SEC Tackles Fund Fees

As America's major vehicle for retirement savings, and with more than $10 trillion of assets under management, the mutual fund industry no longer suffers the risk of a premature death.

Nor has the 12b-1 fee structure provided the economies of scale promised to investors. Of the 8,129 fund share classes that Morningstar has tracked for the past five years and that currently charge 12b-1 fees, 27.9% saw an increase in the overall expense ratio between 2002 and 2006. And while 25.7% of the 4,395 funds without these fees also saw their expense ratios rise, they typically started with lower expense ratios, Morningstar says.

Shortchanging Investors

As funds grow bigger, the 12b-1 fees harm investors in two specific ways. Because the fee is a percentage of total assets, as the fund acquires more assets, the firm gets paid a larger fee. But if inflows rise, not only doesn't the fund need to spend on marketing, but it actually makes it harder for the fund to trade nimbly, potentially lowering its total return.

Even more galling is the fact that when funds close to new investors and have no further need for promotion, they continue to charge 12b-1 fees. For these reasons, Morningstar wants the fees eliminated.

Just to be clear, the 12b-1 isn't a hidden fee. It's part of the expense ratio and mutual funds specifically break it out in their prospectuses.

Considering that mutual funds collected $11 billion in 12b-1 fees last year, the industry is unlikely to let go of what many consider to be easy money. And the fees aren't just free money for many smaller mutual fund firms; they help these money managers find the new investors they need to survive.

While many people assume 12b-1 fees are being paid to financial advisors in exchange for promoting certain funds over others, that's not always the case. Fund families often use these fees simply to make them more easily available by placing them on mutual fund supermarkets, such as the Charles Schwab(SCHW) platform, where many investors shop.

"I think Cox's cable analogy is a poor one," says Lee Schultheis, chief investment strategist at AIP Funds, a company based in White Plains, N.Y. that runs two mutual funds. "If I live in town with one cable company, I have to use them or get no cable. But there are tons of mutual funds an investor can pick from, so I need to pay to get my name out there."

If the SEC decides to take action, it would first issue a formal proposal, which would then be subject to public comment.

>To order reprints of this article, click here: Reprints