A-, B- and C-shares

An open-end mutual fund that adds sales charges can take the sales charge from investors either when they buy or when they sell their shares of the fund.

A-shares charge a front-end load when the investor acquires them. B-shares charge a back-end load when the investor sells them. For a B-share, the investor pays the NAV, but will leave a percentage behind when she sells. The percentage usually starts to decline in the second year, and after several years (6 to 8), the back-end load goes away completely. At that point, the B-shares are converted to A-shares.

B-shares are associated with contingent deferred sales charges. As the name implies, the sales charge is deferred until the investor sells, and the amount of the load is contingent upon when the investor sells. If the NAV is $10, the investor receives the $10, minus the percentage the fund keeps on the back end. So, if she sells 100 shares and there is a 2% back-end sales charge, she gets $1,000 minus $20, or $980 out the door.

Since the back-end or deferred sales charge eventually goes away, as long as the investor isn't going to sell her shares for, say, seven years, she should purchase B-shares, right?

Well, not exactly. While sales charges cover distribution costs, such costs are also covered by a 12b-1 fee. Yes, a 12b-1 fee also covers distribution costs. You've heard of no-load funds, but you may not have gotten the whole story. A no-load fund can charge a 12b-1 fee, as long as it doesn't exceed .25% of the fund's assets. Every quarter, when they take money out to cover expenses, these no-load funds can also take an amount not to exceed 25 basis points one-quarter of 1%.

But, while 12b-1 fees are associated with no-load funds, loaded funds also charge 12b-1 fees.
So, again, should the investor buy the A-share or the B-share? The choice has to do with the 12b-1 fee. The A-shares for the growth fund might charge a load as high as 5.5% on the front end, but the 12b-1 fee will often be .25%, while the B-shares will charge a 12b-1 fee of, say, 1.00%.

That complicates things. While the person who bought the B-shares is waiting for that contingent deferred sales charge schedule to hit zero, he's paying an extra .75% every year in expenses in this example. .75% times seven years is an extra 5.25%.

And, this 12b-1 fee is a percentage. As an investor's assets are growing over time, that .75% is also taking more money from him, even if it's a flat percentage.

As we'll soon see, 5.5% would probably be the maximum sales charge on the A-shares. If the investor puts in more money, she can reduce the sales charge to 3 or even 2%, which is why long-term investors with a large amount of money should almost always buy the A-shares. In fact, investors with $1 million or more will find that funds with sales charges waive those charges for investments of that size.

 Does that hurt the salesperson? No, the agent wants and earns most of the 12b-1 fee. The bigger the account value, the higher that fee.

Then, there are also C-shares, which usually don't charge an upfront load but do carry a 1% 12b-1 fee. The level 1% 12b-1 fee is the reason these are referred to as "level load." The level load shares are intended for shorter-term investments only.
 

So, which type of share should an investor buy? As a general guideline:
•    Long-term investor with $50,000+ to invest — A-shares
•    Long-term investor with small amount to invest — B-shares
•    Short-term investor with up to $500,000 to invest — C-shares

The difference in expenses between A-shares on one hand and B- and C-shares on the other has to do with the 12b-1 fee. However, the 12b-1 fee is just one expense. The fund also charges a management fee to cover the cost of the investment adviser serving as portfolio manager. That fee is the same for all investors across the board and must be a separate line item. Management fees are not covered by any other charge. Rather, they must be clearly disclosed.

Other expenses cover transfer agent, custodial, legal and accounting services involved with running the fund. To see what the dollar amounts are investors can check the statement of additional information or SAI. For example, according to the SAI for the American Balanced Fund, the investment adviser received $189 million managing the portfolio the previous year. The transfer agent, by comparison, received $74 million.

When we add the management fee, the 12b-1 fee, and the "other expenses" fee, we have the total operating expenses for the fund. Divide the total expenses by the assets of the fund, and we arrive at the fund's expense ratio. The expense ratio shows the administrative efficiency of the fund.

Both loaded and no-load open-end funds charge the following expenses, which are deducted from the fund's assets going forward:

•    Management (investment advisory) fees
•    Distribution fees
•    Administrative service fees
•    Transfer agent service fees
•    Custodian fees
•    Auditing and legal fees
•    Shareholder reporting fees
•    Registration statement and prospectus filing fees

Again, not all open-end funds have sales charges, but all open-end funds deduct operating expenses from portfolio income. Shareholders don't get a bill for the operating expenses, but whatever the fund takes out represents money that could have been paid to the shareholders in the form of dividends.

An open-end fund could be managed by an investment adviser, who then uses an outside distributor, transfer agent, etc. Management fees might be enough to interest the adviser to keep the fund open. At American Funds, on the other hand, the distributor, transfer agent, and investment adviser are all the same company. With over 50 different mutual funds all taking in fees from portfolio income it is not surprising this company has grown since 1931 to be one of the biggest players in the industry.