Choosing the right home for your money
What are Mutual Funds?
When you buy a mutual fund, what you’re getting is essentially a sampler platter of investments. It’s a bunch of “fractional shares” — smaller slivers of many assets instead of big chunks of just a few things. This diversification helps protect you against any one thing going down the drain and wiping you out.
Mutual funds are actively managed, typically by human beings at an investing institution who work, essentially, on commission. They take a small percentage of your portfolio’s value, so they make more money by making you more money. It’s in their best interest to maximize your profits.
However, when advisors pitch mutual funds, there are a lot of things that are legally supposed to be explained, but which are glossed over. Even when those things are disclosed, clients often don’t really understand what they’re hearing. But since mutual funds are a cornerstone of the modern financial world, it’s imperative for us to understand.
Types of Mutual Funds:
There are different types of funds, and not all of them are created equal.
There are A, B, and C-shares, as well as I-shares, ETFs, and indexes. But don’t let your eyes glaze over just yet — it’s not as complicated as it sounds.
For instance, the “I” stands for “Institutional.” I-shares are things like 401Ks that you don’t really have access to as a private investor outside of your employer.
What we’re concerned with are A, B, and C-shares. Overall, you just need to know A, B, and C shares are all the same sampler platter. Whether the stock market goes up 10% or down 10%, A, B, and C-shares are all moving together. We’ll call our investment the All Same Fund, so our imaginary ticker on Wall Street is ASF. (That’s not a real ticker right now as far as I know.)
If A, B, and C are the same, it doesn’t make any difference which one you pick, right? No, it matters! Fund managers just don’t want you to see all the fugazi in play, because your ignorance can make them a lot of money.
How it works:
If A, B, and C-shares are the same, which one will your broker try to sell you? The A-shares. Why? Because it’s got the biggest rip — that’s what you call the amount you rip from the client’s account and put into the firm’s account. This is how brokers working on commission make bank.
Generally, the advisor takes 40–50% of the rip and the company takes the other portion. So if you get someone coming to a broker with $10,000*, that broker is going to want to sell you a A-shares. If he does, he instantly pockets at least $250. Why would he want to sell you on B or C-shares for nothing when he can get $250 right now whether you stay with his company or not?
*(The average investor with some kind of 401K only has between 5K and 15K to invest. That’s why we’re using a 10K middle-ground. It’s not a multimillionaire, but it’s not so low that you should be focusing on other daily expenses first.)
You may want to reference back to this table as you read along:
The A-Shares Sales Pitch:
The advisor is going to sell you A-shares by asking if you’re stable, if you’re planning long term, that kind of thing. He’ll be feeding into answers you should be giving anyway if you’re thinking of parking 10K in an investment. Of course you’re thinking long term, of course you’re stable right now, of course you want the safest investment. And that’s what they’re going to say A-shares of ASF are.
They’ll tell you that in the last 10 or 20 years, the ASF has averaged 8% (or whatever) per year. They’re going to babysit your 10 grand, and you’re going to make $800 a year. But as soon as you sign on the dotted line, that $10,000 immediately becomes $9,500 due to the 5% rip.
When Johnny Client calls back freaking out about his first monthly statement, the broker will probably have to explain again that his active fund management fee is only 1% a year. Is that good? Actually yes, it’s very good. 1% or less is prime tier. And there’s no technical lock-in period. 10 years is recommended, but there’s no minimum time period to hold A-shares. When you finally sell, there’s also no fee to sell on the way out.
So that doesn’t sound that bad, right? I already know this is going to immediately come together for some of you out there.
For the rest of us who haven’t quite hashed it out yet, let’s keep it simple and not deal with compound interest and decimals yet, even though you’d technically be paying a “bigger” 1% on gains you make year over year.
With A-shares, we’ve got 5% up front and then 1% for ten years. So we’ll say our exit cost total is actually a collective fee of 15%.
Johnny’s Ex comes in with 10K and she’s all about the ASF. But this is a strong, smart woman, and she won’t stand for any up-front fees. She flatly refuses to accept that 5% rip. Okay, great! She can immediately start making gains on that extra 500 bucks she’s not losing to the rip.
The problem is you aren’t going to get that prime management fee. Instead of 1%, we’re going to take 1.5% per year for ten years. Plus, you’ll have an additional penalty if you want to sell before 5 years.
But Johnny’s Ex is a big picture player. She’s not going to sell before 10 years, right? So when she sells, there won’t be any exit fees. Fantastic! We’ll put her on the B-shares and we’ll notate on her paperwork the term “fee sensitive.” When a compliance manager says, “I’m gonna report you and take away your license!” we have our butts covered because the client stated she was “fee sensitive,” and we offered A-shares. It’s in the system, so we’re good to go.
The funny thing about that is that with those A-shares, the broker got 40–50% of the rip, so about 2–2.5% of the account value goes to the broker. With B-shares, there’s no rip, but the firm will still pay the broker about 2%. Where does that money come from? It comes from the gains the firm makes by having that client locked in long term. Remember, the B-shares client can’t close out this deal under 5 years without paying a penalty, so even if they do a 5 year minimum, 5 years at 1.5% a year is 7.5% of account value.
So the firm isn’t getting as much up front, but the broker will make about the same amount. It really doesn’t matter too much which choice you make unless he’s in a nice firm that’s giving him 50% of the rip for the A-shares. That extra 0.5% cut will add up to thousands of dollars for him, but it’s not generally worth the fight if Johnny’s Ex is insistent on the B-shares.
If you’re not taking into account compounding numbers yet, you might just be thinking: “Well, the A-shares at the end of 10 years are 15%. The B shares at the end of ten years are also 15%. So it didn’t really matter, did it?”
