Skip Plan B (Along with Plans A and C)

Skip Plan B (Along with Plans A and C) 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 Cancun 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.