Objective information about retirement, financial planning and investments

Mutual Funds – Know Your ABCs

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The mutual fund companies in many cases do nothing to make selecting or understanding their funds easy.  One area of potential confusion for investors is (in some cases) the myriad of share classes available among the same fund.

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Under the broker-sold model, the basic share classes are A, B, and C.  Using the American Funds Washington Mutual Fund, a Large Cap Value fund, as an example here is a comparison of the returns and expenses by share class:

A – AWSHX B – WSHBX C – WSHCX
3 yr return 15.66% 14.79% 14.72%
5 yr return 1.21% 0.44% 0.40%
10 yr return 6.11% 5.31% 5.25%
Expense ratio 0.62% 1.38% 1.42%
Front Load 5.75% NA NA
Max Def Load NA 5.00% (6 yrs) 1.00% (1 yr)
12b-1 fee NA 1.00% 1.00%

Source:  Morningstar

All three share classes are sold by commissioned based and fee-based advisors.

  • The A shares are the cheapest to own over time; however investors pay an upfront charge of 5.75%.  For every $10,000 invested, $9,425 actually goes to work for you with the rest going to the broker.  Typically there is no load for purchases above a certain dollar level and subject to some restrictions exchanges between other funds in the same family will not incur a sales load.
  • The B shares are no longer sold by the American Funds and many other fund companies.  While there is no front-end load, the deferred sales charge starts at 5% in the first year, drops to 1% by year 6, and disappears in year 7.  This means that there is a back-end sales load if you sell in the first 6 years.  In addition, the 12b-1 charge which is part of the expense ratio makes the fund more expensive to own each year.  This fee goes to compensate the broker in lieu of the front-end load.
  • The C shares have a level load in the form of a 1% 12b-1 fee that never goes away.  In addition there is a back-end load in the form of a 1% deferred sales charge for the first year.  With both the B and C shares, there is typically no additional charge for transferring to another fund in the same family and share class, though this could trigger a taxable situation if there is a gain and the fund is held in a taxable account.

Beyond the load world, there are still a number of share class options to consider:

  • A number of fund companies offer separate retirement share classes for use in 401(k) plans.  The most robust menu of retirement plan share classes belongs to the American Funds.  Continuing with the American Funds Washington Mutual example, there are 6 retirement plan share classes with the following expense ratios:
    • R1 – 1.40%
    • R2 – 1.39%
    • R3 – 0.96%
    • R4 – 0.65%
    • R5 – 0.35%
    • R6 – 0.31%

These lower expenses fall right to your “bottom line” in the form of higher returns to shareholders.  If your plan contains funds in what appear to be a higher cost retirement share class (whether via the American Funds or other fund families) this might be a reason to question those who are responsible for running your company’s plan.  The fund expense disclosures that you have likely received by now for your company retirement plan are a great starting point to review the expenses of all investment options offered by the plan.

  • Even low cost provider Vanguard has different share classes for some of their funds; generally the more advantageous share classes have a higher minimum investment than their base Investor share class.  Using the Index 500 Fund as an example, the Investor share class has a low expense ratio of 0.17%.  However, if you have $10,000 invested in this fund you will have access to the Admiral share class with an ultra-low expense ratio of 0.05%.  In some situations the next level fund for investors might be the Signal share class with an identical expense ratio.  If you hold the Investor share class check with your custodian to see which share class you are eligible for.  Typically if you invest directly with Vanguard they will notify you automatically if you are eligible for the Admiral shares.
  • One of the advantages that I am able to offer my clients is access to more advantageous share classes than they could generally get on their own.  One example is the PIMco Total Return bond fund.  The D share class is no-load with a $1,000 minimum investment.  This share class carries an expense ratio of 0.75%.  I have access via Schwab to the Institutional share class of the fund, which usually carries a $1 million minimum investment and a much lower expense ratio of 0.46%.  This difference is significant especially in a bond fund.  This is a benefit that many advisors can bring to their clients across various investment platforms.

These just a few examples of differences in share class among the same mutual fund.  Whether you invest on your own, via a financial advisor, or within your company retirement plan; it behooves you to understand and question the various share classes available to you.  While the differences in expense ratios may seem small, the impact of a lower expense ratio can be huge in terms of the amount you accumulate over time.

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American Funds-The Secret Sauce for 401(k) Plans?

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Many registered reps selling 401(k) plans in the small to mid-sized market would have you believe this.

To be clear, I have enormous respect and admiration for American Funds as a fund family. They offer a number of excellent funds. They have a deep management/research group. I use several of their funds in 401(k) plan line-ups and in the accounts of some of my individual clients (no-load share classes).

Contrary to what these registered reps may tell you, an all American Funds lineup is not, in my opinion, a complete 401(k) solution.

  • There are no domestic small or mid cap funds in the American Funds line-up. These are typically core asset classes in a well-balanced plan lineup.
  • For 401(k) plans, the R class of shares is typically used. For smaller plans this might entail the R1 or R2 share classes, larger plans can use the much more reasonable R4 or R5 share classes.
  • For example looking at the Large Value Washington Mutual Fund
    • R1 expense ratio is 1.43% which includes a 12b-1 fee of 0.99%
    • R2 expense ratio is 1.50% which includes a 12b-1 fee of 0.75%
    • R3 expense ratio is 0.97% which includes a 12b-1 fee of 0.50%
    • R4 expense ratio is 0.69% which includes a 12b-1 fee of 0.25%
    • R5 expense ratio is 0.39% with no 12b-1 fee
  • In the case of most registered reps and commissioned brokers, the 12b-1 will go to compensate them for their involvement with the plan.
  • These expenses take their toll on the quality of the fund. Washington Mutual’s R1, R2, and R3 shares earned a score of 42 in the Fi360 ranking system as of 3/31/2010. This score is just in the top half of the peer group. By contrast the R4 shares earned a score of 23, which places this share class in the top quartile of its peer group. The R5 shares earned a score of 17.
  • Looking at this another way, the five year average annual return for the R1 shares is 0.47%; for the R5 shares it is 1.55%.

As a plan sponsor, if your advisor suggests going with an all American Funds line-up for your company’s 401(k) plan, you should ask many questions.

In the commissioned world, the American Funds represent one of the best fund families many of these reps can sell. As with other top-notch fund families such as T. Rowe Price and Vanguard, using a line-up consisting exclusively of any fund family is usually not a good idea and generally does not provide the best 401(k) line-up. This approach may be in your broker’s best interests, but as a 401(k) plan sponsor you need to do what is in the best interests of the participants in your company’s retirement plan.

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