Unit trust 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

I hate surge pricing. It is the most brutal when I most need that ride, or when I'm drenched from head to toe from the sudden downpour.

Surge, or dynamic pricing, has become pretty efficient for all modes of transportation. If you have not yet booked your Chinese New Year getaway, that flight to Phuket is now 4x the normal price, not to mention the surging hotel prices too.

We live in an increasingly efficient world, where we can pay huge premiums for the same experience because of the almost immediate reflection of the laws of supply and demand in price.

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 fund as your friend, but paying different fees because you've invested in different share classes. The funds' objectives and underlying investments are the same 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 fund 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: A guide to getting ripped off: A dictionary on unit trust fees

Unit trusts/mutual funds commonly have several share classes, but these can generally be categorised into retail or institutional clean share classes. For example, let's say there is a mutual fund called Singapore's Money Making Fund (MMF) with the following share classes:

• Class A is a retail share class with a minimum investment amount of $1000, and a total expense ratio of 2%.
• Class B is a retail share class with a minimum investment amount of $5000, and a total expense ratio of 1.7%.
• Class I is an institutional clean share class with a minimum investment amount of $10,000,000, and a total expense ratio of 0.5%.

There is no naming convention for unit trust/mutual fund share classes in Singapore, so you need to read the Prospectus and Product Highlight Sheet carefully to get a better understanding of which share class you are investing in.

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

The answer lies in sales incentives. One of the key differences between institutional and retail share classes is the trailer fee, which is embedded in the total expense ratio of a retail share class. This is essentially a sales commission that is paid on a recurring basis by the fund manager to the distributor/banker/broker that sold you the fund. This includes popular online fund distribution platforms.

Because of its lower fees, the institutional clean share class inevitably generates the highest returns of the different share classes. Unfortunately, there is usually a high minimum investment amount required to invest in the institutional clean share class, which is typically around $10,000,000. The institutional clean share class is usually targeted towards pension funds, hedge funds or large family offices.

Fees matter, a lot: Remember that a difference in fees of 1% equates to over 300% of return difference after 30 years (assuming a global stock market return).

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