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How to choose the right fund share class

With some funds having as many as 40 different share classes, investors struggle to make the right choice. But a change in regulation is making the situation even more confusing.
February 1, 2013

The Aberdeen Emerging Markets fund has been one of the top performing funds over the past five years and most investors will have been happy with their choice. But an investor in its 'Z' share class may have been a little happier: He will have received an annualised return of 13.7 per cent, whereas an investor in its 'I' share class will have received just 12.6 per cent. Investors may be willing to overlook this in a fund with the performance record of the Aberdeen fund, but are they likely to be as casual in a weaker fund?

Buying the right share classes for a fund is an often-neglected wrinkle in investment selection. Different share classes have different costs, currencies, minimum investment levels and selecting the right (or wrong) one can have an impact on the long-term performance of an investment. Some funds carry as many as 40 different share classes, according to Morningstar.

More bewildering still for investors is that there is no industry standard for different fund share classes. Some fund managers only offer one class, whereas others offer several. Darius McDermott, managing director of Chelsea Financial Services, says: "Share classes from Invesco Perpetual might be labelled X, Y, Z, while the same share classes from Jupiter may be A, B, C. There is no commonality to labelling."

The topic is pertinent because, as part of the changes in the advice industry brought about by the Retail Distribution Review, many fund managers are introducing new share classes. This is likely to make an already confusing situation even more so.

The biggest difference between different share classes is cost and, within that, the biggest difference is between retail and institutional classes. Lee Robertson, chief executive officer of financial planning group Investment Quorum, says: "Retail fund classes carry higher charges, typically with an initial charge and an ongoing charge. Institutional fund share classes carry lower charges due to bulk buy discounts and often have no initial charge and a much reduced ongoing charge." Lower-cost units will deliver the best returns over the long term because costs exert a smaller drag on performance.

That said, for most self-directed investors, the difference will not be between retail and institutional classes - with minimum investment levels of £1m-plus, the institutional share class will be out of reach for the majority of investors - it will be between the different types of retail unit.

This is a thorny issue in itself and is currently in a state of flux. Previously, the traditional retail share class would incorporate an annual management charge of 1.5 per cent. It would be lower for bond funds, a little higher for certain prized equity funds. But not all of this would go to the fund manager; part of the charge might go to the platform provider and to the financial adviser.

Mr Robertson continues: "Typically A Class shares are offered to retail clients - although confusingly some fund groups term these B Class and some fund groups call their institutional share classes B also - and will carry the fairly standard charging structure of around 5 per cent initial charge with around 1.25-1.55 per cent ongoing charge annually. A Class however may often give discounts on the initial charge for online purchase or platform purchase."

Confused? It's likely to get worse. The Retail Distribution Review came into effect on 1 January this year. This stops advisers taking commission and has given rise to a whole new raft of 'clean' or commission-free share classes. The typical annual management charge on this new share class will be 0.75 per cent, but again this is not standard. Mr McDermott says some active managers of popular funds have kept their premium pricing.

But there will be a period of transition and the old commission share classes will remain in place for the time being. Gavin Haynes, investment director at Whitechurch Securities, says: "Following the implementation of the Retail Distribution Review financial advisers cannot receive fund-based commission for new investments advised upon. However, they are still eligible to receive commission from legacy investments placed before RDR implementation."

As the Financial Services Authority (FSA) is fond of reminding investors, costs can make a significant difference to the long-term returns for investors, but costs are not the only element that varies from share class to share class. Share classes can be bought in different currencies, for example. If a sterling investor finds himself in the euro share class of a fund, he will be exposed to any rise or fall in the value of sterling versus the euro. This would have turbocharged the investment in some environments and been extremely painful in others. Either way, it may not be quite the investment that was originally sought.

Similarly, global funds buy shares around the world, thereby exposing the end investors to different types of currency risk. Some managers reason that it evens out over time and it is therefore not worth the expense of hedging away the currency exposure. Others believe investors do not want that uncertainty and offer 'hedged' share classes as well. Neither is necessarily the 'right' approach, but investors need to understand the risks they are taking.

