Deciphering Differences in Share Classes

If you buy a mutual fund from a broker, financial planner, or banker rather than directly from the mutual fund company, you may run into a confusing variety of share classes. These different classes of shares have varying fee structures, and choosing among them can be tricky. You can avoid this complication by sticking to a no-load fund and buying direct. But if buying a load fund from a broker, planner, or banker interests you, you may need to know the differences in class shares:

• Class A shares: These usually involve paying a sales charge (load) up front. The typical front-end load is in the neighborhood of 5.75%, but it may be higher or lower.
• Class B shares: You don’t have a front-end sales charge on these shares, but you do have a 12b-1 fee, which is usually 1% a year. In addition, expect a declining back-end charge (sometimes called a redemption fee). For example, if you sell between one and two years after buying, you may be charged 4%; between years three and four, 3%, and so on. Typically, after year six, you may have no charge.
• Class C shares: These involve a so-called level load, which means they may charge a front-end charge of 1% plus a 1% annual 12b-1 fee.

Which class of shares offers the best deal? No single right answer exists. Although the high front-end load of the Class A shares sounds scary, paying the 5% once may be cheaper than paying 1% annually over (say) a 10-year investment period.
To further complicate matters, in many cases, a B share or C share automatically converts to Class A after a period of time. The quicker B shares convert to A, the better, because this conversion eliminates the annual 1% fee. Unfortunately, share classes are not regulated and may vary from one fund company to another. Sometimes, only specific groups of investors are able to invest in special share classes.
For example, a certain share class may be designed for those who participate in 401(k) retirement plans. When buying a mutual fund through a broker, financial planner, or banker, be sure to ask about share classes and make certain you know what fees you will be charged.
If you want to avoid the confusing share classes, opt for a noload fund. No-load funds have no front-end sales charges or other loads to figure out.

Deciding When to Buy

Be careful about buying shares in a mutual fund during the last quarter of the year (that is, during the months of October, November, and December). Most funds announce their dividends, capital gains, and other such profits for the year during this quarter. The actual payment of these profits to shareholders (called the distribution) usually doesn’t take place until January.
However, according to Internal Revenue Service rules, these profits are considered paid on December 31, and anyone who is a shareholder as of that date must pay taxes on them. Thus, you’re probably better off waiting until after the January distribution to invest. You can receive the benefits of the profits, but you won’t have to pay a tax bill on them because you were not a shareholder as of December 31.

What are Fund Supermarkets?

A relatively new phenomenon in the mutual fund world are so-called fund supermarkets. These allow you to buy funds from several fund families for no or low transaction costs and to manage all your money in a single account. It’s a convenient way to get access to literally thousands of mutual funds from a single source.
The fund supermarkets are managed by some of the leading discount brokerage firms — financial companies that specialize in no-frills investment buying and selling services for individual investors. Such firms as Charles Schwab, Muriel Siebert, Jack White, and National Discount Brokers are among those running fund supermarkets. If you open an account with one of these firms, you’ll be able to buy and sell shares from a wide range of fund families; switch from one fund to another with ease, even if the funds are in different families; and receive information about all your accounts in a single statement.

Knowing Where to Buy Mutual Funds

Investors use a wide range of channels to purchase mutual funds, but buying directly from the fund is the most popular, Buying directly from a fund company is the cheapest and most convenient way to buy for most investors. Just telephone the company of your choice and ask for an application. Complete the application form and send in your initial investment in the form of a check, and you’re an investor —it’s that simple.
(If you participate in a 401(k) plan or other employer-sponsored investment program, you may have the opportunity to buy shares from a fund company indirectly, through your company’s investment plan. The paperwork and procedures are quite similar.) Only a couple of the questions on the typical mutual fund application are likely to cause you any confusion. Expect to state how you want any capital gains and dividends handled. You can have these profits paid to you in cash, or have them automatically reinvested in your account, buying more mutual fund shares. I recommend that you reinvest profits from capital gains and dividends so that your investment portfolio can benefit from the power of compounding. The mutual fund application may also ask whether you want to participate in an automatic monthly investment plan. This kind of plan automatically transfers a specified amount of money each month from your checking account into the mutual fund of your choice.
If you’re starting out with an investment program, I strongly recommend that you choose this option. After a few months, you won’t even notice the money “missing” from your budget, but you can look forward to the satisfaction —excitement even — of the steady growth of your investment portfolio, as reflected in your monthly or quarterly statements. Not all investors choose to buy mutual fund shares directly from fund companies. Some prefer to invest through full service brokers, financial planners, or their bank or credit union. Investing in this way has one significant advantage and one major disadvantage. The advantage is the availability of investment advice and guidance. A good broker, planner, or banker should be willing to spend time analyzing your personal financial situation and be capable of offering unbiased, thoughtful suggestions concerning the best investment options for you. He or she should also have printed materials to share with you giving information about funds, investment strategies, economic forecasts, and other useful data. If you want this kind of help, consider consulting one of these financial professionals. The disadvantage is the cost associated with this professional help. Full-service brokers, financial planners, and banks generally sell load funds rather than no-load funds. Load funds charge sales fees, often significant ones, whenever you buy shares. These fees can have a real impact on your investment profits. Show that the investment performance of load funds is no better than that of no-load funds.
Therefore, the sales fees you pay buy the services of your broker, planner, or banker, but not an improvement in investment profits. It’s up to you to decide whether the professional’s advice is worth the expense.
If you invest through a broker, planner, or bank, you may also have to deal with the confusing phenomenon of share classes.

