How Different Mutual Fund Share-Classes Affect your Retirment Plan or Investment Portfolio
At times, we examine institutional investment portfolios to provide an independent assessment. Our review typically illuminates the cost of the existing arrangement as well as any risks that may be unknown to the investor. When we conduct a review of a portfolio, we examine the mutual fund share classes that are in use.
Many of the principles applicable to institutional investors apply to individual investors too. Institutions and individuals that are not large enough for separately managed account arrangements, should, whenever possible, be investing through portfolios made up of institutional mutual funds or exchange traded index funds (“ETFs”).
Institutional mutual funds are typically reserved for larger investors and are among the lowest cost ways to invest in publicly traded mutual funds. It’s important to check the minimum investment required. Sometimes, the minimum investment can be $100,000 or more, although this can be a fairly low hurdle for an institutional investor. Sometimes investment advisors are allowed to aggregate their client’s assets to meet the institutional share class minimums. At other times, there is no minimum or low minimum, which makes them accessible to all investors. There are few, if any free lunches in investing. Investing in a “no-minimum” institutional mutual fund is at least a blue plate special.
With a little research, (for example, on Morningstar.com or on Yahoo Finance), an investor can easily look up the ticker symbol of any mutual fund to learn its share class. Mutual funds exist in A-shares, B-shares C-shares, I-shares and many other share classes. The ticker symbol serves as a unique key to the mutual fund’s identity, including the particular share class. Although there are many types of share classes, for purposes of this article, we will compare A-shares, C-shares and I-shares, since those are the ones we see most often.
In general, the A-shares, B-shares, and C-shares of a mutual fund are a mutual fund’s retail share classes. Importantly, an A-share can have a costly front-end load, higher fund expenses, including recurring 12-b 1 fees (higher than an institutional share). Sometimes the letter “A” appears prominently in the fund name or in the body of the ticker symbol. Fee only advisors sometimes used the “load waived” versions of the A-shares if the fund is not available in an institutional share class.
Another retail mutual fund share class is the C-share. The C-share usually does not have a load, but often has a “contingent deferred sales charge” (CDSC). When a broker sells a C-Share they get a sales commission, let’s say, for purposes of discussion the sales commission is 1%, and the investment has a CDSC of 1%. If the client sells a C-share before a year passes the client must pay the mutual fund company 1%. After the year passes the client can sell the holding with no penalty. In addition to the original commission the broker receives the 12-b 1 fee of let’s say 1% each year that the mutual fund is held.
B-shares don't have a front end load, but usually have high contingent deferred sales charges, that are scaled depending on how long the investor holds the B-share mutual fund. It may take 5-7 years to be able to sell the B-share without any CDSC. The illiquidity could become an issue with a mutual fund underperforms its benchmark or has a change of management. The reason for this illiquid structure, is the payment made by the mutual fund to the broker when the B-share is sold. Becasue of the CDSC structure, the mutual fund company gets time to recoup the payment made to the broker at the time of sale. B-shares, like other retail, broker-sold share classes, usually have a 12(b)(1) fee as well that is paid annually to the broker, often 1%.
In contrast, to the retail A-share class or C-share, the institutional share class is sometimes called an I-share. Institutional shares can sometimes have the letters “INST” in the fund name or the letter “I” in the name or prominently in the ticker. Again, with a little research, the investor can identify the institutional share class of a particular mutual fund with its corresponding ticker.
So why does all this matter? If one compares the costs of investing through different share classes of mutual funds you will find that usually, the additional costs take a bite out of the fund’s comparative performance. It’s important to note that all of the share classes are offered by the same asset management company and managed similarly: with similar investment mandates and by the same teams of asset management professionals.
We mentioned that advisors sometimes use load waived A-shares, with good reason. For example, an I-share may not be available at all, or perhaps the client might not meet the minimum investment hurdle. In these cases, the advisor constructing the portfolio must consider whether the costs of another share class are worthwhile, considering the underlying fund manager’s long-term performance record. The Advisor must believe that the fund's manager is likely to outperform in the future. In general, however, the burden of proof is on the use of retail share classes if there is an institutional alternative.
Fees matter. In The Investment Answer, Daniel C. Goldie, CFA, CFP & Gordon S. Murray, January 2011, the authors illustrate a what happens to a $1 million investment with a return of 8%, over a thirty year period, with fees of 1%, 2%, and 3% annually. The returns are significantly diminished by the fees. According to their scenario, $1 million with a 1% fee would result in $7,612,225 at the end of the period. A $1 million portfolio with a 2% fee would result in $5,743,491 at the end of the period (a difference from the 1% fee of $1,868,734). The same portfolio with a 3% fee would result in $4,321,942 (a difference from the 1% fee of $3,290,283).
There is one other potential issue for holders of mutual fund retail front-end load share classes or shares with CDSCs; the use of these share classes could limit investment flexibility. If one pays a 1-5% load or a 1% CDSC, if the position is sold, say within the first year after it is purchased, the investor will realize an immediate cost to the portfolio and a reduction in performance (even vis-a-vis the same fund's performance). This potential cost, may create a reluctance to sell these shares. Institutional and load waived shares can be sold at any time without penalty (some mutual fund’s I-shares have a minimum holding period to prevent market timing).
There are many free tools available on the internet today. By paying attention to sales commissions and costs, and by doing a bit of research, 401k plan administrators, institutional investors, and individual investors may be able to find ways to re-examine their investment portfolios and reduce their asset management costs.
Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author but not necessarily those of the Third Sigma Investment Advisors LLC. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. All investments carry risk and may lose value. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Third Sigma Investment Advisors LLC. ©2012, Third Sigma