Class B Shares in Mutual Funds: Understanding Costs and Benefits

4.2.5.2 Class B Shares

Class B shares are a specific type of mutual fund share class that comes with unique characteristics and cost structures. Understanding these features is crucial for financial professionals preparing for the Series 6 Exam, as well as for investors seeking to make informed decisions about their mutual fund investments.

Understanding Class B Shares

Class B shares are designed to provide investors with a way to invest in mutual funds without paying an upfront sales charge, known as a front-end load. Instead, they impose a back-end sales charge, commonly referred to as a contingent deferred sales charge (CDSC). This charge is applied when the investor sells the shares within a certain period, typically starting high and decreasing over time.

Key Characteristics of Class B Shares

1. Back-End Loads (CDSC): Unlike Class A shares, which charge an upfront fee, Class B shares impose a CDSC. This fee is contingent on how long the investor holds the shares. The longer the shares are held, the lower the CDSC becomes, eventually reaching zero after a specified period, often six to eight years.

2. Higher Annual Expenses: Class B shares typically have higher annual operating expenses compared to Class A shares. These expenses include 12b-1 fees, which cover marketing and distribution costs. The increased expenses can impact the overall return on investment, especially over the long term.

3. Conversion to Class A Shares: After the CDSC period ends, Class B shares often convert to Class A shares. This conversion is beneficial because Class A shares generally have lower annual expenses. The conversion process is automatic and does not trigger a taxable event.

4. No Front-End Sales Charges: One of the appealing aspects of Class B shares is the absence of front-end sales charges, making them attractive to investors who prefer to invest the full amount of their initial investment.

5. Lack of Breakpoints: Class B shares typically do not offer breakpoints, which are volume discounts on sales charges available with Class A shares. This absence can make Class B shares less cost-effective for investors making large investments, as they miss out on potential discounts.

The Impact of CDSC and Conversion

The CDSC is a significant factor to consider when investing in Class B shares. It is designed to discourage short-term trading and ensure that the mutual fund company recoups its costs for managing the fund. The CDSC schedule is typically structured as follows:

• Year 1: The CDSC might be as high as 5-6%.
• Year 2: The CDSC decreases to 4-5%.
• Year 3: The CDSC continues to decrease, often to 3-4%.
• Year 4: The CDSC further decreases to 2-3%.
• Year 5: The CDSC might be reduced to 1-2%.
• Year 6 and Beyond: The CDSC is typically eliminated, and the shares convert to Class A shares.

This decreasing schedule encourages investors to hold their shares for a longer period, aligning with the mutual fund’s long-term investment strategy.

Conversion Benefits

The conversion of Class B shares to Class A shares is advantageous because it reduces the ongoing expense ratio. Class A shares generally have lower annual fees, which can enhance net returns over time. This conversion is automatic and does not require any action from the investor.

Cost Considerations and Long-Term Returns

When evaluating Class B shares, it’s essential to consider the impact of higher annual expenses on long-term returns. The absence of front-end sales charges may seem attractive initially, but the higher ongoing costs can erode returns over time, particularly if the investment horizon is long.

Example Scenario

Consider an investor who invests $10,000 in Class B shares with an annual expense ratio of 1.5% and a CDSC that starts at 5% and decreases over six years. If the investor holds the shares for eight years, the CDSC would not apply upon sale, and the shares would have converted to Class A shares with a lower expense ratio of 1.0%.

• Year 1-6: The investor incurs higher annual expenses, impacting net returns.
• Year 7-8: The shares convert to Class A, reducing annual expenses and improving net returns.

This scenario illustrates the importance of considering both the CDSC schedule and the long-term impact of higher expenses when choosing Class B shares.

Practical Considerations for Investors

When advising clients or making personal investment decisions, it’s crucial to weigh the pros and cons of Class B shares against other share classes, such as Class A and Class C shares. Here are some practical considerations:

1. Investment Horizon: Class B shares are more suitable for investors with a medium to long-term investment horizon, as they benefit from the eventual conversion to Class A shares.

2. Investment Amount: For large investments, Class A shares might be more cost-effective due to the availability of breakpoints, which are not offered with Class B shares.

3. Expense Impact: Consider the impact of higher annual expenses on the investment’s overall performance, especially if the investment is held for a long time.

4. Tax Implications: The conversion of Class B to Class A shares is not a taxable event, which can be advantageous for tax-conscious investors.

5. Alternative Options: Evaluate other share classes, such as Class C shares, which offer level loads and no conversion but may have higher ongoing expenses.

Regulatory Considerations

When dealing with mutual funds and share classes, it’s essential to understand the regulatory framework that governs these investments. The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) provide guidelines and rules to ensure transparency and protect investors.

• Disclosure Requirements: Mutual fund companies must provide clear and comprehensive disclosures about the fees and expenses associated with each share class. This information is typically found in the fund’s prospectus.

• Suitability Obligations: Financial professionals must ensure that the recommended share class aligns with the investor’s financial goals, risk tolerance, and investment horizon. This is part of the suitability obligation under FINRA rules.

• Cost Considerations: Investors and advisors should consider the total cost of ownership, including sales charges, annual expenses, and potential CDSC, when selecting mutual fund share classes. For more information, refer to the SEC’s guide on cost considerations.

Conclusion

Class B shares offer a unique combination of no front-end sales charges and a deferred sales charge structure, making them an attractive option for certain investors. However, the higher annual expenses and lack of breakpoints require careful consideration, particularly for large investments or long-term holdings. By understanding the features, benefits, and costs associated with Class B shares, investors and financial professionals can make informed decisions that align with their financial objectives and regulatory requirements.

Series 6 Exam Practice Questions: Class B Shares