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Class Wars

Class B shares fell out of favor with fund investors two years ago, and they raise some suitability issues that may make brokers wary. Yet, to some, Class Bs remain a good option for small investors.

As the bear market clawed through Wall Street, sales of Class B fund shares collapsed. In 2002, investors withdrew $24 billion from B shares, according to Financial Research Corp. By contrast, A and C shares — the other major load share classes — recorded positive inflows. That is a dramatic turnaround from 2000, when B shares led the parade, recording net inflows of $31 billion, outpacing the other share classes.

Part of the bloodletting of the B shares can be traced to their high annual expenses, which often top 2 percent a year. When the market soared 20 percent a year, equity investors scarcely noticed the costs. Now that many clients are focused on earning single-digit returns from bond funds, the extra burdens of B shares have sent many fund shoppers scurrying elsewhere.

However, B shares suffer from other problems besides fees. During the past two years, the NASD has brought half a dozen enforcement actions against brokers who sold B shares. The SEC is also investigating, and some clients have filed suits. “B shares are under a cloud,” says Howard Suskin, a securities lawyer with Jenner & Block in Chicago. “They may not be the best choice for many investors.”

B shares are notoriously complicated, and terms vary from one to the other. Class A shares typically charge maximum front-end sales load of around 5 percent. When a client puts $10,000 into A shares, $500 goes directly to the broker as a commission, while $9,500 ends up in the account earning returns. On Class A equity funds, clients face fund expense ratios of around 1.5 percent, plus 12b-1 charges of about 0.25 percent.

The ABCs

B shares charge no upfront fees. Instead, all the money goes to work in the account. Brokers receive up-front sales commissions of 4 percent or so, which are paid by fund companies. The client pays annual expense ratios that are typically higher for B shares than for A, and B issues come with 12b-1 fees of about 1 percent. In addition, Bs charge back-end loads of 5 percent. When a client puts $10,000 into B shares and sells them a year later, the broker takes $500. If the client holds for two years before withdrawing, the back-end charge drops to 4 percent. And, in each succeeding year, the charge keeps dropping until it vanishes at the end of six years or so.

C shares charge no front-end loads, but come with higher annual expense ratios, plus 12b-1 fees of 1 percent and 1 percent back-end loads.

Under NASD suitability rules, brokers must recommend securities that meet the needs of clients. But deciding on the right fund share class can take some judgment. Suppose, for example, a client says he believes technology stocks will skyrocket this year, and he wants to put $10,000 to work right away in a fund focusing on the sector. The investor plans to hold for three or four years. The best choices could be C or B shares, which do not charge front-end loads. If a more patient investor plans to hold for seven years, then A shares may win the nod. After a long holding period, the low annual expenses of A shares more than compensate for the costs of the front-end load.

Because they typically emphasize long-term investing, brokers at Edward Jones focus on front-end load A shares, which account for 88 percent of the company's fund sales. In the late 1990s, when many investors rapidly traded B shares of technology and sector funds, Jones brokers emphasized A shares of broadly diversified choices. Such investments avoided big losses and helped maintain the loyalty of clients. Partly as a result of the conservative philosophy, most Edward Jones clients hold their funds for more than 12 years, compared to an average holding period of 3.5 years for the rest of the industry. “I can't think of many instances when B shares would be the best alternative for our clients,” says John Sloop, a partner at Edward Jones.

Besides offering lower annual expenses, A shares provide special discounts — breakpoints — for customers who make substantial investments. While a client who invests less than $25,000 may pay a 5 percent load, the charge could drop to 4.25 percent for purchases of $25,000 to $50,000. The figure dips to 2.75 percent at $250,000 and 0 percent for purchases of $1 million. Instead of receiving commissions directly from customers, a broker who sells a client more than $1 million in A shares is paid 1 percent by the fund company.

Because B and C shares do not provide breakpoints, customers making large purchases are nearly always better off buying A shares. That has served as a lightning rod for regulators. In June, the NASD slapped a $100,000 fine on McLaughlin, Piven, Vogel Securities, a privately held Wall Street firm, for selling large amounts of B shares. In one instance, a client of the firm made a purchase of $650,000 of B shares.

Heading Off Trouble

To avoid trouble, some fund companies are limiting B purchases to a maximum of $250,000. Brokerage firms are also beginning to issue their own rules. “There is no simple rule for determining the best share class, but we are beginning to see firms that will only allow their brokers to sell up to $100,000 of B shares,” says Jim Ruff, president of Oppenheimer Funds Distributors.

For the most part, regulators have only punished brokers for big sales of B shares. So brokers need not worry about small purchases where the choice between A and B shares is not clear. “When you are picking share classes, there can be gray areas, but the regulators have concentrated on the most obvious abuses,” says John McGuire, a securities lawyer with Morgan, Lewis & Bockius in Washington, D.C.

Considering their disadvantages, will B shares soon become extinct? No, says Jim FitzGerald, president of MFS Fund Distributors. He says that although MFS is a leading marketer of A shares, the company derives 17 percent of its total sales from B shares. The B shares are sound choices for many small investors who don't qualify for breakpoints, he says. Says FitzGerald, “There is a place for all three pricing models — as long as they are used appropriately.”

The Collapse of B Shares

Annual net flows by share class in millions of dollars

Pricing Group 2003* 2002 2001 2000 1999 1998
A Shares 10,094.4 17,217.1 27,262.8 19,335.8 -5,136.7 30,372.7
B Shares -5,694.5 -24,435.6 -7,416.6 31,187.1 21,587.7 33,496.5
C Shares 7,822.8 24,163 23,462.9 30,608.5 20,748.2 17,379.7
Source: Financial Research Corp.
*Year to date through 4/30/03.
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