Mutual fund investing: On surge pricing, institutional clean share classes, and sales incentives

Institutional clean share classes: What investors need to understand about different share classes before investing in mutual funds

This week's headline news in Hong Kong has been around plans by 1,000 taxi drivers to join a potential strike against car hailing giant Uber's threat to the industry.

While there are certainly merits to the convenience and seamless digital experience brought by car hailing service. There is one thing that I loathe about it - surge pricing. And it is the most brutal when I most need that car ride, or when I'm drenched from head to toe from the sudden downpour.

Unfortunately we live in an increasingly efficient world, where we can pay huge premiums for the same experience as the result of the immediate reflection dynamic changes to supply and demand, such as that car ride which might be 3x more expensive under the black rainstorm warning.

It seems rather unfair, but it works in our capitalist world.

Mutual fund (unit trust) investing is similar yet different. We get the same experience but could pay drastically different fees.

Even more annoyingly, this is due to sales incentives rather than the laws of supply and demand.

You could be investing in the same mutual fund as your friend, but paying different fees because you've invested in different share classes. The funds' objectives and underlying investments are identical across all the share classes and managed by the same fund manager, but each share class has a different fee (expense ratio) and perhaps minimum investment requirement.

To make it even more confusing, the bank or broker that you buy the unit trust from may also only be able to offer you certain share classes, depending on the distribution agreement that they have with the fund house, or their internal rules to maximise on sales commissions (trailer fees).

Read more: Unit trust investing in Hong Kong: The pains of trailer fees

Mutual funds/Unit trusts commonly have several share classes, but these can generally be categorised into retail or ”clean” institutional share classes. 

There is no naming convention for mutual fund/unit trust share classes in Hong Kong, so you will have to read through the Prospectus and Product Factsheet to carefully conduct some detective work to find out which share class you are investing in.

Below is a real life example to the starking more than 60% difference in fees between the retail share class (Class E, total expense ratio at 1.45%) and the institutional clean share class of the PIMCO GIS Income Fund (Class I, total expense ratio at 0.55%), which you can access through Endowus Hong Kong. 

Devil in the details: trailer fees

The institutional clean share class carries the lowest fees (total expense ratio) of the different share classes of the same mutual fund/unit trust. Why is there a significant fee difference?

The answer lies in sales incentives. One of the key differences between institutional and retail share classes is the trailer fee (also called trailing commission), which is embedded in the total expense ratio of a retail share class and is paid on a recurring basis by the fund manager to the distributor/banker/broker that sold you the mutual fund as long as you continue to hold the fund. This includes popular online brokerage platforms who often market themselves as “zero commission” channels.

The retail share class is essentially a way for retail fund distributors to collect extra “hidden” commissions from investors, on top of “non-hidden” charges such as subscription fees, platform fees etc. 

Read more: A guide to mutual fund fees in Hong Kong

Fees matter, a lot

Because of its lower fees, the institutional clean share class inevitably generates the highest returns of the different share classes. Unfortunately, traditionally there is usually a high minimum investment amount required to invest in the institutional clean share class, typically close to HK$50,000,000 or more. The institutional clean share class is usually targeted towards pension funds, hedge funds or large family offices.

Fees matter, a lot: Remember a $100,000 investment in a fund earning 7% per annum , but with a fee of 1.75% versus 0.75% will deprive you of 152% in returns ($152,000) over 30 years.

Accessing institutional share class funds through Endowus

At Endowus, we believe all investors deserve access to Best-In-Class investment products at the lowest achievable cost. This is why we built our Endowus Fund Smart platform and Endowus model portfolios using Best-In-Class institutional clean share class funds, which are now available to retail investors in Hong Kong in ticket sizes of as low as HK$500.

In cases where the institutional share class is not available, Endowus will provide 100% Cashback on trailer fees we receive from fund managers to our clients, achieving the same effect as accessing the clean institutional share classes. 

This also removes any potential conflict of interest, as we are not incentivised to recommend to you a particular fund that pays us the highest trailer fees.

Click here to get started on your investing journey with Endowus Hong Kong today. If still in doubt, feel free to schedule a free consultation with our SFC-licensed client advisors to start curating a personalised investment plan utilising institutional clean share class funds.

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