C's Boil to the Top

The shift to fee-based brokerage services is not only changing how reps and advisors go about their business, it is also changing the products they sell. Exhibit A in this trend is a new category of C-class mutual fund shares. These so-called Level II shares have a fee structure that can be especially appealing to brokers doing fee-based business and, as a consequence, have helped turn C shares, formerly

The shift to fee-based brokerage services is not only changing how reps and advisors go about their business, it is also changing the products they sell. Exhibit A in this trend is a new category of C-class mutual fund shares. These so-called Level II shares have a fee structure that can be especially appealing to brokers doing fee-based business and, as a consequence, have helped turn C shares, formerly the stepchild to other loads, into a hot growth category. By late last year, net sales of C shares were running neck-and-neck with those of A shares.

The Level II option lets brokers widen their asset gathering nets without scaring away smaller investors who balk at the high loads that have accompanied A and B shares. It also helps address rising NASD concerns over suitability rules, which require firms to assess an investor's resources and recommend the most appropriately priced share class.

While traditional C shares charge investors an annual 12b-1 fee of 1 percent and a back-end load of 1 percent for early redemptions, Level II C's pay brokers 2 percent up front. Investors feel little sticker shock, because they pay just a 1 percent load up front. The additional 1 percent comes from the fund providers, who are paying brokers to promote their products. The added incentive helps brokers overcome their natural reluctance to abandon lucrative A and B share sales, for which upfront payouts can run as high as 5 percent and 4 percent, respectively.

“The new shares offer a gradual way to make a transition to a fee-based practice,” says Kristin Adamonis, an analyst with Boston-based fund tracker Financial Research. In the first 10 months of 2001, net new sales of C shares — at about $18.8 billion — matched A share sales, according to Financial Research. In the same period, B shares suffered net withdrawals of $4.2 billion. The numbers represent a big change from 1998, when A and B shares each accounted for more than $30 billion in sales, and C shares lagged with $17 billion.

About a dozen fund companies, including American Skandia, Franklin, Salomon Smith Barney and Pioneer, now offer the new C-class variation. John Hancock, which introduced the shares a year and a half ago, saw the new approach as a way to distinguish itself from funds sold in wrap programs where A fees are waived and investors generally pay an annual fee of 1 percent up front. “We added the 1 percent sales charge to our C shares to give brokers a little incentive,” says Keith Hartstein, John Hancock executive vice president.

The approach has worked well. While fund redemptions were prevalent in early 2000, when the stock market was reeling, Hancock's Level II C shares registered net sales.

Evergreen Funds offers another variation. Instead of adding a front-end load on the C shares, Evergreen — and not investors — pays brokers 2 percent up front as an incentive to sell its products and tacks a 2 percent back-end load on redemptions made in the first year. That way brokers can avoid charging clients a load and still receive an upfront commission of 2 percent. Evergreen reckons that the back-end load will discourage investors, who pay Evergreen an annual 1 percent fee for expenses, from churning their accounts.

Brokers have greeted the change with enthusiasm, and as soon as the new structure was introduced in February 2000, Evergreen's C sales climbed.

That same year Invesco Funds began offering C shares. The move was particularly noteworthy because the company had long been strictly a no-load distributor. Invesco took the step when it noticed that much of its no-load sales were going to investors who used a fee-only planner or a wrap program.

“Many advisors said they would use us even more, but there wasn't a fee structure that fit their needs,” says Ray Cunningham, president of Invesco Funds. Cunningham notes that many clients who were formerly do-it-yourselfers are turning to advisors. In fact, Invesco surveyed clients and found that virtually all its new sales were coming through advisors. So, the company has elected to drop no-load sales, except for existing customers. In March, Invesco will begin offering A and B shares along with the C's to give customers a choice.

Much of the growth in C shares has come at the expense of B shares (see chart). Part of the problem may be that B shares are difficult for brokers to explain. Besides charging high annual fees, they impose back-end loads of as much as 5 percent if an investor withdraws in the first year. That can make them particularly expensive and, in some cases, in violation of suitability rules.

Howard Suskin, a securities specialist with Jenner & Block, a Chicago law firm, cautions that it is often hard for brokers to be sure that they are observing NASD suitability rules, which can be vague. Moreover, clients are not always clear about their needs. Still, brokers should attempt to learn the goals of their clients and spell out the advantages of different share classes. “The problems mostly occur when the client is unhappy with the fund's returns,” Suskin says. “Then, the investor may argue that the fund was too risky, and he wasn't advised about the sales fee.”

American Funds — the third-largest fund group — long resisted offering B and C shares. And when it finally started selling B shares in March 2000 and C shares a year later, it adopted strict rules to avoid running afoul of the NASD.

B shares can only be purchased in amounts of up to $100,000, and the shares must convert to A shares after eight years, so that investors can enjoy lower annual expenses. The company's sales literature cautions that investors with sizable investments should probably buy A shares. The company is also offering a new F (for “fee”) class. These are, in effect, load-waived A shares that are sold through brokers such as Charles Schwab and Fidelity. The share class is designed for fee-only planners and others who could not buy American Funds in the past. The new classes have enjoyed strong sales, the company says. “Brokers like having shares that suit the way they do business,” says Chuck Freadhoff, an American Funds spokesman.

Not everyone is embracing C shares, however. Edward Jones Investments encourages customers to buy A shares, which account for 84 percent of its sales. Still, the brokerage is willing to sell B and C shares. Some customers just hate the idea of paying loads, the company says, and those people are welcome to buy the C shares.

By still emphasizing A shares, Edward Jones may appear old-fashioned. And, in fact, the company takes pride in its conservative approach. However, most other brokers will likely rely more heavily on C shares and other alternatives designed for clients who are increasingly wary of paying front-end fees.

Estimated Net Flows by Share Class
$ in billions
Pricing Group YTD Flows Annual Net Flows
*2001 2000 1999 1998
Class A 18.9 19.3 -5.1 30.4
Class B -4.2 31.2 21.6 33.5
Class C 18.8 30.6 20.7 17.4
No Load 66.4 129.9 120.3 148
*YTD Net Flows through Oct. 2001
Source: Financial Research Corp.
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