Sunday, July 24, 2005

The ABCs of Mutual Funds

Nothing is quite so perplexing to mutual fund investors as the issues around sales charges and share classes. No-load funds and advisor-distributed funds, the alphabet of share classes and 12b-1 fees, what does it all mean?

To fully understand, let's first take a quick look at the history of mutual funds. In 1924, MFS Investment Management introduced the first mutual fund in America. Suddenly, the U.S. stock market, previously the exclusive domain of the wealthy, was within reach of the average investor. But access came with a price. Early mutual funds carried steep up-front sales charges and these "loads" remained prevalent until the mid-80s when no-load funds began to grow in popularity.

With the introduction of SEC rule 12b-1 and competition from no-load families, advisor-distributed fund families began to restructure the way they charged investors to purchase their funds.

The up-front sales charge on what became Class A shares dropped from 8.5% to 4-5.75% and Classes B and C were added by many advisor-distributed fund families.

Class B shares carry no front-end sales charge but a declining redemption fee if you sell your shares early (typically in the first six years). This is called (are you ready) a Contingent Deferred Sales Charge or CDSC. Class B shares usually carry an additional expense called a 12b-1 fee that is typically .25% to cover distribution costs. In other words, it goes to the advisor that sold you the fund.

Class C shares don't carry front-end loads either but they also don't have any redemption fee (usually after one year). They do have a much higher 12b-1 fee (around 1%) that really pushes up total fund expenses.

So, what does it all mean and which share class is best?

The answer depends on how long you expect to hang onto your fund. According to an October 2003 study conducted by Standard and Poors, Class C shares outperformed Class A shares in the 1, 3 and 5-year time frames. Class A shares outperformed in the 10-year time frame but bear in mind that, according to a 2003 study by Dalbar, the average holding period for mutual fund investors is only 29.5 months.

You could of course avoid all of this confusion completely by picking your own no-load funds and directing your own investments. You can lower your investment costs by taking a pass on the education and experience of a financial professional but this route is not for everyone, particularly if you've built a sizable nestegg that you don't wish to jeopardize by going it alone.

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