Mutual Fund Fee Makeover

The NYT featured an article titled “Mutual Fund 12-b1 fees Could Get a Makeover.” Here are some highlights:

Many investors might skip over the line on their mutual fund disclosure statements that says, ”12b-1 fee.”

They might want to start wondering what’s behind that label. These fees are the money that many funds collect to offset a variety of expenses, from advertising to broker’s commissions. They can cut into investors’ returns.

The fees, whose name is a legacy of the Securities and Exchange Commission rule that created them three decades ago, brought in $9.5 billion for fund companies last year. That amount is equal to 18 percent of all fund expenses, not counting sales charges, according to the fund industry’s Investment Company Institute. The 12b-1 fees typically amount to around $2 a year for every $1,000 invested.

The SEC is questioning whether investors should be paying them. Chairwoman Mary Schapiro has asked her staff to present a recommendation on 12b-1s for the commission to consider this year. Schapiro’s predecessors have studied possible 12b-1 changes, but there haven’t been any overhauls.

Schapiro sounds serious. ”Investors may have no idea these fees are being deducted, what services they are paying for, or who they are ultimately compensating,” she said in a speech last month.

Broadly, the SEC says 12b-1s are supposed to cover fund distribution, and in some cases, shareholder services. These expenses frequently aren’t covered by the sales charges that many funds assess, or the management fees all funds charge for overseeing an investment portfolio.

And a fund that doesn’t compensate advisers through a 12b-1 is probably collecting that money elsewhere. Increasingly, 12b-1s have become revenue substitutes for the growing number of funds that don’t charge ”loads,” or sales fees. A fund touting itself as ”no-load” may be hitting you up in the form of a 12b-1 or another expense after you buy in.

”It doesn’t make sense to use 12b-1s alone as a tool to screen out funds,” says Mercer Bullard, president of Fund Democracy, a fund shareholder advocacy group. Bullard is a former assistant chief counsel at the SEC.

Besides compensating brokers, 12b-1s were created to help a then-struggling fund industry recover from tough times in the 1970s. The thinking went like this: 12b-1s could help funds cover marketing and advertising costs to lure back investors. The more assets the funds have, the more efficiently they’ll be run, leading to expense cuts that can benefit all. Eventually, many funds could become big enough that their governing boards would decide to stop charging 12b-1s.

But it often hasn’t worked out that way, because of the varied arrangements that fund companies use to compensate brokers selling their funds. Take American Funds, which assesses 12b-1s at its biggest funds. That includes the nation’s largest stock fund, Growth Fund of America, whose biggest share class (AGTHX) charges a 12b-1 fee of 0.24 percent. That’s about one-third of overall expenses at the 36-year-old fund, whose assets now total $156 billion.

American Funds spokeswoman Maura Griffin said the company views 12b-1s ”in part as a method of compensation for transaction-based financial advisers for their ongoing advice and service to their clients.”

ICI, the industry group, says scrapping 12b-1s would eliminate incentives for advisers to continue serving clients, for example, by giving them investment advice. A 2005 study by ICI found that only 2 percent of 12b-1 fees supported advertising and other promotions. About 40 percent went to advisers for initial sales, with 52 percent for ongoing support.

”The vast majority of 12b-1 fees are for compensating advisers for services they provide, and investors want,” ICI chief economist Brian Reid says.

But the National Association of Personal Financial Advisors — whose members are compensated on a fee-only basis without commissions — applauds Schapiro’s 12b-1 review.

”When you peel back the layers, you see that some mutual fund companies are making a profit on 12b-1 fees,” says NAPFA Chairman William Baldwin.

Schapiro says the fees may have made sense when they were introduced in 1980. But now, she says, ”it is past the time to reassess their need and their effectiveness.”

I agree that the original idea of 12b-1 funds may have had merit, but an overhaul of this old law is in order especially if these fees are no longer used for their intended purpose.

To increase profits for mutual fund companies in a roundabout way, that is not transparent to the investor, is simply not acceptable. Additionally, if you purchase such a fund directly, and some of these fees are at times (at the fund’s discretion) used to pay a commissioned broker, then you should not be paying for “services” you don’t receive.

According to the above article, 12b-1 expenses seem to have turned into a kind of a slush fund for mutual fund companies to be used as they see fit. In today’s environment of transparency and disclosure, this is an area that definitely needs to be improved.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
This entry was posted in Uncategorized. Bookmark the permalink.