Why You Shouldn’t Invest in Mutual Funds with Different Share Classes

by Kevin on October 21, 2008

I love making broad, sweeping strokes with titles. There is always exception to various rules, but I think this one stands pretty firm.

Let’s say you’d like to retire someday. You go to a financial adviser to come up with a plan. He tells you to invest your money with a portfolio of mutual funds and if you stick to the plan you’ll be egg will definitely be golden in retirement.

While that may be true the size of your nest egg will depend primarily on two things: your portfolio’s asset allocation and the expenses that the mutual fund charges you to invest your money.

A Brief Overview of Mutual Fund Expenses

There are two primary types of mutual fund expenses:

  • expense ratio (also known as management fees)
  • loads

Expense ratios are fees that are paid on the total value of the investment. For example, if your expense ratio is 0.25% and the value of your investment is $100 you are charged $0.25. If the value is $10,000, you are charged $25.00. You are charged this on an annual basis no matter how large or small the account is or how long you’ve had the money invested. Keeping this ratio as low as possible is a major step in increasing the value of your portfolio over time.

Loads are charges that you either pay up front or when you cash out the fund. They usually come in two varieties: front or deferred.

With a front load you pay the charge up front. If the front load is 5%, for every single dollar you invest with the mutual fund the company takes 5% off of the top. If you invest $100, you’re really only investing $95 because the company takes $5 from you up front.

With a deferred load you defer the charge until a later date (when you cash out the fund, usually). There are also things known as Contingent Deferred Sales Charge (CDSC) that essentially says that if you sell your investment in the fund before a certain time frame (3, 5, or 7 years for example) you are charged the deferred fee. If you do not sell your shares before that time frame, you don’t pay the fee. If the deferred load is 3% and you have $10,000 invested and decide to sell your shares, you will be charged $300.

Of course if your investment grows to $1,000,000 you will be charged $30,000.

Why are there different share classes with mutual funds?

From what I can tell, the different share classes of mutual funds offer different combinations of high cost expenses. As a generic rule of thumb, I would encourage all of you out there to not invest in funds with different share classes without doing a lot of research up front.

You can look at this Bankrate article and this Financial Industry Regulatory Authority article to learn more about the different share classes.

What are the different classes and how can I differentiate them?

The title of the fund usually tells you what class shares they are. For example, going off of our Franklin Templeton discussion yesterday let’s take a look at one of their mutual funds with the different share classes: Franklin Templeton Growth Target.

  • Franklin Templeton Growth Target A (FGTIX)
    • Front Load: 5.75%
    • Deferred Load: N/A
    • Expense Ratio: 1.33%
  • Franklin Templeton Growth Target R (FGTRX)
    • Front Load: N/A
    • Deferred Load: N/A
    • Expense Ratio: 1.58%
  • Franklin Templeton Growth Target C (FTGTX)
    • Front Load: N/A
    • Deferred Load: 1.00%
    • Expense Ratio: 2.08%

Let me first start by saying none of these look like good investments. The expense ratios alone are all above 1% which is the high end of the acceptable threshold for expense ratios. That last fund with a 2.08% expense ratio is laughable, yet I know there are people still invested in those shares.

The different loads make it that much worse. More money going into the company — and your broker’s — pocket.

Why even have loads?

The simple answer is because people are dumb enough … or to be politically correct, uninformed enough, to not know what is better for them. The loads also help pay the broker or “financial adviser” (aka your sales agent) for convincing you to invest in the fund. At the end of the day those loads go out of your pocket and into that adviser’s pocket. How does that make you feel?

The middle fund without the load has a higher expense ratio to also help pay for the sales agent, so any way you cut it you are losing money on investing in these funds.

Are there any alternatives to loaded funds?

A lot of people may think “Well gee, I only have these fund options being presented to me so I have to pick one of them.”

Wrong! You have alternatives. Very inexpensive alternatives that can help you reach your investment goals faster than these funds.

They are called no-load funds. I’ll tell you about those tomorrow.

Edit: Five Cent Nickel also talked about loaded funds today.

