Share Classes Set the Fee Structure

Ron Logue was awaiting his seat assignment recently when an airline agent asked a question far removed from “Window or aisle?”

She had noticed that Logue works for State Street Bank & Trust Co., a Boston firm that performs back-room number crunching for fund companies, and she wanted “to know the difference between A and B shares. She had just bought a fund for her mother and wanted to be sure she had gotten a fair shake.”

“It hit me like a ton of bricks,” says Logue, executive vice president overseeing mutual fund services at State Street. “The investing public just doesn’t understand share classes.”

Mutual fund share classes are, essentially, different ways to sell the same fund. They evolved because of one thing that most investors both understand and despise: front-end loads. With people reluctant to pay an upfront commission, funds created new and different ways to pay sales representatives. [Mutual fund share classes are not related to the classes used to differentiate types of a company’s equity shares.]

But as Logue’s encounter points out, many people buy load funds without clearly understanding the payment structure.

Here’s how it works: Oppenheimer Target Class A, B or C shares, for example, are all invested in the same underlying fund. Each share has a unique fee structure. The differences boil down to whether you want to pay now or pay later.

Share classes are doubly confusing because there are no set rules. What one fund defines as Class B may be Class II at another. Many load funds now offer a class of shares that appear to be no-load, although they can only be sold through an advisor who takes a fee for managing your money.

It’s only going to get more confusing.

“Never go by just the letter,” says Betsy Treitler, managing director of the Center for Interpretive Research, a Wrentham, Mass.-based think tank that tracks industry trends. “You have to look at the particular structure of the individual fund and fund company. Each time you pick a new fund and consider which shares to buy, you have to do the math all over again.”

Focusing on sales charges is the wrong way to select a mutual fund. Instead, zero in on the quality of the fund company, the manager, the assets it buys and how those holdings mesh with your portfolio. Once you have gone through that process, share classes come into play.

Obviously, no-load investors avoid this decision. For the rest of the investing public, here’s how share classes work:

Class A shares charge traditional front-end commissions, usually lopping 3% to 6% from the investment to pay the advisor. Oppenheimer Target A, for example, charges a 5.75% load; annual operating expenses are 1.03%.

Front-end loads are best for long-term investors who want to get the commission out of the way and minimize long-term costs.

Class B shares, meanwhile, carry a back-end load payable if you sell the fund within a set period, usually four to six years. Generally, Class B shares work best for an investor who expects to be in the fund throughout that load period.

At Oppenheimer Target B, for example, the pay-when-you-leave charge starts at 5% and declines to zero over six years. Expenses, meanwhile, are 1.9% per year for the first six years, before falling to the same 1.03% as the A class.

So-called level-load, or Class C, shares generally have neither a front-end nor back-end load but carry higher expenses. As a result, they offer flexibility if you expect to sell in a few years, but higher costs if you’re a long-term investor.

Oppenheimer Target C, for example, has no sales charge upfront or deferred--except for a 1% penalty if you sell the fund within a year--with annual expenses fixed at 1.9%.

The best deal depends on your time horizon. Assuming a 5% annual return, the cost of holding a $1,000 investment in Oppenheimer Target A for a year is $67, compared with $19 for the B and C shares. Holding the funds for five years, the A fund shares cost $111, compared with $103 for both the B and C shares. At 10 years, however, your ownership cost for the A fund would be $176, compared with $179 for the B shares and $222 for Class C.

It’s important to note that the math could work out much differently on shares structured some other way. The cost differences also translate into variances in returns that, while minimal on paper, can be substantial over time; and you can pay through the nose if you have a sudden change of heart and jettison a long-term investment before the costs even out.

There are also Class D shares (hybrids that can charge a little bit of everything), institutional shares and other classes that fund groups make up and name on their own. No matter what they’re called, the onus is on you to do the math.

“The simplicity of A shares, to my mind, is preferable, but it’s not what the public has chosen,” says Don Phillips, president at fund tracker Morningstar Inc. “Share classes are confusing and complicated, but they don’t have to be. Look at the fund’s setup and your needs, run the numbers and do what’s best for you.”

Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at [email protected] or at the Boston Globe, P.O. Box 2378, Boston, MA 02107-2378.