Mutual fund distributors have devised dozens of specifi c commissions schemes, but they all fall into one of three major categories: front-end loads, back-end (CDSC) loads, or level loads. Many funds employ all three approaches in their different share classes. The Colonial U. S. Government Fund series, a group of typical load funds sold through the nonproprietary broker channel, illustrates these approaches and how they work.
As an excerpt from the funds’ prospectus shows (see Table 8.1), funds in the Colonial Intermediate U.S. Government Fund offer three classes of shares: A (front-end load), B (CDSC), and C (level load). The prospectus also spells out exactly how the commission scheme works for each class.
Table 8.1 Shareholders Fees*(paid directly from your investment)
Class A Class B Class C Maximum sales charge (load) on purchases (%) (as
percentage of the offering pricer)
4.75 0.00 0.00
Maximum deferred sales charge (load) on redemptions (%) (as a percentage of the lesser of purchase price or redemption price)
1.00 † 5.00 1.00
Redemption fee (%) (as a percentage of amount redeemed, if applicable)
‡ ‡ ‡
* A $10 annual fee is deducted from accounts of less than $1,000 and paid to the transfer agent.
† This change applies only to certain Class A shares bought without an initial sales charge that are sold within 18 months of purchase
‡ There is a $7.50 charge for wiring sale proceeds to your bank.
Source: Colonial U.S. Government Funds Services
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Fund Distribution: The Broker Channels 173
Front-End Load
Front-end loads are commissions paid directly by the investor when the pur- chase transaction is made. The commission amount is typically expressed as a percentage of the fund’s offering price, which is the NAV adjusted for the commission. The load table associated with the fund determines this adjust- ment amount. As the load table for the Colonial Intermediate U.S. Government and Federal Securities funds illustrates, a front-end load fund often provides for reductions in the commission rate for larger purchases.
To illustrate how a share purchase in a front-end load fund works, con- sider the example of a $10,000 investment in the Colonial Federal Securities Fund, which, at the time, has an NAV per share of $10.00.
•
The offering price is calculated as the NAV divided by one minus the com- mission rate ($10.00/(1–.0475)), or $10.50. Prices are always rounded to the nearest penny.•
The investor gets 952.381 shares ($10,000 divided by the offering price of $10.50 per share). Open-end fund share amounts are rounded to the nearest thousandth of a share.•
The fund gets $9,523.81 (952.381 shares times the NAV per share of$10.00).
•
The brokerage fi rm gets $425 ($10,000 times the dealer concession rate of 4.25 percent).•
Finally, the distributor gets the remainder, $51.19 in this case. The load table shows a difference between what the investor pays (4.75 percent) and what the dealer fi rm gets (4.25 percent), and this accrues to the fund’s distributor. The distributor also “eats the breakage”—that is, absorbs the effect of any rounding errors that occur in the calculations. In this case, there was a $1.19 breakage (.5 percent of $10,000 is $50, not $51.19). This breakage results from rounding the offering price (from $10.49868766404 to $10.50) and the number of shares purchased (from 952.380952381 to 952.381).As Table 8.2 shows, the investor could reduce the commission paid by increasing the size of the purchase. Front-end load funds typically also give these volume discounts if:
1. the investor executes a letter of intent (LOI) to invest a larger amount within a specifi ed period, often 13 months; or
2. the purchase plus the total amount already invested in the investor’s account, or a group of accounts related to the investor, reaches the levels that qualify for a reduced load. This practice of considering the current
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Table 8.2 Colonial Intermediate U.S. Government Fund and Colonial Federal Securities Fund
Amount of purchase
As a % of the public offering
price
As a % of your investment
% of offering price retained by fi nancial advisor
fi rm
Less than $50,000 4.75 4.99 4.25
$50,000 to less than $100,000 4.50 4.71 4.00
$100,000 to less than $250,000 3.50 3.63 3.00
$250,000 to less than $500,000 2.50 2.56 2.00
$500,000 to less than $1,000,000 2.00 2.04 1.75
$1,000,000 or more* 0.00 0.00 0.00
* Class A shares bought without an initial sales charge in accounts aggregating $1 million to $5 million at the time of purchase are subject to a 1% CDSC if the shares are sold within 18 months of the time of purchase. Subsequent Class A share purchases that bring your account value about $1 million are subject to a 1% CDSC if redeemed within 18 months of their purchase date. The 18-month period begins on the fi rst day of the month following each purchase.
