Mutual Funds
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| | Mutual Funds
'B' shares are second-class investments
Got a bundle to sink into a mutual fund? Brokers are supposed to cut their commissions for customers like you -- but they may steer you toward a very costly loophole instead.
By Timothy Middleton
Creating an investment portfolio isnt rocket science, but some people want the advice of a licensed professional. Nothing wrong with that, except for this: Legions of so-called financial advisers are simple salesmen, much more interested in their own capital than their customers'.
The issue is literally on trial in Tennessee, where four groups of investors charge they were bilked by Morgan Stanley (MWD, news, msgs). The matter turns on the almost unknown issue of break points, or discounts for bulk purchases that one fund class offers and two others don't.
In most circumstances, and for most share-class structures, brokers have monetary incentives to sell the class of shares that is least advantageous to investors, writes Wake Forest finance professor Edward ONeal in a scholarly article that underpins the Tennessee case.
What kind of incentives? The lawsuit alleges that one investor was put into a Class B fund share that paid higher commissions than those on Class A shares -- as much as 67% higher.
The lesson for investors who use brokers is this: After youve asked a financial adviser about loads, fund fees and expenses, ask this: How much do you get paid if I buy this share class that you recommend? If your broker squirms, scram.
A class system
Its so easy being a no-load fund investor: Theres only one kind of no-load fund. It used to be equally easy for customers of brokers: Funds have front-end loads, or commissions, which is how the broker got paid.
But then brokers customers began to balk, so new funds were created that looked like no-loads, but werent. Today theyre called Class B and Class C shares, while the old-fashioned type, with the upfront loads, are Class A.
The break points come in on the Class A shares. As the name suggests, they give investors a break on brokerage commissions when they buy Class A shares of broker-sold mutual funds. At Morgan Stanley, for example, the load, or upfront fee, on the purchase of up to $25,000 worth of equity funds is 5.25%. If you invest more, you pay less: 4.75% on investments of more than $25,000, 4% at $50,000, 3% at $100,000, 2% at $250,000 and zero at $1 million.
Break points are a load-fund customers best friend, because they apply to the total assets you have invested with the fund complex. With just $100,000 invested, the load you'd pay at high-cost brokerage Morgan equals what low-cost Fidelity charges on many of its funds -- and with the Fidelity funds, you dont get the benefit of a brokers advice. With $250,000 in your account, you qualify for a load that will pay for itself in little more than two years, so great is the difference in fees between A shares and the others.
But of course, break points apply only to funds with front-end loads. Class B and C shares dont have those, so if you prefer them, you get no break, literally or figuratively. Instead, you get much, much higher annual fees, as well as back-end loads.
Heres an example, once again drawing upon a fund that figures in the lawsuit, the Morgan Stanley Utilities Fund B (UTLBX). It has no front-end load, but it does have a 5% back-end load -- a commission charged if you sell the fund within six years. The rate declines in annual steps to zero.
This isn't a pretty fund, ranking in the bottom half of its Morningstar category over the last five years. Its partly hobbled by that extremely high expense ratio -- one whole percentage point of which goes to pay the salespeople who pitched it. The Morgan Stanley Utilities Fund Class A (UTLAX) has expenses of only 0.9% and produces returns that rank in the top half of the category.
The key question
So why would anybody with $175,000 to invest in this fund choose the B shares? The answer to that question will come in the federal lawsuit.
For those of you who dont want to wait for the courts answer, here's mine: The sales force makes more money by selling the B shares.
With break points, the sales commission on the A shares in that $175,000 investment is $5,250 (3% of the $175,000). On the B shares, however, there are no break points on the 5% deferred load, so the sales force pockets $8,750.
Note I said sales force, rather than just broker. Thats because the middleman between funds and brokers, called the distributor, keeps a share of commissions and annual fees. So the middleman makes extra profit if fees are high. The middleman for Morgan Stanley funds is -- surprise! -- Morgan Stanley.
The mutual fund industry loves B shares because superficially they look like no-load funds. After being explicitly sanctioned by the Securities and Exchange Commission only in 1995, they have exploded, and now account for 18.8% of retail shares of broker-sold funds, according to mutual-fund tracker Lipper.
Morgan Stanley really loves B shares. Back when the company was still known as Dean Witter, before merging in 1997 into a classier name, it didnt sell any other kind. Today an eye-popping 88.2% -- yes, almost 90% -- of the assets of retail funds at Morgan Stanley are held as B shares, according to Lipper.
Sting like a 'B'
Morgan dismisses the lawsuit as having no merit, and a spokesman adds, B shares are an entirely appropriate choice for many investors. Certainly Morgans 12,500 brokers (which it calls financial advisers) think so, because Morgan continues to sell vastly more B shares than its competitors.
For example, Morgan Stanley All Star Growth Fund, which was launched in February 2001, four years after multiple share classes were introduced to the companys funds, Class B shares (ALLBX) have more than five times the assets of the C class (ALLCX) and 10 times the assets of the A class (ALLAX).
Morgan Stanleys B shares happen to be particularly ugly because, whereas at other fund companies they convert to A status after seven years with a corresponding drop in annual fees, at Morgan they hang around for a full 10 years.
Arguments can be made for owning C shares in some circumstances. Their back-end load is only 1%, and it expires after one year, so they are much better than A shares if you dont benefit from hefty load discounts and are only going to own them a few years.
An even thinner case can be made for B shares -- you might want to sell early, but if you dont, theyll eventually convert to A shares (which C shares never do) and you escaped the front-end load. The annual expense penalty is a kind of convenience fee.
But my logic is this: If a salesman makes more money on one version of two identical products than he does on the other, Ill have what he aint having.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article, thank goodness.
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