Why Mutual Fund Fee Reform Misses the Mark

It has taken the Securities and Exchange Commission decades to get around to addressing 12b-1 fees, those arcane charges that show up as part of your mutual fund’s expense ratio but that are often used as a substitute for an upfront sales load. However, it will take you just minutes to see how the SEC’s proposed overhaul of these fees falls short.

To be sure, the SEC’s proposed rule on the charges is infused with good intentions. It would require funds to better disclose how they use 12b-1 fees, which are often called “marketing” or “distribution” expenses but are in part paid to brokers as an ongoing sales commission. And it would limit the total an investor could pay in these fees over time in a given fund.

But the proposal leaves plenty of leeway for fund companies to continue to compensate brokers and advisers for their sales efforts in inscrutable ways. One way a fund company will continue to be able to do so is by paying brokers and advisers out of its own pocket. “The SEC has said that a fund’s adviser [the firm that manages the fund] can pay for distribution expenses out of its own profits, as long as those profits aren’t excessive,” says Ruth Epstein, a partner in the Washington, D.C., office of Dechert LLP, a law firm. The current proposal reinforces this option for compensating salespeople, even though these profits come, at least in part, from the management fees you and I pay as fund investors. Such compensation is sometimes referred to as “revenue sharing.” Fund advisers will also continue to be able to pay out of their own coffers to land on brokers’ “preferred” lists.

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Fund-industry insiders are responding that any fee scrutiny is better than no fee scrutiny. “Anything the industry can do to bring down costs helps the long-term investor,” says Todd Rosenbluth, a mutual fund analyst at Standard & Poor’s. “This will decrease some of the bureaucracy surrounding 12b-1 fees,” adds Mellody Hobson, president of Ariel Capital Management, which runs the Ariel funds.

But the SEC’s good intentions may amount to little more than that. Should the rule be enacted, fees will come down only for certain investors -- mainly those who own a fund’s Class C shares, which normally levy annual 12b-1 fees of 1%. Once C-share investors have paid 12b-1 fees comparable, in percentage terms, to the maximum sales charge on a fund’s highest-load shares (usually Class A shares, which levy upfront commissions and, typically, annual 12b-1 fees of 0.25%), their shares would convert to a class that charges 12b-1 fees of no greater than 0.25%. For example, if a fund’s A shares charge a 5% load upfront and its C shares charge 1% per year in 12b-1 fees, the C shares would convert to A shares after five years. The total amount of commissions paid by investors in the different share classes will likely vary depending on a fund’s performance.

Sounds complicated, but it’s similar to the way Class B shares already work. B shares typically combine a gradually declining redemption fee with annual 12b-1 fees of 1% and automatically convert to A shares after a certain number of years. However, some fund companies have stopped offering Class B shares to new investors, and money has been flowing out of these shares over the past decade.

If enacted, the proposed changes won’t affect very many investors. For every $1 currently invested in C shares there’s $5 invested in A shares. Moreover, investors hold mutual fund shares for just over three years on average -- few stick around long enough for that fee cap to kick in. Investors who buy only no-commission funds (which may not levy 12b-1 fees in excess of 0.25% annually and still call themselves no-load) won’t be affected.

On the other hand, some advisers have been speaking out against the rule, which suggests it could be poised to make a real dent in their remuneration. As the Wall Street Journal and Investment News have reported, some advisers complain that the new regulations will push more investors toward fee-only planners, whom, they argue, investors of modest means may not be able to afford.

The flaw of such reasoning is plain: It implies that such small-time investors were happy enough to pay for financial advice when they paid for it through an obscure (and presumably lucrative) commission, but that these same investors will balk once they see the true cost of this advice in dollars. “Brokers can’t come out and say, ‘We want to continue to make this much money on commissions,’ so instead they have to make the argument that investors will be penalized” says Susan Fulton, founder and president of FBB Capital Partners, an advisory firm in Bethesda, Md.

The lesson for investors is that -- regardless of whether this proposed rule is enacted -- you must always be vigilant in monitoring the costs of your funds and of financial advice. A 90-day comment period must pass before the SEC takes further action.

Another aspect of the SEC’s proposed changes looks far more promising. If enacted, the rule would allow brokers to compete on mutual fund sales loads -- similar to the way they compete on commissions for stock trades.

The idea is that load-fund families, such as Oppenheimer and BlackRock, would have the option of opening a new share class -- say, F shares -- for which brokers could set loads as they see fit. This might allow unscrupulous brokers to rip off unsophisticated investors. But it could also allow discount brokers, such as Fidelity, TD Ameritrade and Schwab, to compete aggressively on commissions.

The rule would be one more chink in the wall dividing “load” and “no load” funds. The division has already begun to crumble in recent years as load-fund shops such as Pimco and Eaton Vance have started making no-load share classes of their funds available to do-it-yourself investors. The question is whether or not fund shops that have a longstanding commitment to the broker-sold business model, such as the American Funds and Franklin Templeton, would choose to offer shares that might undermine that model. Representatives of several large load-fund shops say it is too soon to comment on the issue.

One source, who asks not to be identified, compares the proposed rule to the deregulation of stock-trade commissions in 1975. Before deregulation, brokers charged commissions based on a schedule set by the exchanges. Fast forward 35 years, and you can find a few brokerages that charge nothing for trades and many others that charge next-to-nothing.