More on mutual fund share classes and 12b-1 fees
A few weeks ago, we talked about a U.S. Securities and Exchange Commission’s Division of Enforcement initiative that required financial firms to make payments to certain customers who purchased mutual funds with 12b-1 fees. The problem the SEC was addressing was not the 12b-1 fees themselves, which go to paying for distribution and shareholder services. Rather, the issue had to do with conflicts of interest with mutual fund share classes.
Quoting the SEC: The 12b-1 fees “were routinely paid to the investment advisers in their capacity as brokers, to their broker-dealer affiliates, or to their personnel who were also registered representatives, creating a conflict of interest with their clients, as the investment advisers stood to benefit from the clients’ paying higher fees.”
In that column, I gave a mutual fund example with two share classes: “One class has operating expenses of, say, 1.5%, the bulk of which is a 12b-1 fee of 1%. … A lower-cost share class may have operating expenses of, say, ½ of 1%, with no 12b-1 fee.”
The reason for my going back to this subject is a question from a San Jose, Calif., reader who challenged my 1% 12b-1 example as being too high.
There are thousands of funds with 12b-1 fees of 1%, and thousands more with 12b-1 fees of 0.25% — it’s all about share classes.
Here is the specific example of a fund with seven share classes (some of the lower-cost shares are only available to institutions or retirement plans):
1. Class C has a 1.5% expense ratio, 12b-1 fees of 1%, which are imbedded in the expense ratio, and a 1% deferred charge (maximum). A deferred charge is a “back-end load” that applies when you sell shares before a certain period expires.
2. Class B has a 1.5% expense ratio, which includes 12b-1 fees of 1% and a 5% deferred charge (maximum). (This fund’s B Shares are closed to new investors.)
3. Class A has a 0.75% expense ratio, which includes 12b-1 fees of 0.25% and a 4% front load (maximum). (No deferred charge.) A front load is the initial sales charge, a one-time deduction from your investment in the fund. In this case, the maximum is charged for purchases of up to $100,000 invested. Between $100,000 and $250,000, the sales charge is 3.25%. Between $250,000 and $500,000, the front load is 2.5%, and at $500,000 and above, there is no sales load.
4. Class M has a 0.99% expense ratio, which includes 12b-1 fees of 0.49% and a 3.25% front load (maximum). (No deferred charge.)
5. Class R has a 1.0% expense ratio, which includes 12b-1 fees of 0.5%. (No deferred charge and no front load.)
6. Class R6 has a 0.37% expense ratio. (No deferred charge and no front load.)
7. Class Y has a 0.5% expense ratio. (No deferred charge and no front load.) (In the fund’s prospectus supplement, you’ll find front load waivers for customers of certain “intermediaries.”)
There are over 3,000 mutual funds that have 12b-1 fees of 1%, according to a mutual fund database called Steele Mutual Fund Expert. (There are over 28,000 funds in the Steele database, excluding money market funds. Over 12,000 have 12b-1 fees and over 16,000 do not.)
Those funds’ expense ratios (which include the 1% 12b-1 fee) range from a high of 8.95% per year to a low of 1.06% for a fund that also charges a deferred charge of 5%. A few funds in that list of over 3,000 also charge a front load. For example, one fund has an expense ratio of 1.97%, which includes the 1% 12b-1 fee plus a front load of 5.75% (maximum).
At the other extreme are about 5,400 funds whose 12b-1 fees are 0.25% per year.
The highest expense ratio is
10.52%. The second highest is 7.51%. That fund also has a front load maximum of 5.75%. Three thousand have front loads.
There are over 3,000 funds with no 12b-1 fees, according to Steele. You might think that those funds have low operating expenses. That’s not necessarily so. For example, one fund has zero 12b-1 fees and an expense ratio of 4.41%; another has an expense ratio of 3.76%. A few funds have expense ratios of zero. Which share class would you choose if you were investing on your own? Which share class would your financial adviser choose for you?