The ABCs of Mutual Fund Share Classes

In mutual fund investing, the old adage that high costs indicate quality couldn't be further from the truth. There is no proof that paying a higher fee results in higher returns. If anything, the mutual fund manager of a high-cost fund might take more risks in an attempt to produce a higher return. If the manager's risky moves don't pan out, you've forked over more money in costs and taken capital losses.

To avoid such a scenario, you should consider which class of mutual fund shares is suitable for you. The class of shares helps to determine what kind of fees you will be paying when you invest in a mutual fund.

What Are Mutual Fund Classes?

While stock classes indicate the number of voting rights per share, mutual fund classes indicate the type and number of fees charged for the shares in a fund.

Mutual fund companies can have seven or more classes of shares for a particular fund; however, there are three main types of mutual fund classes: A, B, and C. They are also known as A-shares, B-shares, and C-shares.

Each of these classes has various benefits and drawbacks.

Class A Shares

A-shares charge an upfront sales fee, or front-end load, that is deducted from your initial investment.

Pros

• Lower 12b-1 Fees: Class A shares tend to have lower 12b-1 fees, which are marketing and distribution fees included in the fund's expense ratio. If you plan on holding these shares for several years, then a front-end load might be beneficial in the long run.
• Breakpoints: These provide a discount off regular front-end load rates each time your investment reaches a certain amount in a series. If the first breakpoint is $25,000, you could invest that amount initially to receive the first discount. Breakpoints clearly favor those with more money to invest.
• Rights of Accumulation: You get a discount on the front-end load if you reach the first breakpoint with subsequent installments. Suppose that the first breakpoint is $25,000, but your initial investment was $10,000. If you invest another $15,000 to reach the breakpoint, you will receive a discounted front-load fee. This is helpful when saving for retirement because working-age adults generally are able to invest more year by year.
• Letter of Intent: Some companies offer front-end load discounts to individuals who initially express the intent to invest more. They must indicate the intention to invest an amount over a specific breakpoint by a particular time.

Cons

• A High Initial Investment: Investors who do not have a high enough balance to reach a breakpoint before the deadline indicated by a letter of intent have to pay regular front-end fees.
• A Long Time Horizon: These funds are not optimal for investors hoping to cash in soon. Suppose that your initial investment is $4,750 after $250 in front-load fees, and your investment increases by 3% during the course of a year. If you sell at the end of the year, you would have actually lost money: ($4,750 x 1.03) - $5000 = - $107.50, or a loss of 2.15%.

Class B Shares

B-shares have a back-end or contingent deferred sales charge. This fee is paid when you sell shares a specified period of years after the original purchase. These shares are typically good for investors with limited cash to invest and a long investment horizon.

Pros

• No Front-End Fees: Your entire initial investment contribution benefits from capital gains and interest income. That is a substantial benefit for new investors saving for retirement because of the power of compound returns. Consider a stock fund that earns 10% per year over 30 years. The initial investment will be worth over 17 times as much in the end. A few hundred dollars saved in front-end fees means a few thousand dollars at retirement time.
• Deferred Sales Charges: The longer you hold the shares, the lower your deferred sales charge. That is another benefit for investors with long time horizons.
• Conversion to Class A: Class B shares automatically convert to Class A shares after a specific holding period. This conversion is beneficial because Class A shares have a lower yearly expense ratio than Class B shares.

Cons

• Long Time Horizon Required: If you withdraw funds within a certain period of time, you will be charged a back-end or deferred sales charge. One must typically remain in the fund for five to eight years to avoid the exit fee.
• No Breakpoints: Class B shares do not provide breakpoints on the deferred sales charge. Regardless of how much you invest, there is no discount on these charges. That can be a significant drawback for wealthy investors.
• Higher Expense Ratios: Class B shares charge higher expense ratios than both Class A and Class C shares until shares are eligible to be converted to Class A.

Class C Shares

Class C shares are a type of level-load fund, which charges an annual fee. This class works well for individuals who could be redeeming their shares in the short term.

Pros

• No Front-End Fees: Your entire initial investment contribution earns interest income.
• Small Back-End Load: The back-end load is typically a modest 1%.
• Opportunity to Avoid Back-End Load: The back-end load is usually removed after the shares have been held for one year.

Cons

• Back-End Load: A back-end load—although small—is typically charged if funds are withdrawn within the first year.
• Higher Expense Ratios: Even though the expense ratios of Class C shares are lower than those of Class B shares, they are still higher than those of Class A shares.
• Conversion: Many Class C shares cannot be converted into Class A shares. That removes the opportunity for lower expense ratios. If you have a long time horizon, Class C shares are not for you as the higher management fees continue indefinitely. In fact, your investment returns will be reduced the longer you stay invested because the fees will add up over time.
• No Discounts: Class C shares do not offer discounts on expenses when the account reaches certain levels.

The Disappearing Middle Class

Although we've looked at all three classes, the middle class of mutual funds—the B-shares—have been disappearing from the mutual fund industry.

There are several reasons for this, but chief among them was more regulatory focus on fees. 12b-1 fees have been a source of shareholder lawsuits against fund companies for alleged misuse.

As a result, many fund companies are dropping these fees and shrinking the class offerings to compete with exchange-traded funds (ETFs).

ETFs themselves put pressure on Class B shares by providing a low-fee alternative for investors with limited investment capital. In short, Class B shares still exist, but they are a dying breed.

Applying the Pros and Cons

Let's look at how the characteristics and pros and cons described above work in the following share classes of the hypothetical ABC Company Bond Fund.

ABC Company Bond Fund, A Versus C Comparison

Source: Hypothetical bond fund, based on a model from PIMCO

In this example, you can see how these two share classes are better for different types of investors and situations.

Suppose that you plan on investing in this fund for retirement and your retirement is 20 years away. Class A shares would work best because they offer costs that decline over time. If you plan to invest just one lump-sum amount and it is enough to qualify for a breakpoint discount, Class A would also be the best over time. With a large initial investment, you would get a discount on the load. Your yearly expense ratio and 12b-1 fees would also be very low, allowing your investment to grow.

Class C shares would work best if you are planning to invest for a limited period of more than one year but less than three. This way, you avoid both front-end and back-end loads. Although your expense ratio will typically be higher than Class A shares, your full investment will gain interest while it is invested. Since you are only in the fund for a few years, the yearly fees do not have a chance to pile up.

The Bottom Line

When deciding which class of mutual fund shares to choose, remember to read the prospectus. In addition, you must take into account your investment horizon and the amount you have available to invest. The frequency of your investments and the probability that you will need to withdraw funds early are also essential considerations.

Correction—Jan. 19, 2024: This article has been corrected to state that many Class C shares cannot be converted into Class A shares.