Source: Colonial U.S. Government Funds Services
amount invested in existing accounts to determine load level on a pur- chase is termed rights of accumulation (ROA).
The fund’s prospectus must describe how an investor can reduce the amount of commission he or she might pay through an LOI or ROA.
Contingent Deferred Sales Charge
CDSC funds were introduced in the 1980s once Rule 12b-1 gave fund groups a convenient method of recovering money distributors advanced to cover bro- ker commissions. They appeal to brokers because they provide an immediate commission at time of purchase, similar to front-end load funds. They appeal to investors, because all the investor’s money is used to purchase shares in the fund at the current NAV per share. To make this possible, the fund’s distri- butor pays the commission to the broker, and then recovers the money from the shareholder over a period of years, by taking an annual deduction from the shareholder’s account.
This creates a contingent liability for the shareholder, which is deferred, and eventually paid off from 12b-1 fees, if the shareholder keeps the money in the fund. If he or she redeems the shares before this money has been recov- ered, however, the distributor must deduct the remaining amount owed from the redemption proceeds. This liability declines over time, as the periodic deductions add up. Table 8.3 excerpted from the Colonial prospectus shows a typical pattern of the decline in liability as the shares age. A shareholder who
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Fund Distribution: The Broker Channels 175 redeems in the fi rst year after purchasing the class B shares will pay a fi ve percent CDSC fee. This rate declines year by year, until after six years when there is no longer any liability. After eight years, the class B shares convert to class A shares, which carry a lower 12b-1 rate.
The distributor of a successful CDSC fund faces the need to arrange fi nanc- ing of these advanced commissions. For example, during 1998, the Eaton Vance Tax Managed Growth Fund Class B, with a distributor-fronted commission rate of four percent, had net purchases of almost $2 billion. This meant that Eaton Vance Distributors, Inc. had to pay out something on the order of $75 million in 1998 to dealers who sold these shares, money that it would recover only over a period of years. Essentially, the distributor makes a loan to the brokerage fi rm and gets repaid by the shareholders. If the distributor cannot fi nance this payment from its own or its parent’s cash fl ow, then it must borrow the funds.
Some borrow the money from banks or other institutional lenders. In recent years, some distributors have begun securitizing these fl ows. They package up the rights to expected 12b-1 fl ows from a fund or group of funds into a sort of bond (much like a mortgage-backed security), and sell these to investors.16
Level Loads
Level load share classes carry a perpetual 12b-1 fee, usually 100 basis points per year, no front-end load paid by the investor, and at most a one percent distributor-fronted payment. Colonial’s level load arrangement for its class C shares is typical, with a CDSC for only one year, so that the distributor can recover the 100 basis points paid to the selling brokerage fi rm in case the shareholder redeems early.
Table 8.3 Colonial Intermediate U.S. Government Fund and Colonial Federal Securities Fund
Holding period after purchase
% deducted when shares are sold
Through fi rst year 5.00
Through second year 4.00
Through third year 3.00
Through fourth year 3.00
Through fi fth year 2.00
Through sixth year 1.00
Longer than six years 0.00
Commission to fi nancial advisors is 4.00%.
Automatic conversion to Class A shares is eight years after purchase.
Source: Colonial U.S. Government Funds Services
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Level loads have generated more controversy than any other share class, since they have misled some investors into believing that they are no-load funds. In 1994, Newsday termed them a “marketing illusion,” in an article in which the SEC’s chief mutual fund regulator expressed concern over how they were perceived.17 Nor have they been a tremendous hit among inves- tors and brokers. Although the number of fund
classes with level loads grew from under 100 in 1992 to approximately 2,800 at the end of 2004, the total assets attributable to this type of fund was only $247 billion, or about three percent of the industry total assets. From Janu- ary of 2000 through November 2004, however, level load shares have captured approximately 48 percent of new load fund fl ows, indicating an upturn in investor and broker interest.
