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The ABCs of Actively-Managed Mutual Funds – Part One

The ABCs of Actively-Managed Mutual Funds
By
Terry Riffle
Managing Principal
Paramount Capital Advisors, LLC

If you would like assistance from a financial services professional, you may consult either a financial advisor or an investment advisor. It is very important to know the difference between them.

Financial advisors are compensated by commissions; they make their livings by selling financial products to their clients. Many investors believe that this form of compensation creates an inherent conflict of interest since financial advisors may be inclined to recommend those products that generate the biggest commissions for themselves rather than what is in the best interests of their clients.

Investment advisors, on the other hand, offer fee-based investment advice. This form of compensation helps to eliminate any potential conflict of interest. For example, an investment advisor may charge a fee of 1% of assets under management in order to manage his clients’ money on an annual basis. With this form of compensation, there is no incentive for the advisor to push any particular financial product.

Financial advisors will often recommend actively-managed mutual funds to their clients. Actively-managed mutual funds, as opposed to index funds, which are passively-managed, are managed on daily basis by a portfolio manager and/or a team of managers. Actively-managed mutual funds can be offered by financial advisors in different share classes. The most common share classes are Class A, Class B, and Class C. It is imperative for an investor to know the differences between these share classes prior to investing.

Class A shares of actively-managed mutual funds that are sold by financial advisors involve upfront sales charges. This sales charge is typically 5.75% for amounts invested under $25,000 and decreases (due to breakpoints) for investments of larger amounts. For example, the sales charge for a $100,000 investment in actively-managed mutual funds is usually 3.50%. Also, Class A shares have the lowest annual expenses of each of the share classes. The average domestic, large capitalization (“large cap”) mutual fund has annual expenses of approximately 1.20% to 1.30%.

You may think of investing in Class A shares to be like getting on a bus. When you get on a bus, you pay first. You don’t pay anything when you get off a bus.

Class B shares of actively-managed mutual funds that are sold by financial advisors do not involve an initial sales charge. However, they do involve a contingent deferred sales charge (CDSC). This means that if you sell your shares within a certain period of time (usually 6 years), you will be subject to a declining penalty. This penalty is typically 5% in the first year and 1% in the last year.

Although Class B shares do not involve an initial sales charge, they do have much higher
annual expenses. Essentially, an investor is financing the sales charge over time in the form of higher annual expenses. After a certain period of time (usually after 8 years), Class B shares will automatically convert to Class A shares. At that point, the shareholder will be subject to the lower annual expenses. It is interesting to note that some mutual fund companies (i.e. The American Funds) have stopped offering Class B shares since they are simply not a good deal for investors.

You may think of purchasing Class B shares to be similar to getting in a taxi cab. You don’t pay when you get into a taxi cab; you pay the fair when you get out.

Class C shares of actively-managed mutual funds that are sold by financial advisors do not involve an initial sales charge; however, they do involve a one year CDSC. This means that an investor will be subject to a 1% penalty if he withdraws his money within the first year. Some financial advisors may give their clients the impression that Class C shares are the same as investing in no-load mutual funds. This representation is false.

Class C shares of mutual funds involve even higher annual expenses than Class A and Class B shares. However, unlike Class B shares, Class C shares will never convert to Class A shares. Therefore, an investor will pay significantly higher annual expenses if
he purchases these shares of a mutual fund. Over a long period of time, Class C shares are actually the most expensive share class to own because of their significantly higher annual expenses.

You may think of Class C shares as being like owning a car. When you own a car, you have to pay for all of the expenses in order to maintain it.

Sales charges and high annual expenses of actively-managed mutual funds are two of the five reasons why I advise my clients not to purchase them. There are a number of much less expensive ways to gain exposure to the markets without investing in actively-managed mutual funds. In order to learn more about these options, please feel free to call me at (330) 915-6114.

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