Reading the Fund Prospectus

The fund prospectus is a legal document that must contain specific information about a mutual fund. The prospectus informs potential investors about the fund’s goals, fees, and expenses, and its investment objectives and degree of risk, as well as information on how to buy and sell shares. You can obtain a prospectus directly from the fund company or from a broker, financial planner, or other financial professional. After you narrow your fund choices to a handful of possibilities (three to five funds), request prospectuses for each and devote an evening to comparing them. A prospectus is usually not fun to read. The document contains a certain amount of jargon and some legal terms (despite recent rules by the Securities and Exchange Commission that encourage the use of plain English in the prospectus). But if you know what to look for, you’re likely to find that the prospectus contains a wealth of information that can help you decide whether the fund is right for you.
Information contained in the standard prospectus includes

• The investment objective of the fund
• Investments the fund manager is allowed to make, even if they may not fit the stated objective
• The financial history of the fund for the past ten years, or, if the fund is younger than ten years, for the life of the fund
• The minimum amount of money required to invest
• The sales charges (loads) associated with investing, and when they are payable — at the front end (on purchasing shares), at the back end (when selling), or both
• The fund’s operating expenses, including management charges, administrative expenses, and 12b-1 fees
• How to buy and sell shares and a description of shareholder services provided

Some funds have policies that allow the fund manager to invest in virtually anything — stocks, bonds, derivative securities, real estate, and what-have-you. I recommend that you avoid such funds, sticking instead with those that have clearly defined investment objectives.
The more prospectuses you read, the more familiar you can become with the terminology they use. By comparing prospectuses from several funds, you develop a sense of each fund’s different personality. You probably find that one fund feels more comfortable to you than the others, which may be a sign that you’ve found a good prospect for your first investment experience.

Evaluating Fund Management

By studying the track records of funds in the categories you’re interested in, you can identify a handful of strong candidates to focus on even more closely. The next step is to examine the management of those funds, looking for signs of strength and weakness that may guide an investment decision. Several firms, including Morningstar, Value Line, Lipper Analytical, and Wiesenberger, specialize in monitoring and tracking mutual funds and publishing reports on their findings. Most public libraries subscribe to at least one of the information services offered by these firms, and with the help of a librarian you can locate a wealth of information on the management styles and strengths of most mutual funds. Below are some of the questions to ask about any fund that you are seriously considering buying. Information services like those provided by Morningstar, Value Line, and so on can provide the answers.
Who is the fund manager? How long has he or she managed the fund? How does the growth record of the fund under his or her management compare to that of other funds? In general, you want the manager to have a record of at least five years with the fund company, preferably ten or more. If the manager has only been with the firm for two years, his track record is too short to be truly meaningful; any success the fund is currently enjoying may be due more to the efforts of his predecessor.
Information about fund managers often is readily available in the financial press. A few superstar fund managers, such as Mark Mobius, the international investment guru of the Templeton Funds, are almost as widely covered in the media as top basketball players or movie stars. Check online or in any index of newspapers and magazines (available at your local library) for articles about or interviews with the managers of the funds you are considering. You may be able to locate one or more profiles in which the fund manager offers his investment philosophy, explains his successes and failures, and indicates some of his strategies for the months and years to come.
Do the investments currently held by the fund match the fund’s stated objectives?
Fund management may not exactly match an advertised description. Some funds touted in advertising as low-risk or conservative investments actually include derivatives and other risky holdings in their portfolios.

