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Mutual Funds
Skip Plan B (Along with Plans A and C)
By Wayne Michael Lottinville, CFA
Chief Investment Officer, Cascadia Investment Consultants
Some mutual fund families offer several classes of
shares that differ in the way they charge fees to
shareholders. Classes A, B, and C are the most
common. The front-end "load" typical of Class A
funds is a sales charge paid when shares are
purchased. Class B funds carry no initial load.
Instead, they have a back-end sales charge that is
paid when shares are sold, but that load declines
over time. Class C funds may at first appear to have
no load, but their other high annual expenses
continue forever. Please note: these fund
classifications and load types are not standardized
across the industry, so the classification of some
funds may differ from what is described here.
A Class Act
Mutual Fund Class B shares consistently
underperformed Class A and Class C shares over the
one, three, and five year periods ending September,
2003, Standard & Poor’s reported recently. The
underperformance was
attributed to the average 4.5
percent back-end load and
the higher overall expense
ratio of Class B shares
compared to A and C class
shares (refer to the nearby
table).
|
| Average Load
| Average Expense Ratio
|
| Class A
| 5.44% front-end
| 1.35%
|
| Class B
| 4.50% back-end
| 2.05%
|
| Class C
| Minimal
| 2.04%
|
Sources: Standard & Poor’s
As if to underscore the expensive nature of Class B
shares, Morgan Stanley disclosed in an October
regulatory filing that the Securities and Exchange
Commission may take multiple enforcement actions
against the company after investigating the firm’s
mutual fund practices - including whether its
brokers were pushing higher commission "Class B"
fund shares when other, less costly share classes
might have been more appropriate for clients. This
and additional charges leveled by the SEC, if true,
imply that Morgan Stanley and its employees placed
their own interests well ahead of the interests of
their clients.
I don’t mean to single out Morgan Stanley. Dozens
of other fund companies are also under the gun, as
discussed in The Skeptical Investor in October. It’s just
that in this case, Morgan Stanley’s alleged pushing of
unsuitable Class B mutual fund shares onto its
clients is associated with Class B’s high fee structure.
A Classless Society
In the final analysis,
however, a savvy investor
will find this whole issue of
little import. The reason?
These investors will likely
not trade in any of these
classes of funds, as
comparable noload
funds are
readily available
and much less
expensive.
| Differences in Returns for Two S&P 500 Index Funds |
| Morgan Stanley S&P 500 Index Class B (SPIBX)
|
|
1998 |
1999 |
2000 |
2001 |
2002 |
3-Sep |
| Total return % |
26.8 |
19.0 |
-10.4 |
-13.2 |
-23.2 |
13.5 |
| +/- Index |
-1.7 |
-2.0 |
-1.3 |
-1.3 |
-1.1 |
-1.2 |
| Vanguard Index 500 (VFINX) |
|
1998 |
1999 |
2000 |
2001 |
2002 |
3-Sep |
| Total return % |
28.6 |
21.1 |
-9.1 |
-12.0 |
-22.2 |
14.6 |
| +/- Index |
0.0 |
0.0 |
0.0 |
-0.1 |
-0.1 |
-0.1 |
Source: Morningstar
I saw this clearly
demonstrated
when I recently
looked into the
differences in costs
between two
similar mutual
funds. Both are S&P 500 Index funds that seek to
match the performance of Standard & Poor’s index
of 500 large U.S. stocks. Index fund fees should be
relatively low because very little management is
required. An index fund manager need only buy or
sell stocks as they are added to or booted from the
corresponding index.
I compared Morgan Stanley’s S&P 500 Index, Class
B, ticker SPIBX, with Vanguard’s Index 500, ticker
VFINX. Refer to the nearby table for the data.
Notice that since 1998, the Vanguard fund’s
performance fell short of the S&P 500 Index by, at
most, 0.1 percent. The Morgan Stanley fund, in
contrast, underperformed the S&P 500 Index
anywhere from 1.1 percent to 2.0 percent—or 11 to
20 times as much as the Vanguard fund.
Accounting for Class
Both funds have similar objectives. So what might
account for this consistent difference in
performance? Let’s take a look at one important
factor: expenses. Morningstar, a mutual fund
database, reports that the Vanguard fund’s total
expense ratio is a mere 0.18 percent. In contrast, the
Morgan Stanley fund’s expense ratio is 1.50 percent,
or eight times Vanguard’s. Now notice how closely
these expense ratios match each mutual fund’s
shortfall relative to the S&P 500 index. In dollar
terms, a $10,000 investment in the Vanguard fund
costs an estimated $58 in expenses over three years.
The same investment in the Morgan Stanley fund
costs an estimated $710 over three years.
By the way, if sold, the load on this Morgan Stanley
fund is 5 percent
in the first year,
then this declines
to zero percent by
the seventh year of
ownership. The
Vanguard fund, in
contrast, bears no
load at all.
Go to the Head of the Class
Again, I don’t
particularly mean
to single out Morgan Stanley. Many other funds have
similar expense structures, and some charge more
than Morgan Stanley. But the bottom line for savvy
investors is clear: Why buy your broker a vacation in
Cancún when you could go there yourself with the
fees you will save by using no-load funds instead of
these return-robbing loaded funds?
Brokers may justify this fee difference with the
observation that they should, after all, be paid
something for their work. True enough. Still, these
fees are disproportionately large for the services
provided. To then add a penalty for selling only
heightens the injustice. The back-end load is one
way brokers attempt to prevent clients from going
elsewhere - by exacting a possible penalty if they do.
Looking deeper, these higher expenses point to a
deep-seated disregard for clients’ welfare and a
tendency to improperly put the interests of brokers
and their firms above the interests of their clients.
For this reason, my general advice is to dump these
high-expense funds where possible, even if it may
cost a few percentage points, and move on to better
run low-cost funds. Many no-load funds likely offer
higher ethical standards and higher regard for the
welfare of investors, an added benefit.
Your own situation may call for a different course of
action, however. If you do not choose to make your
own independent investment decisions, find a
qualified investment consultant who charges a
reasonable fee and who will not put you into loaded
or high-expense mutual funds.
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