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B shares more beneficial to broker than investor

Mutual-fund companies call them B shares. But if I were you, I would give them an F.

In fact, only last week, the National Association of Securities Dealers issued an alert, warning investors about the costs involved in buying B shares. These back-end-commission funds account for 18 percent of the money invested in broker-sold stock funds, according to Chicago's Morningstar Inc.

"It can be very alluring to be told you aren't paying any fees upfront," NASD vice chairman Mary Schapiro said. "But that doesn't mean there aren't any fees at all. There are relatively few instances where B shares are the better choice."

I have given it a lot of thought and I still can't figure out why investors would want to own these puppies.

If you buy funds from a broker or financial planner who charges commissions, you usually will be sold A, B or C shares. What's the difference? Here's what the pricing typically looks like on a broker-sold stock fund:

A Shares: You might pay an initial sales commission of as much as 5.75 percent, plus an annual "12b-1" fee of 0.25 percent, which is partly used to provide ongoing compensation to your broker. That 12b-1 fee is on top of the fund's other annual expenses.

B Shares: There's no initial brokerage commission and a 1 percent annual 12b-1 fee. But if you sell your B shares in the first six years or so, you will get hit with a back-end commission. That commission might decline from 5 percent in the first year to 1 percent in year six. After eight or nine years, B shares convert into A shares, with their lower 12b-1 fee.

C Shares: Like B shares, there's no upfront commission and a 1 percent annual 12b-1 fee. But unlike B shares, that 12b-1 fee typically never declines. There's also no back-end commission, unless you sell within the first year, in which case you will usually get dinged for 1 percent.

Clearly, C shares make the most sense if you think you will sell within the first few years, because you won't lose a big chunk to an upfront or back-end commission. Meanwhile, A shares are a better bet for long-term investors, because the hit from the initial commission will fade and you will benefit from the lower annual expenses.

So when are B shares the best deal? It's a darn good question. B shares will always be a worse deal than C shares if you sell within the first half-dozen years, because of the back-end commission. In fact, it is not until the eighth or ninth year, when the lower 12b-1 fee kicks in, that B shares start to outperform C shares. But if you hang on for that long, you will likely fare better with A shares.

The reason: If you have at least a moderate amount to invest, there's a decent chance you qualify for a reduced commission on the A shares, based on the so-called breakpoints. For instance, the regular 5.75 percent upfront commission on A shares might drop to 5 percent if you invest $25,000, 4.5 percent if you invest $50,000 and so on. The commission is typically waived on $1-million investments.

You usually can qualify for these reduced commissions based on your family's entire investment at a mutual-fund company, and not just on the sum you are investing in any one fund. By contrast, with B shares, there's no reduction in the back-end commission, no matter how much you invest.

"In the vast majority of cases, the B shares are never the most advantageous of the share classes," argues Edward O'Neal, a finance professor at Wake Forest University in Winston-Salem, N.C.

O'Neal knows what he's talking about. He has produced academic studies on the pricing of different share classes. He also has been hired as an expert witness to testify in two lawsuits against brokerage firms. The lawsuits allege investors were encouraged to buy B shares, even though it wasn't in their best interest.

Are there any cases where B shares would outperform? O'Neal offers one possible scenario: If you're investing a very modest amount for the long term and you buy B shares, you will outperform C shares and your results should rival those on A shares.

"But if you have an investor who can hit that first breakpoint (on the A shares), then A shares are almost always better," he says.

So why do B shares exist? My contention: They were designed to be sold, offering unethical brokers two great advantages.

First, in flogging B shares, brokers can pitch the funds as being "no-load" or having "no initial sales commission." To be sure, C shares can also be sold as "no-load." But for unscrupulous brokers, B shares are far more attractive. Which brings us to the second advantage.

With C shares, brokers receive a moderate amount of commission every year. But with B shares, they get paid a hefty initial commission, just like they would with A shares. In fact, on big fund purchases, brokers can earn more from B shares than A shares.

"If you're a larger investor and you've been sold B shares, I would contact the broker and find out why the heck he put you in B shares," O'Neal says. "It's a clear indication that the broker may not have your best interests at heart."

_ Wall Street Journal


Here's how to choose among the different share classes offered by broker-sold funds:

+ Favor A shares if you're a longer-term investor or you have a large sum to invest.

+ Purchase B shares if you're a small investor with a long time horizon. But over long periods, you will likely do equally well with A shares.

+ Buy C shares if you think you will sell quickly.

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