The Class B structure creates challenging financial issues for the fund sponsor This structure carries inherent risk in that the fund’s NAV could decline substantially, decreasing the amount of 126-1 fees and CDSCs received by the sponsor, possibly below the amount it advanced to the broker-dealer. This is especially a risk for an equity fund sponsor, since equity assets are more volatile than other asset types. In recent years, many fund sponsors have sought relief from the risk that the CDSC arrangement entails by taking advantage of new methods of financial engineering developed by banks and investment banks. These methods enable fund sponsors to reduce or eliminate this risk by securitizing and selling the future cash flows from 12b-1 fees and CDSCs. For example, consider a fund sponsor that has just paid a broker a 4% commission for selling Class B shares of a growth find. Rather than wait to recoup this commission via 12b-1 fees and/or CDSCs, the sponsor may sell the rights to these future cash flows to an unrelated party in exchange for a modestly lower payment today. This sale effectively protects the sponsor against the risk associated with a possible downturn in the equities market and consequential decline in cash flows from 12b-1 fees and CDSCs.

Beside Classes A and B, fund sponsors have developed classes with other pricing structures. Class C is sometimes described as a “level load” because it combines a high 12b-1 fee with a modest CDSC for one or two years. Class C typically imposes no front- end load, although the fund sponsor usually advances a small commission to the brokerdealer.A mutual fund could also offer a Class I, called the institutional class, with neither loads nor 12b-1 fees. This class is designed for institutions with very large accounts and financial planners who are collecting a separate fee from their customers.

FundsThe 12b-1 fee (but not the sales load) is one of several components of a fund’s expenses, often expressed in basis points as the fund’s total expense ratio (the ratio of the fund’s total expenses to its assets on an annualized basis). The most important component is the management fee paid by the fund to its investment manager. The management fee must be approved periodically by a majority of the fund’s independent directors.Another fund expense is the transfer agent fee.This fee may be paid to a transfer agent affiliated with the fund manager or an external service provider. Other fund expenses include smaller amounts paid for fund audits, pricing and bookkeeping, custody charges, independent director fees, registration fees and sometimes proxy solicitations. By contrast, brokerage commissions are included as part of the capital costs of the fund’s portfolio securities rather than as part of the fund’s total expense ratio.

Some mutual funds, especially bond and money market funds, have “all-inclusive fees.” In this arrangement, the management company charges a single fee of a specified amount (e.g., 50 bp) and assumes responsibilities for all fund expenses including transfer agency and other annual expenses as well as management costs.All-inclusive fees effectively shift the risks and rewards of controlling the fund’s total expenses from the shareholders to the fund management company. Of the 100 largest mutual funds in 1997-1999, 19 had a single all-inclusive fee, according to the SEC. Alternatively, management companies may choose to impose voluntary caps on fund expenses. This has much the same effect as an all-inclusive fee, but with the difference that a voluntary expense cap, unlike a management fee, may be changed without shareholder approval.According to Lipper, 40% of stock funds and 52% of bond funds had some sort of voluntary expense cap in effect during the third quarter of 2000.

Fund sponsors impose other types of fees on shareholders, rather than on the fund, to modify their behavior and/or make them absorb certain fund expenses. Funds sometimes impose redemption fees on shareholders who leave the fund after a short period of time (e.g., 90 days or six months). (See the case study in Chapter Nine.) Such redemption fees go back to the fund (not to the distributor) to cover the transaction costs imposed on remaining shareholders by departing sellers. Fund managers increasingly use short-term redemption fees on shares held less than 90 or 180 days in an effort to reduce the amount of “hot” (frequently traded) money flowing in and out of a fund. Frequent trading in and out of a fund increases its transaction costs, which ultimately decrease total returns of the fund. Fund managers have found that implementing redemption fees has been an effective tool in curbing frequent trading. Similarly, some index funds impose fees on new purchasers to defray the fund’s costs in acquiring more shares of companies in the index.

In addition, some fund sponsors charge fees for specified types of transactions, such as wire redemptions or fund exchanges, or for specific types of accounts. Most fund sponsors charge shareholders a fee for serving as the custodian for an individual retirement account or other retirement account, although such custodial fees may be waived for large accounts Small account fees are another charge that shareholders may incur as individual investors. These fees, designed to offset in part the relatively higher costs of servicing smaller accounts, are payable by shareholders to the transfer agent. For example, a fund may deduct an annual maintenance fee of $12 front-accounts with a value of less than $2,500 as of the last Friday in October. Some funds may waive this fee if the shareholder has aggregate assets in the complex above a certain amount (e.g., $50,000). To discourage the attraction of very small accounts, most funds have a minimum initial investment requirement. Further, most funds reserve the right to close any account that falls below the minimum balance and send the proceeds back to the investor if he or she fails to reestablish the minimum balance within a specified time period, such as 30 days after notification.

Any type of fund expense imposes a drag on fund returns actually received by fund shareholders. Given the mathematical realities of compounding over time, the difference between seemingly small variations in fund expenses can make quite large differences in returns over the long term.

Suppose $100,000 is invested with these three identically positioned equity funds: one with annual expenses of 0.50% (11.00% return net of fees), a second with annual expenses of 1.00% (10.50% return net of fees) and a third with annual expenses of 1.50% (10.00% return net of fees). The $100,000 invested in the fund with an expense ratio of 0.50% would be worth $806,231 after year 20. The $100,000 invested in the fund with an expense ratio of 1.00% would be worth $736,623 after year 20. The $100,000 invested in the fund with an expense ratio of 1.50% would be worth $672,750 after year 20.Thus, there would be a difference between the highest and lowest net return of $133,481, all due to fund expenses.

Since fund expenses are ultimately borne by fund investors, the SEC takes particular interest in the manner in which these expenses are disclosed. The SEC requires that all transaction and operating expenses charged by a fund be presented near the front of the prospectus in a relatively standardized format. This fee information is divided into three sections: shareholder transaction expenses (including sales loads and redemption fees), fund operating expenses (including management, transfer agency and 12b-1 fees) and a standard hypothetical illustrating the dollar amounts of fund expenses paid on a $10,000 investment in the fund over 1, 3, 5 and 10 years.

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