by: Donald Jay Korn
from:  Financial Planning
November, 1998

In simpler times, there were three TV networks, one long-distance telephone company and two types of mutual funds: load and no-load.   Investors could do their own fund picking and avoid sales charges.   Alternatively, clients who needed the advice of a registered rep would pay a one-time upfront sales charge.

In the idiom of the day, an investor might pay $10,000 and se $850 paid to a broker, meaning that $9,150 was in the account "working for him."

That straightforward approach has been replaced by an alphabet soup of share "classes" among funds that carry sales commissions.   The basic framework includes:

• A shares with initial loads.  Sometimes A shares are sold without the load - at net asset value (NAV) - in wrap programs where investors pay asset management fees.
• B shares without initial loads.  In a typical scenario, B shares impose deferred sales charges that taper off over a period of five to seven years.  During this period, B shares impose annual expenses greater than those of A shares.  when the deferred sales charge no longer applies, B shares often convert to A shares, with lower expense ratios.
• C shares without initial loads.  The deferred sales charge usually applies only for a year.  There is no conversion to A shares so the higher expense ratio applies indefinitely.

this lineup can be confusing to many investors and to more than a few financial planners.  Moreover, one fund family's B shares may not be the same as another family's B shares.  "The specifics vary quite a bit from fund to fund," says Mike Stout, a senior analyst at Morningstar.  "You need to read the fine print to discover the differences.  In general, though, long-term investors are best served by A shares, and short-term investors are better off with C shares."

To help planners make such distinctions, Morningstar crunches the numbers for multi-share load funds and publishes "recommended holding periods."

At Davis New York Venture Fund, for example, Morningstar recommends A shares for holding periods of 6.5 years or longer, and C shares for holding periods up to 6.5 years.  (For holding periods of 6 to 6.5 years [!], the B shares are recommended along with the C shares.)

The A-long, C-short rule may be easy to master, but there are plenty of exceptions.  At Dreyfus Premier Core Value Fund, the A shares beat the B and C shares no matter what the holding period, according to Morningstar.   Yet at Dreyfus Premier Value Fund, the A shares are not recommended at all:   Morningstar gives the nod to the C shares for up to six years and the B shares for longer holding periods.

With all of these conflicting signals, how are planners supposed to serve clients in the real world, given the uncertainty about holding periods?  "A lot of clients say that they're long-term investors", says Richard Van Benschoten, a financial planner with Cowan Financial Group in New York, "but that's not always the case.  Last summer, when the market turned down, you saw many investors sell their fund shares."

Financial planners tend to emphasize long-term goals so their clients are most likely to buy A shares.  It's worth paying more upfront, the reasoning goes, because ongoing fees will be reduced.  Share classes that charge higher expense ratios (B and C shares) impose increasing fees if the investor's portfolio appreciates, which hopefully will be the case.  thus, some planners say that investors are better off paying a one-time initial sales charge.

"For long-term investors, A shares are the way to go," says jackie Coyne Figliola, senior vice president at Financial Network Investment Corp. in Torrance, Calif.  "Altogether, I'd say that 75% of our orders for load funds are A shares, either sold with a front load or at NAV."

Elaine collins, a planner in Libertyville, Ill., agrees that most investors should choose the A shares.  "I don't think I've ever recommended a B share."  To take the sting out of front loads, Collins bills her clients on a fee-offset bases.  "I'll quote my clients a fee for my services, then I'll recommend whatever mutual fund I think is best for their needs, load or no-load," she says.  "If I do receive a commission, I'll reduce the fee I charge by that amount, so the client will pay the same amount no matter which funds I recommend."

In some situations, though, there may be advantages to going beyond A to B or C.  Some clients don't like the idea of writing a check for $10,000, so these share classes may encourage reluctant investors to venture into mutual funds.  Moreover, some planners believe that the deferred sales charges may discourage harmful in-and-out behavior.

"B and C shares may be appropriate where the adviser is going to have a relationship that goes beyond recommending which funds to buy," says Chet Helck, senior vice president at Investment Management & Research in Atlanta.  "If the adviser is going to provide a great deal of monitoring and support, B and C shares can help spread the costs over many years."

