In most mutual funds, you’ll find different classes of shares for retail investors, usually ranging from Class A to C. For institutional investors, there may be an extra share class known as Class I. If you’ve ever wondered where these came from and what purpose they serve, this is an article you don’t want to skim.
Mutual funds have different classes of shares that were born out of innovations in the industry and created to help investors choose suitable pricing options. Funds charge management fees based on share classes, and choosing the right class is critical to any investment’s long-term performance.
Read on for an eye-opening discussion as I take you through the origins of different classes of shares, explore their importance, and provide actionable tips for choosing the class suited for your investment needs and goals.
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How Different Classes of Shares Emerged?
Share classes are a result of decades of innovations in the mutual fund industry. Through these innovations, the various pricing models emerged, giving rise to different classes of shares. Funds that have a long history, like Vanguard and American Funds, are a testament to this evolution.
For instance, American Funds has been operating since the 1940s. Back then, there were only two funds types:
- Front Load. In a front-load fund, brokers would charge commissions based on the investment size. Commissions were determined using a sliding scale that ranged between 1% and 5%. On top of that, brokers would charge an ongoing commission (typically 0.25%) known as trail or a 12b-1 fee every year.
- Institutional. Dealt with investments larger than a million. No commissions were charged.
Today, these two are known as Class A shares.
In the 1960s, Vanguard, Fidelity, and other companies started marketing no-load funds to retail consumers directly. In light of this new trend, broker-sold funds had to adapt, and their response was to create B shares.
With Back-Loaded (B) shares funds, investors would invest and switch between other funds in a company commission-free. However, there was a penalty for selling shares within the first five years. This came in the form of a sliding scale ranging from 5% and 1% (declining each year).
B share funds also bumped up internal expenses and charged a 1% 12b-1 fee. Seven years into the investment cycle, B shares would convert to Class A shares.
The 90s saw No-Load funds apply pressure to the industry, and its response came in the form of Class C shares. These were pretty much like B shares in every aspect except that:
- The penalty for selling your shares in the first year decreased to 1%.
- They didn’t eventually turn into Class A shares.
Around this period, broker-sold funds and No-load funds began to offer additional Institutional fund classes. These were typically lower cost than their predecessors and were usually offered to endowments, wealthy investors, 401k plans, brokerage advisory plans, and pensions. Here’s how some of the oldest funds offered these:
- American Funds initially offered class A but without the 12b-1 fee. Eventually, a new class of shares known as F shares was created.
- Vanguard also replicated American Funds’ move, but with Admiral and Institutional classes.
- Other mutual fund companies termed these Institutional Funds as Advisor Class. These had higher minimums, came without 12b1 fees, and were lower cost.
When 529 college savings plans became popular later on, the various sponsoring states enforced price requirements. As a result, there was a need for another class of shares, and American Funds responded by creating more affordable versions of classes A, B, and C: R1, R2, and R3. However, these are company-specific classes, and A, B, and C remain the universally accepted classes of shares.
As you can see, innovation is the main reason we have different classes of shares today.
The Purpose of Different Classes of Shares in Mutual Funds
Different classes of shares in mutual funds are down to the varying pricing options. Funds’ management fees are charged (and vary) according to the various share classes.
The management fees you pay on a particular share class will significantly affect the long-term performance of your investment. This is why a multi-class framework exists to allow investors to choose the most fitting fee structure for their investment goals.
Institutional shares come with the lowest fees and are typically geared towards large-scale retirement plans. F shares commonly feature in managed accounts, while class A and C shares are typically retail-grade.
Here’s a more in-depth look at the various shares classes you might encounter when investing in a mutual and the typical management expenses charged on each.
Class A Shares
Shares in this class usually levy a front-end sales load. However, the 12b-1 fee is often lower, and the annual expenses are typically lower than in other share classes. In some cases, a mutual fund may lower the front-end load as the investment grows, giving investors breakpoint discounts.
Class B Shares
Shares in this class don’t come with a front-end sales load. Rather, a back-end sales load is levied, along with a 12b-1 fee and other annual charges.
The Contingent Deferred Sales Load (CDSL) is the most commonly charged type of back-end sales load. Usually, the longer you hold onto your shares, the lower the applicable CDSL. It’s also worth noting that shares in this class might auto-convert into a different class with no CDSL and lower 12b-1 fees.
Class C Shares
A 12b-1 fee may be charged on Class C shares. Other annual fees may apply, too, alongside either back-end or front-end sales load.
The back-end sales load for shares in this class is usually lower than that of Class B shares. Similarly, the front-end load for Class C shares is lower than that of Class A shares.
Unlike their class B counterparts, Class C shares don’t’ eventually change their class. As such, the back-end load remains constant (doesn’t decrease). It’s also noteworthy that the annual expenses are generally higher in Class C than in Classes A and B.
Class I Shares
Shares in this class have lower annual fees than those in classes A, B, and C. However, they’re only available to institutional investors, who typically purchase shares on a large scale. Still, retail investors may gain access to Class I shares via their employers (for instance, through a retirement plan).
Choosing the Right Share Class
Different share classes suit different investors. To help you choose the most appropriate class for your needs, here are some factors to consider:
- Your holding period. If you’re looking to hold onto your shares for a long time, you might want to choose class B shares to save on back-end sales.
- The size of your investment. A sizable investment might see you qualify for Class A’s breakpoint discounts. Some funds also provide company-specific discounts for significant investments.
- Other holdings you have. Sometimes, you may qualify for discounts if you buy shares in a fund family that you already own holdings in. If you’re planning to make future investments in the same fund, you can use this provision to set yourself up for future discounts.
- Account Type. Your account type may also determine the discounts and share classes you’re eligible for. For instance, advisory accounts, accounts for charities, and some retirement plans may offer special discounts and/or share classes.
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Conclusion
To wrap things up, there’s one last thing I’d like to stress: carefully studying the prospectus. When a mutual fund offers different share classes, each class may have its own prospectus. Alternatively, all the classes in the fund may be described in one prospectus.
In either case, you’ll want to carefully examine the prospectus for the share class you’re looking to invest in. This way, you can figure out the costs attached to your investment and how they add up over time before you put your money into anything.
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