Mutual Fund Sales Practices

The pricing arithmetic

Net asset value per share is total assets minus total liabilities, divided by shares outstanding. It is what the portfolio is worth per share.

The public offering price is NAV plus the sales charge. Because the sales charge is quoted as a percentage of the offering price and not of NAV, the formula runs:

POP equals NAV divided by (one minus the sales charge percentage).

A fund with a NAV of $9.40 and a 5 percent sales charge has a POP of 9.40 divided by 0.95, which is $9.89. Note what happens if you take the wrong route: adding 5 percent to $9.40 gives $9.87, which is wrong, and it is wrong in exactly the direction the exam's distractor will offer you.

Running it backwards, the sales charge percentage is (POP minus NAV) divided by POP. With a POP of $9.89 and a NAV of $9.40, the charge is 0.49 over 9.89, which is 4.96 percent — round to 5.

Redemption is at NAV, sometimes reduced by a contingent deferred sales charge. Under the 1940 Act, the fund must pay redemption proceeds within seven days.

For a no-load fund, NAV and POP are the same number, which is the quickest way to spot one in a quotation.

Sales charges and the reductions

FINRA Rule 2341 caps the aggregate sales charge on investment company shares, and the cap is conditional rather than flat. The maximum of 8.5 percent of the offering price is available only to a fund that offers a specified package of features: dividend reinvestment at net asset value, rights of accumulation, and quantity discounts at prescribed breakpoint levels. A fund that omits one of them faces a lower ceiling — the rule steps the maximum down through 8.0, 7.75, 7.5 and 7.25 percent depending on which features are present and whether service fees are paid. Funds with asset-based sales charges are capped separately.

In practice almost no retail fund charges anything near 8.5 percent today. The number remains on the exam because it is the statutory ceiling and because the conditions attached to it are the substance.

A breakpoint is a purchase amount at which the sales charge percentage drops. A schedule might charge 5 percent below $25,000, 4.5 percent from $25,000, 4 percent from $50,000 and so on. Breakpoints are available to an individual, to a customer with their spouse, to a parent purchasing for a minor child, and to certain fiduciary accounts purchasing for a single beneficiary — but not to an investment club and not to two unrelated customers pooling purchases to reach a level.

A letter of intent lets a customer receive the lower charge immediately by committing in writing to reach a breakpoint within thirteen months. The fund holds shares in escrow to cover the difference if the customer does not complete; if they do not, the higher charge is applied by liquidating enough escrowed shares. A letter may be backdated by up to ninety days to include a recent purchase, which shortens the remaining period accordingly.

Rights of accumulation give the lower charge on new purchases based on the total already owned plus the new money, valued at the greater of cost or current value. Unlike a letter of intent, they carry no time limit and no commitment, and they apply prospectively rather than retroactively.

All of these operate at the fund family level — combining across two unrelated fund families does not reach a breakpoint, which is the seed of the switching violation below.

Share classes and 12b-1 fees

Rule 12b-1 under the 1940 Act permits a fund to pay distribution expenses out of fund assets under a written plan approved by the board including a majority of the independent directors and reviewed at least annually. The fee is an ongoing charge borne by all shareholders, and it is the mechanism behind the share class structure.

Class A shares carry a front-end sales charge, offer breakpoints, and have low ongoing 12b-1 fees. Because the front-end charge is paid once and the ongoing cost is small, Class A is generally the cheapest class for a large investment or a long holding period — and the class where breakpoints actually help.

Class B shares have no front-end charge but a contingent deferred sales charge that declines each year to zero over a period of several years, plus a higher ongoing 12b-1 fee. They typically convert to Class A after the CDSC period, at which point the higher fee stops. Class B has largely disappeared, partly because it was so frequently mis-sold on large purchases where Class A breakpoints would have been cheaper.

Class C shares carry a level load: little or no front-end charge, a small CDSC for the first year, and a permanently higher 12b-1 fee. Class C is generally cheapest for a short holding period and the most expensive for a long one, because the annual fee never stops and there is usually no conversion.

The selection rule the exam wants: large amount or long horizon points to Class A; short horizon points to Class C; a large purchase steered into Class B or C to avoid triggering Class A breakpoints is a violation, not a preference.

A fund may describe itself as no-load only if its asset-based charges stay within the limit FINRA Rule 2341 sets for that description. A fund charging a substantial 12b-1 fee is not a no-load fund merely because it has no front-end charge.

The named violations

Four practices have their own names and their own rules, and each is a way of taking sales charge that the customer need not have paid.

Breakpoint sales. FINRA Rule 2342 provides that no member shall sell investment company shares in dollar amounts just below the point at which the sales charge is reduced on quantity transactions, so as to share in the higher sales charge. A customer investing $24,000 where the breakpoint sits at $25,000 must be told about the breakpoint. The violation is complete whether or not the representative intended it — the duty is to inform.

Selling dividends. Encouraging a customer to buy just before an ex-dividend date on the argument that they will 'get the dividend' is prohibited under Rule 2341, because there is no benefit: the NAV drops by the distribution amount, and the customer has simply bought an immediate tax liability. Presenting an upcoming distribution as a reason to buy is a misrepresentation.

Switching. Moving a customer from one fund family to another, incurring a new sales charge, without a documented reason why the new fund is better suited. Because breakpoints and rights of accumulation work only within a family, switching also destroys accumulated discounts. The regulatory presumption is against it, and the burden is on the firm to show the customer benefited.

Unsuitable share class recommendations. Putting a large or long-term investment in a class whose ongoing costs exceed the alternative. Regulation Best Interest applies to the class choice as much as to the fund choice, and cost is an explicit factor.

One more idea to hold alongside: dollar cost averaging is investing a fixed dollar amount at regular intervals, which buys more shares when prices are low and fewer when high, so the average cost per share comes in below the average of the prices paid. It is a legitimate technique and a common exam calculation. It is not a guarantee against loss in a declining market, and describing it as one is its own misrepresentation.