Nevertheless, at IM&R, B shares are the least popular class of funds, Helck says.  "It's relatively easy for clients to understand A shares, either sold with a front-load or at NAV in fee-based plans.   Similarly, clients can understand C shares, which impose a sales charge that's the same percentage each year.  B shares, on the other hand, are more complex and may be the hardest to understand.  Actually, B shares aren't a bad structure, as long as both the adviser and the client understand how they work."

Indeed, B shares may be appropriate in some situations.  "The dollars generally are about the same in A or B shares," Stout says.  "With B shares, though, the investor pays those dollars over a period of years rather than upfront."  Morningstar's analysis points to several funds (Zweig Trust Strategy, for example, and MFS Capital Opportunities) in which the B shares pencil out to be better for long-term investors than the A shares.

"I use a software program [Multiple Class Calculator for Mutual Funds from Money Marketing Inc. of Croton-on-Hudson, N.Y.] that shows how the various classes compare," says Richard Jaffe, managing executive at Royal Alliance Associates in New York.  "Often, when you run the numbers, the B shares wind up to be best for the client."

That doesn't mean Jaffe always recommends B shares.  "On a large order, where a discount on the front load is available, the A shares may be better.  In fact, our compliance department won't accept an order for B or C shares on large orders where A shares are inexpensive."

What's more, B shares may come burdened with excess baggage.  "Some B shares never convert to A shares," says Stout, "so the investor keeps on paying the higher annual expenses."

Roxanne Fleszar, a planner in Peabody, Mass., recently observed the dark side of B shares.  "I was called in to advise a business owner who had been self-managing his company's profit-sharing plan," she says.  "For years, the plan had been buying and holding B shares that never had converted to A shares."

According to Fleszar, the B shares carried an expense ratio of 1.84% while the fund's A shares had an expense ratio of 1.08%.   "I told the business owner this would be all right if the broker who sold the funds had been providing extensive support service:  asset allocation, portfolio reviews, fund monitoring.  The owner said that wasn't the case; the broker had provided no support at all.  The client didn't have any idea of what B shares were or why he was buying them."

Whether or not B shares convert to A shares, they may be sold as "no-loads."  That is, investors are told that they pay no charge up front and no deferred sales charge either, as long as they hold on for six years or so.

"Many funds are sold on this basis," Collins says, "but that's deceptive.  Investors will wind up paying the broker through higher annual expenses."

Ironically, B shares may pose problems even for planners who generally recommend no-load funds.  "Many new clients come to us with funds already in their portfolio," says Stewart Welch III, a planner in Birmingham, Ala.  "We then have to decide if they should sell the old funds and reinvest in new ones that we've screened, perhaps paying some capital gains tax.   That decision is more difficult if the client holds B shares, with a deferred sales charge.  We're more likely to recommend that the client retain those shares for a while, at least until that deferred sales charge disappears or becomes negligible."

Welch says he has noticed situations in which a new client has previously purchased A or B shares, only to see a highly prized portfolio manager leave the fund.  "Then what does the client do?  Stay with a fund that has an unproven manager?  Leaving the fund means either forfeiting the upfront load or paying a deferred sales charge.  From that point of view, investors buying load funds have a lot more flexibility with C shares:  They can leave the fund with no penalty after one year."

Thus, C shares appeal to some planners and their clients.  Wes Bigler, a planner with Financial Network Investment Corp. in Atlanta, says he generally sells A shares at NAV to clients who invest through the firm's "personal asset management" (PAM) wrap account.  "Some clients, though, prefer to buy C shares outside of a PAM account," he says.  "Either way, I'm essentially getting paid on the basis of assets under management.  I haven't sold a fund with an upfront load for years."

What about B shares? "They're too restrictive," Bigler says.  "Clients feel like they're locked in for years.   With C shares, there's no deferred sales charge after one year."

To make matters even more difficult, mutual fund share classes go beyond A-B-C to M (in Putnam funds), T (in Fidelity Advisor funds) and Y (one way of designating shares for institutional investors) and so on.  "No matter how many classes of shares there are, planners should explain all the options to clients," Van Benshcoten says.  "If this explanation confuses some clients, it's up to the planner to make a recommendation.  Clients trust planners to advise them, so you need to really learn about the different share classes in order to earn that trust."