10 things you need to know about Class B share mutual funds

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There has been quite a bit of controversy surrounding Class B shares in the last few years.

The NASD and SEC are taking a very close look at advisors that do a lot of B share business; attempting to determine whether or not the B share investment recommendation(s) are in the best interest of the client or the advisor.

Since there is such a firestorm over this issue, my top 10 list will have a strong bend towards addressing some of these concerns. Without further ado…

10 things you need to know about Class B share mutual funds:

1. Class B shares do not have a front end sales charge. Unlike A shares, where your starting value is reduced by the load, with B shares you start with the full amount you plan to invest. For example, with an A share if you have $25,000 to invest and pay a 5% load, your starting investment is $24,000. With a B share you start with the entire $25,000.
2. Instead of an upfront sales charge you are faced with a CDSC (contingent deferred sales charge). Which is exactly what it sounds like, a deferred sales charge, contingent on you selling out of the fund (usually) in the first 6 years of owning it.

   

   1. Like the saying goes, “if they don’t get you on the way in, they’ll get you on the way out.”
3. Brokers and advisors that sell B shares are paid a flat commission, usually 4%, regardless of the size of the initial client investment. So it doesn’t matter whether the size of the trade is $10,000 or $700,000, the broker still makes 4%. This is where the conflict of interest between client and advisor usually begins.
4. Class B shares don’t have breakpoints. Remember the breakpoint chart (from the previous post) for A shares? Well not only does that chart show the reduced charges the client pays for hitting fund breakpoints, it also shows the reduced commissions paid to the broker on those A shares.
   • Because B shares don’t have breakpoints, and broker commissions on B shares are always 4%, it makes the situation potentially ripe for abuse.
5. Be suspicious of an advisor that offers no fund alternatives other than the B share.
6. Be suspicious of an advisor that tells you there is no charge for buying a B share.
7. The annual expenses are much higher for a B share, when compared to those of an A share. This is because of distribution fees (12b-1 fees) charged against the assets of the fund. Basically, the fund has to hit you somewhere, to make up for the 4% commission they paid the broker, as well as, the pass they gave you on not paying an upfront charge.
8. Most Class B shares convert into Class A shares after a certain number of years, usually after a period of 8 years. At that point, your investment takes on all the characteristics of an A share, including reduced annual operating expenses.
9. Since B shares have no breakpoints there are no rights of accumulation or LOI’s (letters of intent) here.
10. It’s time for this once again. Here’s an excellent mutual fund expense analyzer that’s easy to use and serves up relevant information about the expenses associated with any mutual fund or ETF of your choosing.

Now I’ve made some references in the above list to some of the problems that can arise with the sale of B shares. Well, I’d like to tie it all together by creating a hypothethical example illustrating the potential conflict of interests.

Warning: Like they say in the movies, all the characters depicted in this illustration are fictional and any resemblance to actual people is purely coincidental.

Lets start by creating a bit of background

Our broker, John Wayne, works in a big commercial bank and isn’t very interested in building a business there. He also thinks the odds are probably good that he won’t be working in that branch in a few years time. He knows that he has to get paid now for the hard work he puts in. So right off the bat he’s decided to only sell A and B share funds; forget the C share approach.

Our client, Matt Carrieri, just inherited $275,000. He doesn’t know much about investing, but knows he wants to invest in quality mutual funds. He tells John that he’s fee conscious but wants to get the best bang for his buck. Matt thinks he wants to be invested for at least 3 years.

Because the client is fee conscious, John doesn’t even bother to talk about the A share with Matt. Why complicate things, that would only ruin the sale, the B share is a layup.

John tells the client that if he buys a B share, there’s absolutely no cost to do so and all he has to do is hold it for a few years, since its a longterm investment. John doesn’t go over the CDSC schedule with the client, he doesn’t want to scare him off.

Breakpoint anyone?

John neglects to tell Matt about the breakpoints he would have been privy to if he invested in the A share. Why should he anyway? The client might have balked at the 2.75% charge. And besides, he wants to make a 4% commission.

So instead, John steers the client into the B share without thoroughly going over the pros and cons of both share classes. He thinks that might only have hurt his chances of closing the business. He also knows the commission of 4%, for the B share, beats the hell out of the 2.75% he might have been paid if he was even able to close the A share business.

John closes the business and receives a commission of $11,000. A heck of alot better than the $7563 if he would have made for selling Matt the A share. John is happy with his days work and rides off into the sunset.

If there’s smoke, is there fire?

Now this little scenario I dreamed up may be a bit dramatic. But I guarantee you many of these thoughts go through the heads of brokers everyday and a smallish percentage act on those thoughts; this is what concerns the regulating bodies.

The overwhelming majority of mutual fund business transacted is done by the book. And the brokers and advisors that sell these funds are honest, hard working people. But comparatively speaking, when B shares are involved, there is a higher degree of suspicion.

Whenever you combine money, greed and the human condition, with low hanging fruit, you’re opening the door for trouble. And that’s what you get more with a B share then with any other class of shares…

On deck: 10 things you need to know about Class C share mutual funds.

Tags: Class B Share Mutual Fund, Mutual Fund expense analyzer, Psychology Behind Financial Planning