False Advertising: The Truth About 12b-1 Fees

"Overhaul 12b-1 fee regulation!" isn't exactly a rallying cry that will unite the investing masses.

People don't pay attention to obscure Securities and Exchange Commission bylaws. However, tell investors that the amount they paid in 12b-1 fees rose to $9.38 billion in 2002 from $1.23 billion in 1990, and they'll sit up and listen.

In the confusing alphanumeric soup of fees and share classes, probably no item is more misunderstood than the 12b-1 fee. The SEC adopted 12b-1 fees in 1980 as a way to let struggling funds use a small portion of their assets, on a short-term basis, to kick-start the marketing of the funds and counter redemptions, which in theory would lead to more assets, economies of scale and lower overall costs.

Of course, the rule was written rather nebulously, and the 12b-1 fee, which is gradually eating away at investors' retirement loot, has become "a loophole that the fund industry has driven a fleet of trucks through," said Morningstar director of fund research Russ Kinnel.

By all counts, 12b-1 fees -- originally meant as a short-term way for funds to pay for advertising and such -- have become a substitute for a front-end sales load. "A large number of funds use 12b-1 fees in this way," said Doug Scheidt, the associate director of the SEC's Division of Investment Management. Indeed, 11,481 funds, or 66% of the 17,366 funds that Lipper tracks, assess a 12b-1 fee.

To Vanguard founder John Bogle and other fund industry critics, 12b-1 fees are a big reason why fund expenses are on the rise and are the mortal enemy of investors' portfolios. These critics highlight inherent conflicts of interest that hurt individuals. However, to the Investment Company Institute, which represents the fund industry, 12b-1 fees serve a vital function to individuals and have actually helped drive fund expenses down over the past 20 years. As for the SEC and other regulators, 12b-1 fees are about to come under review and an eventual overhaul. For individual investors, 12b-1 fees merit closer scrutiny so people can see if they're paying them -- and whether or not they should be.

Put the Load Right on 12b

While the debate about 12b-1 fees gears up, there are two related misconceptions that have mucked up the picture in the early going.

The first misconception is that 12b-1 fees are "hidden." In fact, 12b-1 fees are prominently disclosed in the fee table and throughout a fund's prospectus, the SEC's Scheidt notes. Also, 12b-1 fees are included in a fund's overall expense ratio -- so it is not a separate levy slapped onto individual investors.