Expenses--The Prospectus and Statement of Additional Information

The prospectus and the statement of additional information (SAI) both offer detailed information on fund expenses. The SAI, unlike the prospectus, is not required to be delivered to prospective shareholders except upon request. But it contains a wealth of further information. Request it when you order a prospectus; use the table of contents in both.

The prospectus begins with mandated fee tables. Within the first few pages are fund expenses for the most recent fiscal year broken out into management fees, distribution expenses (sometimes called 12b-1 fees, service fees, or asset based sales charges), and "other" expenses. These annually recurring fund expenses make up the expense ratio. Also in the first few pages of the prospectus are 10 years of condensed financial information, including the expense ratio for each year. The expense ratio is the total of all these fund expenses divided by the average net assets (size of the fund) during the fiscal year.

The statement of operations at the end of the SAI gives a fuller picture of the "other expense" component. Check the directors' fees, for instance. They should not be excessive relative to can-charge management fees; sales charges are just a way to get professionals to help sell the funds. In 1993, the National Association of Securities Dealers (NASD) leveled the playing field among funds with sales charges by adopting rules that limit sales charges as a percentage of new sales plus projected appreciation of a fund's prior assets. These rules are based on the total of front-end, back-end, and asset-based sales charges and take into account whether a service fee is charged.

The regulatory agencies have also attempted to give potential investors a clearer idea of what their charges will be by requiring a table that hypothetically estimates the dollar cost of all charges for all classes, including sales charges and fund expenses, with (and sometimes without) redemption, for a $1,000 investment earning a five percent hypothetical annual return over different time periods. These tables appear early in the prospectus and allow a reader to estimate the differences between classes without a compounding calculator. But they don't take into account variations in performance.

Rule 12b-1 Fees

The Investment Company Act of 1940's Rule 12b-1 established these fees to allow distributors to compensate broker/dealers for selling their funds. Often, a small fee, usually about .25% annually, is funnelled through broker/dealers and a portion paid to the registered representative who sold the fund for as long as the shares are in the fund. In effect, the fee gives the registered representative or financial advisor a kind of "annuity" for the assets the fund company retains. It encourages the representative not to move a client out of the fund, and the funds management firm derives income from the client's investment. For older funds that did not always have these fees, the total 12b-1 percentage actually charged to the fund may not be as high as the maximum allowed because not all the assets of the fund are subject to it.

True "no-load" funds will not have sales charges or 12b-1 fees. The management fee and "other" expenses will make up the total. But some "direct-marketed" funds that look like no-loads, because there are no front- or back-end sales charges to the investor, do have 12b-1 fees in order to offer incentives to brokers.

In the case of some newer classes of shares, B and C shares, an extra fee, sometimes called an asset-based sales charge, usually about .75%, is added to the .25%. This may be kept by the distributor (sales branch of the fund group) to recoup the broker's commission when there was no traditional front-load sales charge for back-end load (B) shares. Or it may be added to the broker's .25% payout as the broker's commission for level-load (C) shares. Let's examine A, B, and C shares more closely as they now appear quite frequently sometimes in the same fund.

Traditional Front-End Loads--Class A Shares

Funds sold by registered representatives have sales charges which are paid to the broker/dealer organization, which passes them down to the individual registered representative or financial advisor as a commission. In the past, the sales charge was always a one-time up-front fee levied as a percent of the investor's total cost. For front-loaded funds, listings in newspapers distinguish the net asset value or price of a share when redeemed (NAV or "bid") and when bought ("offered"). The Wall Street Journal prints these quotes each Monday for closed-end funds and daily for open-end funds.

A required table in the prospectus under "sales charges" distinguishes this charge as a percent of the total original cost from the charge as a percent of the total investment.

Within a "family" of load funds, investors have several options for saving money on traditional front loads. "Break-points" are established where sales charges are reduced as the amount of money invested in any fund in the family increases. Investors may reach these levels through rights of accumulation (amounts already invested in other funds in the same family can be counted toward the breakpoint) or a letter of intent (the investor pledges to reach the breakpoint with subsequent investments before the end of 13 months).

