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Under the Heat, B Shares Start to Fizzle

B-shares are beginning to show signs of wear. At least three mutual fund advisors have recently decided to at least temporarily pull the plug on selling B shares. These include JPMorgan of New York, Quaker Funds of Valley Forge, Pa., and Bank of Hawaii of Honolulu, advisor to the Pacific Capital Funds.

Sales of mutual fund B shares and their related expense structure have come under increased regulatory scrutiny recently. Insiders speculate that the heyday of B shares is over. "Fund families dropping B shares is a good thing in the long run for investors," said Dr. Edward S. O'Neal, a professor at the Babcock Graduate School of Management at Wake Forest University in Winston-Salem, N.C. "In some cases, B shares appear to offer similar returns as A or C shares. But there are very few cases where B shares are clearly the best investment," he added.

Unhappy investors have even sued at least one fund sponsor. This past February, Morgan Stanley was hit with a landmark, potential class action lawsuit alleging that its brokers consistently and inappropriately invested client assets in expense-laden B shares (see MFMN 3/10/03).

Citing concern that investors don't fully understand the differences among share classes, in late June the NASD issued an investor alert that explained share class variations.

That investor alert was the final push, if not the overwhelming reason, that on July 15 the Quaker Funds suspended sales of B shares on all nine funds through at least the end of this year, said Kevin J. Mailey, president of the $320 million fund group. Only participants in 403(b) plans for not-for-profit organizations will still be allowed to buy B shares.

The prime reason for sidelining B shares was the significant $1 million capital commitment the Quaker's advisor faced to keep those B-shares alive, Mailey said. B shares don't carry front-end sales charges from which fund sponsors can pay commissions to selling intermediaries. Instead, 100% of an investor's assets are invested into the fund, and the sponsor must reach into its own pocket to advance commissions, and then recoup that expense through 12b-1 account fees or contingent deferred sales charges that kick in if an investor redeems within a few years.

Alternatively, an advisor can seek the financial assistance of a B share financing company. But these finance firms are having their own troubles with dwindling B share sales, resulting in thinner 12b-1 fees.

To B or not to B?

For the Quaker Funds, B share financing wasn't an option. Finance companies said they weren't interested in the pint-sized fees that the small-fry fund group generated, Mailey said. A careful review of sales revealed that between 5% and 7% of all new assets flowed into B shares, he added. Those meager B share sales just didn't justify the necessary capital investment. So the firm discontinued selling them, at least for now. "We're making a business decision that the amount of capital required would be better spent in other directions," he said.

Overall, investments in B shares represent only 8% of all mutual fund long-term assets, according to Financial Research Corp. of Boston. No-load shares hold the lion's share, with 55% of all assets, and A shares represent a significant 32.5%. As a percentage of all types of load shares, A shares still reign supreme, accounting for 72% of the load share market, while B shares come in a distant second representing 19%.

That obvious lack of enthusiasm for B shares was one of the main reasons Bank of Hawaii, advisor to the $2 billion 11-fund Pacific Capital Funds group, also suspended shares of its B shares on June 1, said Bill Henry, president of Pacific Capital Funds.

The firm had seen sales to its B shares drop off by a whopping 80% last year, he added. The conjecture is that B shares, which have gotten most of their traction from equity fund sales, had simply fizzled in recent times as investors raced into bond funds in light of the bear market, said Andrew Spencer, EVP of Pacific Capital Funds.

But B shares also fell out of favor when the fund group began offering a wrap product to brokers and trust officers, which utilized the funds' no-load/no 12b-1 institutional shares, Henry said. The final straw was when the firm's B share financier demanded onerous terms at renewal time. Bank of Hawaii chose to allow the B share financing agreement to lapse.

Even bigger players are taking a hard look at B shares. In an SEC filing last month, JPMorgan announced it was suspending sales of both B and C shares on seven of its funds. Both share classes, with a tiny combined $1.7 million in assets, will be merged into A shares, said spokeswoman Gabrielle Gagliardo. "The changes are part of our ongoing business strategy," she added.

Not all fund companies are weeding their share classes. At Putnam Investments of Boston, B share sales haven't decreased relative to the sales of other share classes, commented Laura McNamara, a Putnam spokeswoman. "Putnam will continue to offer a full range of share class pricing (including A. B. C, M and R shares) to accommodate the needs of investment advisors and their clients," she said.

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