If a fund generates an income, fund managers will usually offer investors the choice of income or accumulation share classes (usually denoted Inc or Acc). The income share class will distribute the income, while the accumulation share class will reinvest any dividends or interest generated into the fund.

Income units will be used by investors relying on the income from their investments to pay expenses - perhaps school fees or general living expenses. Tim Cockerill, head of research at Rowan Dartington, says: "Unless an investor wants income they should buy accumulation units. In a nutshell this means that any income received into the investment fund is reinvested. Long term the reinvestment of income has a powerful compounding effect, which is often overlooked. Quoted performance figures for funds always give total return, ie accumulation shares, and can show a very big [better] difference in performance to income shares."

Investors who believe that they might need the income from an investment in the future may wish to buy income units and then reinvest the income rather than buy accumulation units and then switch. The change does not trigger a capital gain in either case, but charges can be higher to switch unit type than to simply 'switch off' the reinvestment of income.

How can investors negotiate this minefield? The first point to make is that it is worth negotiating, particularly for certain types of fund. For example, a steady, low-risk UK equity fund such as Neil Woodford's Invesco Perpetual fund has delivered a three-year annualised return of 10.62 per cent (source: Morningstar, to 03/01/2013) in the low charge share class and 10.03 per cent in the higher charge share class - not a huge difference (an annualised rate of return is the return on an investment over a period other than one year, such as a month or two years. multiplied or divided to give a comparable one-year return). However, the difference between the top and bottom share classes in the Aberdeen World Equity fund is 2.8 per cent over the same period (source: Morningstar, comparing C2 and Z2 share classes).

Mr Cockerill says that, usually, there will be just one appropriate share class for an investor. Mr Haynes adds that the key is to determine the annual management charge (AMC) or, preferably, the total expense ratio (TER) for the share class. (The TER includes the AMC plus additional expenses such as trading fees, legal fees, auditor fees and other operational expenses.) It is then possible to see the 'drag' effect of charges on that particular share class: "The 'I' share class will typically stand for institutional and the 'A' share class is often the traditional retail share class. However, it really is a case of looking at the specifics of the share class," he adds.

Mr Robertson says that there is no alternative to detailed homework: "Investors who opt not to use an adviser may be able to get discounts direct from the fund groups, although some fund groups have already said publicly that they will not offer discounts to direct investors as they prefer investors to access their funds via platforms. An interesting point here is that by using an adviser investors may be able to secure greater discounts than they could for themselves, even when they factor in the charges from the adviser."

He says that investors should ask for the share class that offers the most favourable terms, whether this is direct or through an adviser. He adds that this is likely to be the 'X' class in most cases.

 

Is anything being done to make it simpler for investors?

The FSA has not issued strict guidance on the subject, but the Investment Management Association (IMA), which represents the UK fund management industry, is taking steps to address the problem: Julie Patterson, director of authorised funds and tax at the IMA, says the group is aware of the concerns that the potential proliferation of share classes as a result of the RDR could cause confusion for investors. However, she adds that delays to the FSA guidance on platforms - which will require further changes to share classes - has stalled any moves towards greater standardisation.

"The delay has put the industry in a difficult position because it has not been able to deal with all the changes required in one efficient move, thereby minimising confusion for investors and costs. Given the circumstances the industry now finds itself in, we shall reconsider with our fund manager members the best course of action," Ms Patterson says.

The cogs of regulation move slowly, so investors should not expect any wholesale moves to greater standardisation in the near term. In the meantime, it is a case of ensuring that investors understand the cost structure and other exposures of the share classes they hold.

 

ONE FURTHER COMPLEXITY

Some funds that implement a performance fee in addition to the standard annual management charge label this share class 'P'. Ms Haynes says: "The issue of performance fees is a controversial topic that divides investors. Some believe that they align the fund manager’s interests with that of the end investor while others believe that the fund manager is being over-rewarded for simply doing their job." If investing in a fund with a performance fee, investors need to be sure that any additional fees are worth it for the returns they receive.