by Doug Cooper
The Elimination of Alphabet Soup
A Proposal to Streamline Mutual Fund Share Classes
Comparing mutual fund shares to a bowl of alphabet soup is a common analogy used to describe the confusion investors face when trying to decide which share class is appropriate for their investment. This analogy has led to many articles attempting to help investors with Decoding Alphabet Soup of Mutual Fund Share Classes, Making Sense of Share Classes, & Unscrambling the Alphabet of Fund Fees to name a few. Some fund families have more than 17 share classes, making selecting a share class very confusing to the average investor. Instead of decoding the alphabet soup, why not eliminate the letters altogether? In this article, after reviewing the current model of mutual fund share classes, it will be evident that the proposed streamlined model, which eliminates fund classes, could be the answer to the share class ambiguity and still be a successful model for both an investor and an advisor.
Investors have a choice to either select their own mutual funds through self-directed brokerage firms or enlist a financial advisor to help them make a suitable selection. If an investor purchases mutual funds through a financial advisor, they are most likely using mutual funds with different share classes (A, B or C shares). To understand the current landscape of mutual fund sales charges, it is important to have a good overview of the types of fund classes. The excerpt below, from the Morningstar Guide to Mutual Funds, (2005)1 provides a short summary of the differences between the most popular share classes.
“If you invest through a financial advisor you’ll have to pay sales charges in addition to the fund’s expense ratio. A sales charge that you pay when you buy a fund, is known as a front-end load. A sales charge when you sell is a back-end load. (These charges are taken out automatically; you will not be writing a check to cover them, so you might not even realize that you are paying them or know how large they are.) Fund companies often identify the different cost structures available as A, B and C shares. Although the alphabet soup can be inconsistent from family to family, here are some common types of loads.” ‘A’ shares have a front-end load that range from 3% to 5.75%. The sales charge is taken out of your investment up front. If an ‘’A share has a 5% up front sales charge and an investor deposits $5,000 into the fund, $4,750 goes into the investment and $250 goes to commissions. ‘B’ shares usually have deferred loads. If a ‘B’ share is sold in the first year the charge could be 5%, but if you hold for 5 years the charge could be 2%. ‘B’ shares usually convert to ‘A’ shares after several years of holding the fund, but also have higher internal expenses (12b-1 fees). Funds with level loads are called ‘C’ shares. ‘C’ shares have no up-front sales charge. ‘C’ shares have higher internal costs since there is no up-front sales charge. The higher internal costs are used to compensate the broker for selling the fund. Generally, the current guidelines are to use ‘A’ shares for long-term investing, since the internal costs are lower over the long run, and to use ‘C’ shares for short term investing since there is no sales charge, but have higher internal expenses. Furthermore, there are additional mutual fund share classes outside of A, B, & C shares, such as F, P, Z, R2, R3, and Institutional shares. This can be very confusing. Why not eliminate the share classes that cause so much confusion, and reward investors with lower internal expenses as the account balance grows?
The tables below show a hypothetical mutual fund share class example, displaying both the sales charges taken from the investment up-front and the ongoing internal expenses. The third table shows the discounts, or breakpoint pricing, for higher dollar ‘A’ share purchases.
Shareholder feesa
| Share classes | A | B | C | F-1, F-2 | R shares |
| Maximum sales chargeb | 5.50% | none | none | none | none |
| Maximum deferred sales charge(load)c | none | 5.00% | 1.00% | none | none |
aFees paid directly from the investments. bLoad imposed on purchases as a percentage of the offering price.
cAs a percentage of the amount redeemed.
Annual fund operating expensesa
| Share classes | A | B | C | F-1, F-2 | R shares |
| Total annual fund operating expensesb | 0.86% | 1.10% | 1.61% | 0.74% | 1.48% |
aExpenses paid each year as a percentage of the value of the investment.
bExpense Ratio.
Discounts (breakpoints) for A share purchases only
| Investments | Sales charge | Internal expense ratio |
| Less than $25,000 | 5.75 | .86% |
| $25,000 but less than $50,000 | 5.00 | .86% |
| $50,000 but less than $100,000 | 4.50 | .86% |
| $100,000 but less than $250,000 | 3.50 | .86% |
| $250,000 but less than $500,000 | 2.50 | .86% |
| $500,000 but less than $750,000 | 2.00 | .86% |
| $750,000 but less than $1 million | 1.50 | .86% |
| $1 million and above | -0- (NAV) | .86% |
The layout above can be very confusing to the average investor. A typical mutual fund prospectus will devote significant ink to cover all the areas of concern around fund expenses, sales charges, and share classes. The tables above could be eliminated by simply moving to a cost structure that combines all expenses internally. The proposed cost structure below shows a hypothetical example of how a new fee design would work after eliminating the share classes.
| New hypothetical* proposed cost structure | |
| Dollars invested | Expense ratios |
| $0 – $25,000 | 2.25% |
| $25,000 – $50,000 | 2.00% |
| $50,000 – $100,000 | 1.75% |
| $100,000 – $250,000 | 1.25% |
| $250,000 – $500,000 | 1.10% |
| $500,000 – $1,000,000 | 1.00% |
| Over $1,000,000 | 0.80% |
*Note. Mutual Fund companies could create different dollar amount thresholds and expense ratios. All purchases made in a managed account and by licensed representatives would qualify for the lowest expense ratios or the $1,000,000 breakpoint.
Instead of having several classes of mutual funds with up-front sales charges and back-end CDSC charges, mutual funds could eliminate the different share classes and trade at the NAV (Net Asset Value). Having all the fees included in the expense ratio would be advantageous for both the investor and the advisor. This structure would make a prospectus easier to read, and provide a simple expense format that an investor could understand. The more an investor adds to a mutual fund family, the lower the internal expense ratios would become, therefore providing more return to the investor. The advisor and financial intermediary would benefit by receiving a higher internal trail as compensation. This simplified cost structure allows an advisor to look at other fund families without having to charge clients an up-front fee. Advisors working with clients through a brokerage account would have more flexibility when switching between different fund families, and would be able to concentrate on proper allocations, instead of share classes and expenses.
The current process for using share classes to purchase mutual funds is dated and is very confusing to the average investor. It’s time to remove the upfront sales charges and back-end CDSC charges from mutual funds, therefore eliminating the need for separate fund classes. The costs can be included internally in the expense ratios to bring more transparency and simplicity to the mutual fund industry. There are many difficult decisions to be made between an investor and an advisor. Selecting a mutual fund share class shouldn’t be one of them.
Doug Cooper is a Compliance Professional in the Broker/Dealer Industry.
1 Morningstar Guide to Mutual Funds, Benz, Di Teresa, Kinnel, 2005).
The Elimination of Alphabet Soup 