- The Washington Times - Tuesday, August 2, 2005

You’ve committed to investing, figured out your asset allocation and chosen to buy mutual funds through a broker. Think all your big decisions are made? Not quite.

If you are working with a typical broker, chances are you will wind up buying load funds, and the share class you purchase will determine how you pay your adviser’s fee: all up front, when you sell your shares or over time for as long as you own the fund. Which share class is right for you depends on your investment strategy.

Financial planners who charge by the hour and do-it-yourself investors favor no-load mutual funds. But about half of all equity funds charge loads — a commission paid to the brokers and advisers who sell them, usually about 5 percent of the assets invested.

Labeling conventions vary, but most load funds have at least three share classes, commonly known as A, B and C shares, that connote, respectively, front-end loads, back-end loads and level loads, where you pay as you go. Some funds have more than a dozen share classes, aimed at institutional investors, individuals saving for retirement or college and others, depending on the clientele the company is trying to reach.

All these share classes create a confusing alphabet soup for novice investors. Many of us would resist the idea of paying up front for a fund, but research shows most people with a buy-and-hold strategy would be better off with A shares because they have lower ongoing expenses. If your investment time horizon is uncertain, you might prefer B shares, which charge a back-end load and typically convert to A shares after a certain number of years. People who change course frequently generally prefer paying an ongoing level load.

No matter which payment method you choose — and that’s essentially what you are doing when you select a share class — there’s no getting around paying the commission. Companies that sell load funds will never let you in for free.

“The point people have to consider about loads is what are they getting for it? You should not be paying a load as an admission fee for a fund. Rarely are any funds good enough to justify that,” said Jeff Tjornehoj, an analyst with fund-tracker Lipper Inc. “You should be getting some solid advice from your broker or planner to justify the load. That’s ultimately what you’re paying for. If you’re getting poor advice or no advice, why go into a loaded fund?”

If you have done all your research on your own and found what you think is the perfect fund for your needs, and it turns out it charges a load, you should probably check your math, Mr. Tjornehoj said. Chances are you would be better off in a no-load fund with a similar portfolio structure.

Besides eliminating sales fees, there’s evidence no-load funds have a performance advantage, as well. A new study by the University of Michigan’s Ross School of Business shows the introduction of multiple share classes tends to hurt fund returns over time, particularly for long-term investors. New share classes attract significantly more money, but funds often see a drop in performance after about two years, said Lu Zheng, an assistant professor of finance at the school.

Mr. Zheng and two colleagues analyzed all diversified U.S. equity funds from 1993 to 2002 to see how the transition to a multiple-class structure affected cash flow, clientele, performance and expenses. They found that in the second year after the switch, multiple-class funds underperformed their no-load counterparts by 1.2 percent to 1.7 percent annually, largely because of increased fund size and higher cash-flow volatility.

“The good thing is it offers choices for investors with different preferences,” Mr. Zheng said. “The downside is, offering this to various investors, specifically short-term investors, invites more short-term money, which is going to impose liquidity costs on the fund, and that is going to hurt fund performance, and returns for long-term investors.”

Costs can have an enormous impact on total returns, Mr. Zheng said. There is mixed evidence on whether active managers can outperform the market, but the evidence is quite clear that returns suffer in high expense funds.

For many investors, the issue of which share class they should purchase is never raised, because they only consider the choice their broker presents. And brokers, skeptics note, are trained to sell the share class that will raise the least concern for investors, and that might not be the best one to own over the long haul.


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