Finding High-Performing Funds

After you decide which categories of funds are likely to be best for you, you can begin to narrow your choices still further. One way to start is by looking at the track record of a wide selection of funds in a particular category. Sources abound for this information.
Magazines that deal with personal finance and investing topics, such as Money, Smart Money, and Kiplinger’s Personal Finance Magazine, run periodic special reports showing comparative investment results for hundreds of mutual funds. The publications usually group the funds by categories, so you can quickly zero in on growth funds, index funds, municipal bond funds, or any other fund type of interest to you. Similar reports appear periodically in business magazines like Business Week and Forbes, in The Wall Street Journal, and in the business sections of many local newspapers. Visit your local library and ask a librarian to help you locate the most recent mutual fund issues of your favorite financial periodical or check out the publication online. The data you need ought to be easy to find.

Be sure to compare the one-year, three-year, five-year, and ten-year annualized returns for funds in the specific type or types of funds you are considering. Look for consistently strong results. The fund that amassed huge profits over the past 12 months may have done poorly in previous years, suggesting that next year’s performance may lag again.
A better bet is a fund that shows an above-average performance year-in and year-out for the past five years or more.

Matching Goals with Fund Categories

The following checklist contains some specific suggestions that can help you decide which types of funds may best suit your personal situation and goals:

• If your investment goals are mainly long-term, consider stock (equity) funds.
• If your investment goals are mainly short-term, consider bond (fixed income) funds, especially money-market funds.
• If you feel able to tolerate a relatively high degree of risk, consider growth funds, aggressive growth funds, emerging market funds, or mid cap and small cap funds.
• If minimizing risk is important to you, consider bond funds (including corporate bond funds), balanced funds, growth and income funds, or large cap funds.
• If you want to target specific regions or industries you think will grow, consider international or sector funds.
• If you want to minimize the costs of investing, consider index funds.
• If you want to minimize the taxes on your investment profits, consider municipal bond funds.

Obviously, overlap exists among these various personal goals. A single investor — call him Matthew for the sake of illustration — may have two or three different yet complementary investment preferences.
For example, say he wants to invest for the long-term goal of retirement, minimize risk, and minimize the tax bite on his investment profits. In light of these three preferences, Matthew may want to consider more than one category of funds, looking for the fund type that offers a comfortable balance among different factors. So zeroing in on one category of fund isn’t necessarily an obvious or easy process. The checklist can help you begin the process of sorting out the possibilities.

The cost of turnover in investing

Another cost of investing that doesn’t show up in the expense ratio of a fund is the cost of turnover. Turnover is the rate at which a fund buys and sells investments. A turnover rate of 100% means that, on average, the fund manager buys and sells stocks or bonds with a value equivalent to that of the entire investment portfolio each year. Every time the fund manager buys or sells a stock or bond, she incurs expenses — brokerage commissions and other administrative costs. The higher the turnover rate, the more frequent trading of securities the manager is engaged in, and the higher the trading costs. Over time, high turnover can be a significant drag on the profits of a fund.
You can find the fund’s turnover rate in the prospectus. The least actively managed funds, such as an index fund, may have a very low turnover rate of just 5% to 10%. A very actively managed fund may have a turnover rate of 500% or more, meaning that each security in the fund is held, on average, for just about one-fifth of a year — 10 weeks or so — before being sold.
In general, turnover rates of less than 30% are considered low; 30% to 100% is average; over 100% is high. If every other comparative point is equal, choose a fund with a lower turnover rate because more efficient fund management is likely to earn you greater profits in the long run.

Understanding 12b-1 fees

A 12b-1 fee, also known as a marketing or distribution fee, is an alternative way to pay the salesperson who sells the fund’s shares and who may provide assistance and advice to the investor. 12b-1 fees may also defray advertising and other marketing expenses of the mutual fund company. Any fund can establish a 12b-1 fee, although not all do. When 12b-1 fees exist, they generally range between 0.25% and 1.0% annually. By law, the fee can be no higher than 1 percentage point of the fund’s average net assets per year. A mutual fund that charges no sales load and charges 12b-1 fees of 0.25% or less is considered a no-load fund. However, if the 12b-1 fee is greater than 0.25%, the fund qualifies as a load fund.
Naturally, the lower the 12b-1 fees charged by a fund, the better. In general, no-load funds are a better bargain than load funds. However, you may find that, in some instances, a load fund may actually be a better buy than a fund with a heavy 12b-1 fee.
Suppose you’re considering a fund with a modest front-end load (say, less than 5%). Because the front-end load is a onetime payment, while 12b-1 fees are an ongoing annual charge, the front-end load may end up costing you less, especially if you plan to keep your investment for a long time. In effect, the existence of 12b-1 fees gives the investor a choice of whether to pay sales expenses later or up-front. Look closely at 12b-1 fees before making an investment decision — they may influence you to choose one fund over another.