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Mutual Funds

Your $12 Billion Burden

Funds are afraid to tell you what 12b-1 fees are used for, so they resort to euphemisms.

You invest through mutual funds, right? Then let's see if you know the correct answers to the following questions: What's a 12b-1 fee? And how is it almost always used? Now, I know you are a smart, savvy person because only smart, savvy people read this column. But I bet you can't answer both questions -- which is why it's time for the Securities and Exchange Commission to heave 12b-1 fees overboard.

Sales fees in disguise

A 12b-1 fee is an extra charge that funds may tack on to their expenses to cover marketing and distribution costs; it and a service fee can amount to 1% of assets annually. That's usually all you will get the fund companies to tell you. The reason they don't want to tell you more goes to the second half of my question -- namely, that 12b-1 fees are used almost exclusively to pay brokers or advisers who sell you the fund.

Investors pay fund companies $12 billion a year in 12b-1 fees. That's an awful lot of money changing hands, especially when most of those who do the paying don't understand what the fee is or what it goes toward.

The fee gets its name from a section of the Investment Company Act, which the SEC enforces. In 1980, sales of funds were in a slump (the whole stock market was in a slump, for that matter), and the idea was to have investors subsidize advertising and other promotions so that more money would come under management and fees would trend down. The standard 12b-1 fee was about 0.25% of assets per year.


But in no time at all, somebody had an idea: Let's eliminate the up-front sales commission to compensate brokers and increase the 12b-1 fee to make up for it (at the time, no-load funds, which sell shares directly to the public without sales fees, were gaining market share). Presto. Out goes the sales fee and in comes an annual expense ratio swollen by one percentage point to accomplish what the sales fee used to do, which is pay brokers.

This is not the message that broker-sold funds wanted to send to brokers' clients, which is probably why you flunked my test. The disclosure of 12b-1 fees in prospectuses was wrapped in happy talk, and to this day almost invariably you're told that the fee is used (I am quoting a Smith Barney explanation) to "cover marketing and distribution costs and sometimes to cover costs of providing shareholder services." See, they're afraid to tell you, so they resort to euphemisms that nobody understands.

Recently, the SEC held a day of panel discussions on 12b-1 fees to elicit opinions from interested parties about what it should do with them. Predictably, people who work for brokerages or funds sold through brokerages said that there's plenty of disclosure and that 12b-1 fees work just fine. Why am I not surprised?

How to pay brokers

Well, disclosure stinks, and 12b-1 fees don't work just fine. To his credit, SEC chairman Christopher Cox calls 12b-1s "sales loads in drag." Brokers must be paid for their advice. But they should be compensated in a straightforward manner that's clearly understood by all. If the funds that market themselves through brokers won't tell investors the truth about 12b-1 fees -- they've failed to do it now for 25 years -- then it's time to get rid of 12b-1s and return to sales fees, or loads, which are up front and unmistakable. If that makes it harder for load funds to compete against no-load funds, well, too bad.