Fund companies that offer level load classes cite one or more of several reasons for doing so. They believe that some brokers pre- fer the continuing annual revenue stream from the 100–basis point 12b-1 charge (but admit that this appeals more to established brokers, who have a reliable income stream, than it does to new brokers, to whom the immediate grati- fi cation of a transaction commission is more attractive.) They believe that investors like the level load scheme because the brokers get paid more if the value of the fund goes up but less if it goes down. Or they believe that level load
funds appeal to commission-based fi nancial advisors by giving them a prod- uct that essentially mimics the fee-based structure (i.e., an annual asset-based charge). As stated by one mutual fund marketer, “it puts brokers and clients on the same side of the table.”18
The load structures in a fund’s prospectus describe what the distributor actually pays the fi rm with which it has a selling agreement. Those fi rms sub- sequently divide up the commission they receive from the fund among the individual representative who has the investor account, his or her manage- ment hierarchy, and the fi rm itself. A registered representative who executes an investor’s $10,000 purchase into a fund with a fi ve percent front-end load will certainly receive something less than the full $500 of commission the purchase generates.
Class C Shares Similar to Class B shares, your purchases of Class C shares are at the fund’s NAV.
Although Class C shares have no front- end sales charge, they carry a CDSC of 1.00% that is applied to shares sold within the fi rst year after they are purchased. After holding shares for one year, you may sell them at any time without paying a CDSC. The distributor pays the fi nancial advisor fi rm an up-front commission of 1.00% on sales of Class C shares.
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Fund Distribution: The Broker Channels 177 The major difference between the proprietary and nonproprietary chan- nels is the universe of intermediaries through which they sell. In the propri- etary channel, the brokers or planners do more or less the same things as do the brokers in the nonproprietary channels, but they do them for the same company as manages the funds. This has both advantages and disadvantages for the funds.
For funds selling through the nonproprietary channel, the great challenge is that of “getting shelf space” within the brokerage community. An A. G.
Edwards broker, for example, has literally thousands of funds to sell from doz- ens, if not hundreds, of fund families—why should he or she expend efforts on any one of these over any other? Fund distributors look for ways to provide valuable services to brokers—software, data about investors, seminars—to get their attention and motivate them to recommend the funds of their particu- lar group. They schmooze them. In this channel, the personal relationships that wholesalers build with dealers play a large role in getting funds sold.
The funds that use proprietary distribution don’t have the shelf space problem with their own captive sales force, but their universe of intermediar- ies is limited to that relatively small group. For this reason, net sales through the proprietary channel has always badly trailed sales through the nonpropri- etary channel. For example, as Figure 8.6 shows, for the 12 months ended November 2004, the proprietary channel experienced net outfl ows while the nonproprietary channel experienced net infl ows. During the late 1990s, many of the players in this channel have concluded that they must expand beyond their captive sales force and distribute via independent brokers and planners if they are to grow at a satisfactory rate. By the late 1990s, such large fi rms as Merrill Lynch, Prudential, and American Express had all begun distributing their proprietary funds through third parties.
This practice continues to erode the distinction between the proprietary and nonproprietary channels. At one time, the sales forces of institutions with proprietary funds sold only their own fi rms’ funds. As the 1990s progressed, most of these organizations found this to be an untenable position—investors demanded a wider choice—so they had to let their salespeople sell compet- ing products. This erosion is refl ected in the response one Prudential broker made to the announcement that Prudential would use third-party distribution for its funds: “The average broker here doesn’t sell much in-house funds, so if someone else wants to sell them, more power to them.”19 And industry guru Lou Harvey thinks the proprietary channel will eventually disappear. “Every manufacturer in this business will sell through every distribution channel. If I’m a manufacturer and want to grow assets, why would I tie my hands behind my back? It’s just nuts.”20
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