Back-End Loads--Class B Shares

In order to allow investors to buy shares without a front-end load, but to continue to pay brokers a commission comparable to the one on A shares, traditional "sales force marketed" fund groups devised Class B shares. B shares have back-end loads or contingent deferred sales charges (CDSC). These charges are levied only when the investor redeems. The CDSC usually runs on a sliding scale with a higher charge for the early years. Once a shareholder has been in the fund for a certain amount of time--usually six to eight years--the charges disappear. At that time, some funds' B shares are converted to A shares on a dollar- for-dollar basis.

Every day, when fund expenses are accrued from the net asset value of A and B shares, B shares accrue the higher 12b-1 expense. This higher expense may be taken out of income, capital gains, or the net asset value of the fund.

Some of the "loopholes" that allow a shareholder to forgo the CDSC for some funds are death or disability, regular systematic withdrawals and distributions from a retirement plan after age 59 1/2 (the last two are usually limited to a certain percent of the total investment). For some investors, these may be good reasons to buy B shares. The distributor advances the initial sales commission on back-end loaded funds. The additional 12b-1 mentioned above, which lasts until shares are converted, pays these financing costs. When B shares are converted to A shares, the extra 12b-1 is no longer charged.

Level Loads--Class C Shares

The most recent entrants are level loads. These allow for a higher annual payment to the broker (one percent) which begins after the first year. The broker is paid a 1% commission at the time of the sale (which may include the service fee). The usual scenario is for fund groups to use .75% of the first year's one percent charge to the shareholder to recoup this commission. There is also a CDSC to the shareholder, but it is typically only 1% for one year. The one percent total 12b-1 fee, however, continues indefinitely since C shares are never converted to A shares.

Brokerage Costs

The SAI of equity funds includes a section called "Brokerage." The brokerage fees incurred by the fund in the last fiscal year's trading appear there and can be divided by the average net assets in the condensed financial statements to obtain a percentage. Morningstar recommends that this percentage be added to the expense ratio. But keep in mind that these fees come out of the fund before net asset value is determined, so expressing them as a percentage of NAV is a little misleading. Also, even though a fund may have a high turnover ratio or overseas investments with high brokerage costs, good performance may more than justify these expenses of active management.

Other Fees Special Deals And Charges

Many load-fund groups allow investors to repurchase the same dollar amount of a fund they have redeemed within six months without a sales charge. Check to see if dividends can be reinvested without a sales charge--most shareholders reinvest dividends and appreciate this privilege.

Penny-Ante Fees

To defray operational expenses, small fees may be charged on exchanges or wire redemptions. These work to the advantage of the long-term investor, because the fund doesn't have to absorb the cost of paperwork for frequent traders. IRA or other retirement plan trustees usually charge yearly maintenance fees as well as set-up fees and fees to begin a payout schedule on retirement. These will be found in the retirement plan document, not in the prospectus or SAI.

Not Exactly Fees, But...

Check the "Notes to Financial Statements" in the SAI or shareholder report for "unrecognized capital gains," particularly for equity funds. This figure, when netted against depreciation and divided by the average net assets from the condensed financial, yields the percent of each share that would be subject to capital gains if all of the appreciated securities in the portfolio were sold to take profits.

Look in the SAI under "redemptions" to find out whether the fund reserves the right to redeem with a payment "in kind," a distribution of securities in the fund, rather than cash. Generally this applies only to redemptions of $250,000 or more. In a rapidly falling market, shareholders would rather not be paid with securities in the fund. If this option applies, look for assurance of the liquidity of the securities.

Tax Planning Hint

Every year shareholders pay capital gains tax on the amount of gains the fund took that year. The NAV of the shares is reduced accordingly. Capital gains also occur when the fund shares are sold, and the original purchase price is determined through either FIFO or "average-cost" basis, at the taxpayer's option. To reduce hassle, especially for shareholders who dollar-cost average or use checking privileges often, it is better to choose a fund group that provides "average-cost basis" for each shareholder account.