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  Lu Zheng

Mutual Funds: The Downside of Introducing B and C Class Shares

7/21/2005 --

Switching to a multiple-class structure that includes back-end loads and annual fees hurts overall fund performance, new study finds.

ANN ARBOR, Mich.—Mutual fund investors who snapped up new classes of shares in the past decade may have jumped prematurely before considering the impact on fund performance, a new study by the University of Michigan business school shows.

In switching to a multiple-class structure by adding B and C shares to existing A shares, load funds offer mutual fund investors more choices but not necessarily better returns, according to Lu Zheng, assistant professor of finance at the U-M's Stephen M. Ross School of Business.

The newer share classes, introduced in the 1990s, offer investors a choice of paying back-end loads (sales charges or commissions paid when an investment is sold) and/or annual fees instead of the hefty front-end loads required for purchases of traditional A shares.

"Introducing the new classes attracts significantly more new money in the first one-to-two years, controlling for performance and other fund attributes," Zheng said. "The downside, however, is that about two years after introducing the new classes, funds experience a significant drop in performance, which is expected to substantially erode the cash-flow growth induced by new classes."

In their study, Zheng and colleagues Vikram Nanda and Z. Jay Wang examined how the transition to a multiple-class structure affects fund cash flows, investor clientele, performance and expenses. They analyzed all diversified U.S. equity funds from 1993 to 2002 (by that year, nearly half of the funds offered more than one share class, with large and well-performing fund families more likely to make the switch to a multiple-class structure).

The study shows that switching from a single A class to a multiple-class fund increases the overall fund cash inflow initially by an estimated 12 percent, controlling for performance and other factors. Given the average fund size in 2002, this amounts to nearly $16 million in new money—but the new growth slows down after the second year.

However, the results indicate that switching to the multiple-class structure hurts overall fund performance. Starting from the second year after the transition, multiple-class funds underperform their no-load counterparts by 1.2 percent to 1.7 percent annually on a risk-adjusted basis. The fund's diminished performance can reduce the inflow of new investment dollars by 2 percent to 3 percent annually.

After a switch, investors do benefit somewhat from additional economies of scale by paying lower operating expenses, the researchers say. However, the slight decrease in fund operating expenses does not offset the drop in fund performance.

"Our evidence suggests trade-offs in switching," Zheng said. "The funds attract additional cash flows after the introduction of new share classes, which may in turn hurt fund performance due to increased fund size and higher cash-flow volatility. These changes result in higher liquidity costs and decreasing returns to scale, which have a negative impact on fund performance."

Zheng and colleagues say that investment horizons play an important role in determining the share class that would maximize an investor's net returns. Typically, investors with long investment horizons prefer the traditional A class. Those with short to intermediate or uncertain horizons generally favor B class, and short-term investors prefer C class.

For more information, contact:
Bernie DeGroat
Phone:(734) 936-1015 or 647-1847