There was a piece in the Wall Street Journal over the weekend on how B class shares in load funds seem to be nearing extinction. That may sound like a classic bottom story, the disappearance of something already obscure, but it’s a good excuse to discuss the economics of load funds.
Open-end mutual funds basically come in two types: load and no-load. A load is a sales charge, a commission paid to the guy who sells the fund and his employer. (And no, I have no idea why it’s called that. Much gratitude to anybody with an etymology.)
There is a widespread feeling that loads are fundamentally a rip-off. Why pay a load when you can get a no-load fund for free? That’s not an entirely illogical argument, but it misses the point. The load funds are sold by financial advisors who need to be compensated for their time somehow. A particular broker may not be worth the money, but that’s an entirely different issue, not a problem with load funds in principle.
In the old days, fund loads were simple. You wrote a check for $1000 to buy a mutual fund, $57.50 went for the load, and you got a $942.50 position in the fund. (5.75% is the standard load rate for small investments. There’s a sliding scale, with investments over $100K paying about half and investments over $1M usually carrying no load at all.) A little slice of the load goes to the fund company, but most of it goes to the brokerage, to be divided more or less equally between the guy who sold it and the house.
Of course, as the financial world developed, as no-load funds emerged, and as commissions in general started to shrink, getting $942.50 worth of fund for $1000 didn’t seem like such a great deal. So the in the 1980s the mutual fund business came up with a new scheme, called class B shares. (The old way then became known as class A.)
If you buy B shares, you get $1000 of mutual fund for your $1000. Which makes you feel much better. Ah, but there is a catch. You will pay higher annual fees on the fund than the A share owners do for six or seven years. And if you sell before the six or seven years is up, you will have to pay a back-end load.
It shouldn’t be surprising that the economics of B shares from the point of view of the investor work out to be essentially identical to A shares. But the psychology is better.
And from the broker’s point of view, A and B shares are even more perfectly identical. You see, the broker gets paid for selling B shares up front, just like A shares. If he didn’t, he might not sell B shares, and we can’t have that, can we? So the mutual fund company fronts the brokerage the money on the premise that the higher fees and back-end loads it will collect in the future will make it whole.
And it is here that the problem with B shares emerges. You pay $1000. The fund company gives $57.50 to the brokerage, knowing it will charge you an extra 1% a year for six years. If your investment stays at $1000 in value, that means the fund company will get six $10 payments. Okay, that works.
But what if, and I am speaking hypothetically here, the fund goes down in value? What if one year it went down something crazy like 40%? Then you would have only $600 invested and the fund company would only be getting an extra $6 per year, not nearly enough to cover what it fronted the broker. That could be a big problem, particularly if the fund company borrowed the money to pay the broker.
Of course, this is exactly what happened, making an already disastrous environment for some fund companies that much worse. This is the biggest reason they are exiting the B share business, something the WSJ fails to mention.