Raymond Kerzérho April 30, 2024 Market Research Mutual Fund Share Classes In the first post of this series, we reviewed the broad underperformance of actively managed mutual funds, the migration of retail investors to passive funds, and why I recommend passive funds in general. This post will discuss a little-known aspect of passive investing: mutual fund share classes. Understanding the various “share classes” or “series” of mutual funds is crucial for Canadian investors. Each share class offers the same portfolio but has different service levels, fee structures, and restrictions. This knowledge empowers you to invest wisely and make informed decisions about your portfolio. A Terrible Mess Most mutual funds offer multiple share classes, usually designated with the letters A, B, C, D, E, etc. For instance, the Mackenzie Global Dividend fund has a staggering 20 share classes![1] This abundance of share classes is common in the Canadian mutual fund market, and to add to the confusion, there is no standardization in the marketplace about the meaning of these letters. For example, “Class B shares” could mean one thing at one mutual fund firm and something else at another. This lack of clarity can be overwhelming. However, to make informed portfolio decisions, it’s crucial not only to compare mutual funds with ETFs but also to grasp the nuances of the various types of mutual fund share classes. Why Create Share Classes? Mutual fund firms create share classes for various reasons. One common reason is to offer different compensation schemes to advisors and their employers. Another is to cater to specific investor types, such as do-it-yourself investors. Share classes also help firms target different sales channels or make regular cash distributions to investors. Understanding these motivations not only provides valuable insights into the financial services industry but also empowers you to make better choices. Types of Share Class There are four main types of mutual fund share class. Here’s a list that runs from the most expensive (and complicated) to the cheapest (and simplest!). 1. Commission-Based “Commission-based” is the most common type of share class. These shares often bear a name ending with “Class A” or “Advisor series,” but other codes are also common. This type of share class is the most expensive because in addition to paying part of the fund’s portfolio management, administrative, and marketing costs, the monthly fees also include a “trailer commission” for the firm that employs the advisor who sold you the shares. The commission can vary, but this type of share class will often redirect at least one percent of the assets per annum to the advisory firm out of the approximately two percent per annum or more in fees paid monthly by the share class to the fund manager. But that’s not all. In addition to monthly fees, some mutual fund share classes also come with an up-front commission (or so-called “front-end load” in fund marketing jargon) of up to five percent to be paid at the time of purchase. This is the worst option for investors: for every $100 you invest, only $95 is put to work for you. The five missing dollars are paid to the advisory firm. This up-front commission also applies if you contribute systematically to the fund. Front-end load shares are rarely proposed to investors. But if an investment advisor or bank employee does offer you this type of share class, my advice is to say “no” and find another advisor. Front-end load fund shares are rarely in an investor’s best interest. Most mutual funds are offered in a “no load” share class. This share class may have a higher monthly fee than the front-end load share class, but at least if you’re not satisfied, you can dispose of your shares without penalty (as long as you aren’t selling them shortly after buying).[2],[3] 2. Do-It-Yourself (“DIY”) “Do-it-yourself” share classes are aimed at investors willing to eschew investment advice in return for lower monthly fees. They often bear a name ending with “Class D” or “Class E.” Since this share class pays little or no trailer commission, the monthly management and administration fee is usually about a half lower than the corresponding commission-based class. DIY share classes of mutual funds can be purchased from a discount brokerage firm and sometimes directly from the mutual fund firm. 3. Fee-Based Advice “Fee-based advice” share classes are like DIY share classes, except they must be acquired through a fee-based advisor. They often bear a name ending with “Class F.” Since these mutual fund shares do not pay any trailer fees, the advisor will purchase this type of share class only for clients who have opened a fee-based account. This means the investor will pay a monthly fee—a percentage of assets under management—directly to the advisory firm. (NB: PWL Capital operates with the fee-based financial advice model.) If you do business with a financial advisor on a fee-based arrangement, your investment costs will include the advisor fees and the fees of the mutual funds and/or ETFs held in your portfolio. 4. Institutional “Institutional” share classes are a particular case of fee-based share classes with lower negotiated fees. They require a very high minimum investment amount and are aimed at institutional investors (like pension funds) or wealthy individuals. The fee difference between “fee-based advice” and “institutional” shares varies from fund to fund and can be modest. Institutional share classes’ names often end with the letters “I” or “O,” but many other designations exist. In many cases, this share class will declare zero costs because the mutual fund firm charges its fees directly to the investor rather than the fund. Investors with considerable amounts (typically millions of dollars) of assets should ask if they can access institutional shares. Comparing Passive Mutual Funds and ETF ETFs are most comparable to DIY and fee-based mutual funds because they don’t incorporate compensation for advice.[4] While many investors believe passive ETFs are superior to their mutual fund equivalent, both products offer benefits investors should consider. Benefits of Passive ETFs Passive ETFs typically charge lower fees than any share class of a comparable passive mutual fund. ETFs also offer a broader variety of index-based products than mutual funds. Several ETF families offer passive asset allocation ETFs, a less frequent product in the mutual fund world. ETFs can be purchased and sold through some online discount brokers with zero-dollar commissions. Lastly, information about ETFs is far more accessible than for mutual funds. In most cases, finding the product you’re looking for in the ETF world is far easier than in the mutual fund market. Benefits of Passive Mutual Funds Mutual funds are more straightforward to transact than ETFs. When buying mutual fund shares, you don’t need to calculate the number of shares to purchase, determine a purchase price, and wait for the trades to be executed. You just need to submit the amount you want to invest, and the transaction will be executed at the fund’s end-of-the-day net asset value of the shares. Like ETFs, mutual funds can be purchased and sold through some online discount brokers with zero-dollar commissions. Finally, unlike most ETFs, mutual funds allow systematic purchases and withdrawals.[5] In my view, the choice for investors isn’t really between passive mutual funds and ETFs but between four types of passive mutual fund share classes and ETFs, which provide investors with more options but make decisions more complex. In the last post of this series, I’ll share advice on the best investment products depending on an investor’s circumstances. [1] Source: Mackenzie Mutual Funds Simplified Prospectus, 2023.[2] Many mutual fund firms charge a “short-term trading fee” of approximately two percent to discourage investors from actively trading their fund shares. This fee applies to investors who dispose of their shares shortly after purchasing them. Each mutual fund firm has its own policy regarding the length of the “short-term trading fee” period. This information is available in the fund facts document and the prospectus.[3] Until recently, mutual fund firms were also allowed to offer “back-end load” share classes, which charge a penalty (known as a “deferred sales charge” or “DSC”) when the investor disposes of their shares within a set number of years (typically seven years). The Canadian Securities Administrators banned the sale of mutual fund shares with DSCs in 2022. However, the existing back-end load shares were grandfathered.[4] A few ETFs are available as commission-based classes, but they are exceptions.[5] A few rare ETFs allow systematic contributions, most notably iShares asset allocation ETFs. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
Market Research Raymond Kerzérho Choosing Between Passive Mutual Fund Share Classes and ETFs May 9, 2024 Market Research