When I mentioned in a post a few weeks ago that American Funds has 19 share classes, it raised a few eyebrows. So let’s take a look at why they need so many. By the way, the working title for this post was “Here a share, there a share, everywhere a share share”, but I thought it might go unappreciated by readers without small children.
First off, two of the 19 share classes I mentioned are really just Morningstar’s internal creations, so the real number is 17 (that’s all?) . Let’s use Growth Fund of America as an example and dig in to see why each share class exists (Exhibit 1).
Exhibit 1 – Growth Fund of America Share Classes and Expense Ratios
Traditional load shares
The main idea here is that the broker who sells the fund to investors gets [handsomely] compensated one way or the other – either through upfront commission or ongoing “trails”.
A share – the granddaddy of them all – investors pay a front load (commission) of as much as 5.75%. The advisor (salesperson) gets this commission although the actual % depends on the amount invested. Then the American Funds charges 0.66% annual expense ratio of which it keeps 0.42% and the advisor gets an annual 0.25% 12b-1 distribution fee also known as “trails”.
B share – there is no upfront charge, but the back load is designed to keep investors from selling the fund. So if you liquidate the position you would pay 5% in the first year, 4% in the second year, and so on until it goes away after year 6. To make up for the lack of an upfront sales charge, the advisor gets a 1% annual trail, leading to a hefty 1.41% expense ratio. Many consider this to be the most “evil” share class. To be fair, American stopped selling B shares in 2009 (how magnanimous!). You can no longer be sold these shares and the existing ones automatically convert to A shares after 8 years (good riddance).
C share – similar to B shares with no front load and a high 12b-1 fee at 1%. There is a back end load of 1% if sold within the first year. After 10 years, the C shares convert to F-1 shares for lower trails of 0.25%. This is the share closest to the modern fee-based business model in which the advisor charges a separate annual fee to manage the investment portfolio.
“Class F-1, F-2 and 529-F-1 shares are designed for investors who choose to compensate their financial professional based on the total assets in their portfolios, rather than commissions or sales charges.” These classes have no loads and lower total expense ratios. You might wonder why they need the F1 class – if you are already paying your advisor an asset-based fee, why do they have to charge the additional 12b-1 of 0.25% on top? Well, sometimes the advisor’s broker/dealer firm gets the 0.25% and other times it gets credited back to the investors account. Registered Investment Advisors like Gordian can choose either share class and and their custodian gets paid by either keeping the 12b-1 fee in F1 or charging a transaction fee of $30 to $50 for F2 trades in lieu of ongoing 12b-1 fee.
This is where we see seven share classes making up the bulk of confusion. Class R shares are available only to retirement plans, such as 401(a), 403(b) or 457. Basically, depending on the size of the plan, the advisor (or sponsor) has a choice of how much they want to get paid in 12b-1 fees. So one might use R1 shares with 1% trails to make a small plan worth the effort or use cheaper R3 to be more competitive on larger plans with multiple bids. R5 and R6 are used for fee-based retirement plans and don’t offer 12b-1s.
These are special fund classes available through the Virginia’s CollegeAmerica 529 program. Class 529-A, 529-B, 529-C and 529-F shares are structured similarly to the corresponding Class A, B, C and F-2 shares. Class 529-E share funds are available only for employer-sponsored accounts. Note that expense ratios for these classes are about 10 bps higher than the corresponding retail ones due to some extra administrative responsibilities that fall on American in this plan.
So there you have it – a market-driven reason for EACH of the 17 share classes! Personally, I think it’s way too convoluted and unnecessary. They are allowing the distribution tail to wag the investment management dog. To be clear, I’m actually a fan of many of their funds and the portfolio management process, but the antiquated distribution process is not cool.
Next time we’ll take a look at assets invested in each class and distribution channel to see what that means for the American Funds business model.
American Funds provides more details about each share class here:
If you are interested in learning more about American Funds investment culture, this Morningstar report is a good primer: