Welcome back to another edition of Foolish mutual fund basics. This time, we're leaving behind the tony tidings of fund raters for the (really) high-rent world of multiple share classes. Ready to get started? Good.
What it is
There are two types of funds: those that charge sales commissions and those that don't. Those that do tend to have multiple share classes that are broken out alphabetically: A, B, and C. When you buy into "A" shares, the fund tends to charge a front-end load, or sales commission. It tends to charge fees when you sell the B and C shares.
Confused yet? Don't worry; I was at first, too. All will be clear once we run through some examples. Let's begin with A shares. Say you've got $10,000 to invest and you like AIMMulti-Sector (FUND: IAMSX ) , which is a five-star choice from Morningstar that has positions in Omnicom (NYSE: OMC ) , Harrah's Entertainment (NYSE: HET ) , and Citigroup (NYSE: C ) .
There's a 5.5% front-end load for Multi-Sector's A shares. Multiplying your $10,000 by 0.055 (5.5%) results in $550, which is subtracted from your account before a single share of the fund is purchased.
Brokers will rarely sell you A shares, however. Why? The B and C shares trade the front-end charge for a higher overall expense ratio and an exit fee, or back-end load. Consider the Multi-Sector fund. Its B shares charge 2.05% annually in fees versus just 1.3% for the A shares. That can add up; Yahoo! Finance estimates you'd pay $2,384 to hold the B shares for 10 years versus $2,230 for the A shares.
And don't forget the deferred sales charge. There's a 5% back-end load for Multi-Sector's B shares. Assuming you could get the same performance that the fund has racked up over the past four years, your $9,450 could reach $20,000 by the end of 2010. Exit at that point and you'll pay $1,000 in fees ($20,000 x 0.05 = $1,000).
That's why Shannon Zimmerman, who co-advises Motley Fool GreenLight and leads our Champion Funds service, says B really stands for broker.
"No load is a good load, but yes, if you're going to pay one, A shares are the way to go," Shannon wrote in response to my questions about share classes yesterday. "Bs and Cs typically run with much pricier expense ratios than As. Plus, some shops offer reduced sales charges at certain investment levels. With these breakpoints, the more you invest, the lower the load. These breakpoints might be out of reach for the average investor, however."
That's no joke, Fool: American Funds Growth Fund of America (FUND: AGTHX ) will reduce its sales charge to 3.5% from 5.75% if you invest at least $100,000. The load disappears altogether if you invest at least $1 million. (Pssst! Hey buddy! Could you spare a million?)
How it works
If you're thinking that there's a pay-for-performance trade-off that comes with loads, think again. More often than not, load funds do no better than their less-encumbered peers.
Consider AIM Multi-Sector again. Morningstar says that, over the past three years, the fund's A shares returned 16.22% annually. That's more than 4% a year better than the S&P 500 over the same period. Nice, but plenty of no-load funds have done nearly as well. Will Danoff'sFidelity Contrafund (FUND: FCNTX ) , for example, has returned an average of 15.83% since 2003.
Better still, because Fidelity doesn't charge a sales load, Contrafund's real cash return trumps that of Multi-Sector. Yahoo! Finance estimates you'd pay just $290 on a three-year, $10,000 investment in the Contrafund versus -- wait for it -- $986 for Multi-Sector. That's a huge difference that could take years to overcome.
Go under the hood
Among the numerous problems with the fund industry, the biggest is that you're unlikely to hear much about no-load funds without doing your own homework. You are, however, very likely to get mailer after mailer of load funds pitching themselves to you.
Next time that occurs, keep the mailer and do your own digging about the mutual fund. Look for front-end, back-end, expense ratios, and any other fees that could affect the return on your investment.
Follow the money
Paying for performance is a great idea when it comes to sports teams, but it's a load of bull when it comes to investing. That's especially true of mutual funds with steep sales charges and multiple share classes. So, go the cheapskate route instead. You, and your wallet, will be the better for it.
Interested in more moneymaking tips? Consider GreenLight. Shannon and co-advisor Dayana Yochim are offering 30 days of free access to the service right now. Click here to get started.
Fool contributor Tim Beyers, ranked 1,099 out of 15,035 in Motley Fool CAPS, is a cheapskate when it comes to cars, funds, and just about everything else. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. The Motley Fool's disclosure policy is a bargain at any price.