In the meantime, a quick question: how many of you out there have investments in funds with different share classes? Why did you pick that investment? Leave a comment and start the discussion.

{ 4 comments }

Russ October 21, 2008 at 9:49 am

FiveCentNickel has a great post today about fund loads: http://www.fivecentnickel.com/2008/10/21/friends-dont-let-friends-pay-mutual-fund-sales-loads/

I agree with you. The only reason people buy loaded funds is because it’s sold to them. And the only reason there are different share classes is so these financial product manufacturers can get paid different ways for doing the same thing. Lack of transparency isn’t a good thing and these multiple share classes certainly cloud the issue.

Great post – thanks

Russell October 21, 2008 at 10:16 am

Kevin, you said “The loads also help pay the broker or “financial adviser” (aka your sales agent) for convincing you to invest in the fund”

I think of it a different way, the loads help pay for convincing SOMEBODY ELSE to invest in the fund after I’VE ALREADY invested in it.

I agree there are plenty of no-load funds around, and also low expense ratios. That’s one of the advantages of the index funds, they have low expense because they are not “actively” managed, they are based on a formula and don’t require a lot of analyst and management input.

Keith June 10, 2009 at 11:45 am

Kevin,

No offense but you really haven’t done your homework here. I find value in investing in actively managed funds through my a.k.a. sales agent (not meaning to knock your obvious disdain for financial professionals). As long as you have a “sales agent” that is up front with you about the shares classes and keeps you in the same fund family to take advantage of breakpoints (reductions in front loads on A shares based on purchase amount), he or she can show you a universe of “loaded” funds that knock the socks off no-load fund families like T.Rowe Price and Vanguard. This is for a very simple reason. You get what you pay for. Do you really think the best money managers are working for the no-load fund families??? The way I see it, “The bottom line is the bottom line”.

Kevin June 10, 2009 at 12:48 pm

@Keith: Unfortunately I think there is evidence to the contrary (that loaded funds are not as wise as no-load funds). The same with actively managed versus passively managed funds. I’ll try to flesh out my main points here for you.

For starters I would say the richest man in the world, Warren Buffett, says that unless you are into finances full-time as a job then you should invest with index funds. Costs are the only thing you can control, so finding the lowest cost fund helps you win in the long run. I’ve yet to see a proper argument that would defeat Buffett’s point.

Let’s look at actively managed vs. passive funds. I did a quick search and came across American Funds AMCAP R4. No-load with a 0.73% expense ratio. Let’s compare to Vanguard’s 500 Index Investor.

Now of course you could pick any time frame you wanted to be beneficial to your argument, but let’s look at the 5 year returns. Over the last 5 years, American’s fund has lost 19.71%, Vanguard’s fund has lost 16.12%, and the actual S&P 500 index (.INX) has lost 17.07%. In this case, Vanguard wins. Period. You’ve lost by 3.59% plus the difference in the expense ratio (an additional 0.55%).

Now if you look at everything since inception (looks to be around 7 years or so — not very long) the American fund has lost 10.48% while the Vanguard fund has lost 12.96% (and the index itself has lost 12.76%). In this case, American wins. If you compare the two in Google finance you’ll see that American did really well toward the beginning of this time period (outperforming Vanguard slightly), but more recently fell behind. So if you had invested more recently with American you may not have seen the same returns.

However what you must also consider is the difference in the fund expense ratios: 0.18% for Vanguard and 0.73% for American. So American is arguing that at the very least they can beat an index by 0.55%. Otherwise, why would you invest with them?

Now factor in some loaded funds (more on this below): many of the loaded funds charge much more than 0.73% and charge you 5.75% on the front end. How long will it take you to not only overcome the extra expense charges as well as make up for the fact that they take the first 5.75% of your money?

Here are two other articles I’ve authored regarding this subject — and it takes into account some of the loads offered by other funds. Why no load funds trump loaded funds every single time, Embracing the Beauty of Being Average, and How I potentially saved a friend over $880,000.

I’d love to see your research that refutes my evidence. I’m always willing to change my tune.

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