $950.

If the fund now goes up 5 percent, you are left with $997.50, not $1,000.

In this case, although the load was 5 percent, the commission you paid, as a percentage of the amount that was actually invested, was 5.26 percent.

By looking at loads this way — the correct way in my estimation — a 4 percent load is really 4.17 percent, a 3 percent load 3.09 and a 2 percent load 2.04 percent.

Humberto Cruz covers personal finance. co Sun-Sentinel, 1800 N. Commerce Parkway, Suite No. 1, Weston, FL 33326. Or e-mail through his Web site at www.sun-sentinel.commoneysavingsgame.