Surprise rebates for some investors
Everyone likes a bargain. But as many as 20 percent of the people who invest in mutual funds through brokers or commission-based financial advisers may not be getting the discounts they deserve.
Through oversight or dishonesty, some advisers did not tell investors that they were eligible for the discounts, according to the NASD, which regulates mutual-fund sales practices. In the past few weeks, thanks to pressure from the NASD, fund companies have begun notifying investors about their eligibility.
To understand those discounts, investors first need to know specifics about the mutual funds involved. Although many experts suggest that average investors buy funds with no sales charges, known as "no-load" funds, the offerings that caught the NASD's attention are "load" funds. These carry higher fees and are usually sold through professionals working on commission. And they come in three main varieties or share classes:
Class A shares. These shares have a front-end sales charge, which means you pay when you invest. So, if you put $10,000 into a fund with a 5 percent front-end load, your actual investment is $9,500. But these shares typically have lower annual expenses. For investors who plan to hold their funds a long time, Class A shares often work best because the one-time charge is paid before the fund's value increases.
"The 5 percent load sounds bad to a customer who doesn't want to pay anything," says Gregg Wolper, a senior analyst at Morningstar Inc. in Chicago. "But over time, because the expense ratio of that class is less, paying up front for Class A shares is usually a better deal for the average person."
Class B shares. These shares do not charge a front-end fee; rather, they have a contingent deferred sales charge (CDSC), which an investor pays if shares are sold within a certain number of years. Typically, if you sell your shares within the first year, you would pay 5 percent. In the second year, the charge might drop to 4 percent. In the third year, 3 percent. After the fifth or sixth year, there would be no charge. But Class B shares also usually have a higher 12b-1 fee, an annual charge to pay for marketing and distribution costs - including payments to brokers. This fee never ends and can be as much as 1 percent of the account, so an investor will pay more each year as the investment grows. (No-load funds can charge only up to 0.25 percent a year for 12b-1 fees, and many no-load funds have no 12b-1.)
Class C shares. These shares typically do not charge a front-end load and, if they have a CDSC, it might be only 1 percent and for just one year. But they often charge a higher annual fee which lasts as long as the fund is held. Since this fee, like the 12b-1, is based on a percentage of assets, it also goes up as the value of the fund grows.
Although Class A shares may be a better deal for the average investor who uses a broker, many people may not be getting the best deal when they buy them, says Jeffrey Voudrie, a financial planner in Johnson City, Tenn. That's because investors who put a lot of money in one fund - or spread their money among several funds in one family - are supposed to get discounts at certain "breakpoints."
For example, if a person invests at least $50,000 ($25,000 at some firms), the 5 percent front-end sales load should be reduced to 4.25 percent. If the investment is between $50,000 and $100,000, the charge might be 3.75 percent. This charge keeps declining until the amount invested reaches $1 million, when there is no sales load.
In addition, investors should have "rights of accumulation" that give them breakpoint discounts if they combine their purchases with previous purchases in the same fund - or with investments of different funds in the same fund family. They also may get the discount if family members invest with the same company. The prospectus describes each fund's right of accumulation policy and has a breakpoint, or sales charge, schedule.
But the NASD reports that 20 percent of investors eligible for discounts did not get them. The regulatory group says brokers or financial advisers failed to inform their clients they were eligible for breakpoint discounts, or that they might qualify for rights of accumulation.
At the request of the NASD, mutual-fund companies have begun sending "breakpoint claim forms" to the customers. Investors can use these forms to apply for reimbursements, if they think they should have paid lower front-end loads on Class A shares.
In other cases, the NASD reports, brokers have put customers in Class B shares without telling them Class A shares were available, or without explaining the advantages, disadvantages, and costs of Class A and B shares.
It's not easy for average investors to know how much they were charged for a fund. "The average investor, unless he is in the industry, may not know what a breakpoint is," Mr. Voudrie says. The purchase confirmation does not show how much was paid in commission, and not enough people read the prospectus to see if breakpoints are available or to learn the difference between A, B, and C shares, he notes.
Investors who need an adviser - and Mr. Wolper at Morningstar says some people should use them - can avoid these problems by asking some hard questions: How is the broker compensated? Does the adviser receive a commission on each trade? What is the broker's commission on this transaction? Is there another fund in this category that performs as well but is less expensive? What are the breakpoints on Class A shares and how can I qualify for them?
"If the broker is forced to explain all these costs right up front, I think that puts everyone on better ground," Wolper says.