Well, no, because you have to assume that you’re actually making gains on this fund. If you’re gaining about 800 bucks in your second year, say 850, 900, 1000 in returns as the years go by, whatever numbers those might be…you’re now paying an extra 0.5% on those returns as well. As a comparison to the A-shares, you’re paying 50% more for your fund management. As your account grows, the value of that 0.5% grows too.
So if you have A-shares for 10 years, that 5% up front is a much smaller 5% than this little extra .5% will end up being after 10 years of gains in some B-shares. The bite becomes bigger and bigger over time, and that’s why brokers have to cover their butts if you go in insisting on this fund that’s actually going to cost you more as a long term investment. If you include the fact that it’ll be compounding with your gains, the real bite is going to come out to around 17–20%.
But for the sake of easy math, let’s continue to assume (for now) that there’s no compounding interest and just call this 15% at 10 years.
Now for my absolute favorite: C-share classes. The client comes in, and he’s a total enlightened Chadzilla.
He doesn’t want to do the B-shares because he might want his money back in a year. Maybe his Camaro payments are high. He read on Investopedia that liquidity is important, and he feels like he knows what that means. And he’s not going to pay 5% up front to anything that doesn’t make him look suburban rich!
Okay, Chad, the C-shares are just for you. You can leave after a 1 year lock-in with no exit fees and no fees up front. A lot of brokers will actively ONLY try to sling C-shares. But what happens is this: clients are investing because they’re planning to park that money long term. You’re an investor, you’re thinking big picture, right? So you end up throwing your money into C-shares and just leaving it there for the full 10 years.
Do you think anyone is going to call and remind you after the first year is up that you could save money by swapping out of C-shares when you’re paying them the highest management fees possible?
So 10 years go by and even before we think about the real losses of taking 2% out of all his gains over the years, Chadzilla is already at 20% losses after 10 years of paying 2% fees.
The reason mutual funds can really squeeze money out of people is because they come in with their minds made up: “No way am I gonna pay 5% up front. No way am I going to be locked in for 5 years!” You can’t really work around trying to change their minds, so C-shares get slung around because — essentially — people are uninformed and stubborn. They pay the price for that stubbornness and lack of technical knowledge.
Not My Money, Not My Job
As a broker, it’s not your job to convince people of the best options they have available. You have to feel them out and see where their circuit breakers are — figure out what you absolutely can’t pitch because they’ll just walk away. Your job isn’t to get them into the best plan for making them money, it’s to get them into any plan to make you and your company money. So if they want to come in and park money in C-shares for 10 years, you let them.
The best thing about all of this, the big reveal! When all three of these clients get their monthly statements, they do NOT see the monthly management fee listed anywhere. This number does not exist on their statement. The client with the A-shares will see the missing 5% rip. But the management number is amortized, which means it’s broken down over a 365 day period. Even though it totals 1 or 2% of the account value, the daily value is so small that it doesn’t have to legally be included in any fashion that lets you see it’s happening.
If you have 1% divided on 10K, that’s 100 bucks. You divide that out into 12 months, that’s just around $8 a month. What the companies will do is average this out of your share prices and then report those share prices as being lower than their actual value. So, maybe they shave a penny off of each one of these tons of fractional shares you own, and you’ll just think that’s what the actual share price was.
This is how wall street makes billionaires. If you’ve ever seen the movie Office Space, the whole scheme to round off pennies on every transaction to add up to tens of thousands of dollars is how this all works in real life. Chad, who’s getting railed for 2% a year on his C-shares, gets a statement saying he made 8% that year. He’s floored by his great investment, not realizing he actually made 10% and the company took 2% without even reporting it to him.
This circus gets even better in a year with an economic downturn. A client loses 8% and then gets a statement telling him he lost 10%, because of course the firm is still going to take their 2% cut even if their active management is losing you money.
Ultimately, figuring out which mutual fund type is best for you depends on your investment goals and time period. And remember, you can always change your policy (although you’ll probably want to do so at the end of any lock-out period).
A Real Example
The table below shows a realistic side-by-side comparison of each share class based on the same initial investment with compounding interest factored on an annual basis. Year over year profit is assumed to be the stock market average of 8% per year and brokerage fees are in line with normal management fees.
This is, of course, just a model — but it’s a reasonable one. It might look a little scary at a glance, but the gist of it is summarized below the table if it’s too much to digest for now.
You can see that A-shares overtake B-shares in profitability in the 11th year. If you’re parking money for retirement (11+ years from now), you should consider A-shares.
B-shares are actually better than A-shares even if you don’t pull your money out after the 5 year lock-in period (up to the the 11th year). However, eventually the lower management fees allow A-shares to overtake B-shares in profitability.
C-shares work out better than A-shares for the first 5 years, after which the high management fees start causing huge damage. But if you’re parking your money somewhere for 5 years, B-shares are better than C-shares at every point.
C-shares should generally be considered if you want to invest short term, but think you will need that money in less than 5 years. For example: if you’re planning on buying a house in a few years and using this money for a down payment.
Of course, you’ll have to talk to your broker and plug in your own financial manager’s fees, as well as your own starting capital amount. Shop around! It’s worth taking the time to do the math to figure out what’s best for you.
Try to realistically assess your situation to determine how long you want to invest. As always, never invest more than you could afford to lose, so you can let this money ride to the future with no lost sleep and no temptation to get cold feet and lose out on rips or fees for breaking lock-ins.
Best of luck to you in your financial future, and thank you for making it this far on a topic you probably never thought you’d care about!