The Securities and Exchange Commission has the mutual fund industry in its sights -- again.
SEC Chairman Christopher Cox has been talking tough about fund governance and fees. Addressing the Mutual Fund Directors Forum, an organization for independent fund directors, earlier this month, Cox said the time has come for a thorough re-evaluation of so-called 12b-1 fees, which are used to cover marketing costs.
Many investor-rights advocates consider this expense a hidden broker's commission, or sales load, and Cox told the fund directors that the fees have outlived their original purpose.
Considering that the SEC took the issue up once before, in 2003, only to let it go, some people are dismissing Cox's statements as a case of "been there, done that." However SEC spokesman John Nester says the issue got placed on the back burner four years ago only because the Commission took on a more pressing issue, market timing of mutual funds, that year.
This time, with shareholder rights becoming a big issue, the likelihood for change is greater.
Created in 1980, the 12b-1 fee arose to solve a specific distribution problem. After the horrible stock market of the 1970s, investors were pulling so much money out of funds that Wall Street feared the industry might not survive.
Assuming the rule would be short lived, the SEC allowed mutual funds to use a percentage of investor assets to offset the cost of advertising and the printing and mailing of prospectuses and other sales literature. The presumption was that this charge would benefit investors in the end. If the advertising worked, more investors would deposit more assets into a fund. By spreading the fixed costs of running the fund over a greater group of investors, the overall expense ratio would fall.
However, "instead of paying for distribution,
the fees quickly became a substitute for front-end loads," Cox said in his speech before the Directors Forum. He said this allowed funds to advertise themselves as no-load funds while still compensating brokers.
Another way the fees moved away from their original purpose was that funds used them to pay for administrative expenses.
"There is a general consensus among the fund industry and regulators that the role of 12b-1 fees has evolved, and we commend the SEC for taking a fresh look at the rule," says Edward Giltenan, spokesman for the Investment Company Institute, the mutual fund industry's national trade association.
Research from the ICI confirms the conventional wisdom: The vast majority of 12b-1 fees, or more than 90%, are used to serve existing shareholders, both on initial purchases and on ongoing shareholder services, such as paying brokers for advice, redemptions and account servicing. Only 2% of the fees are used for promotion and advertising.
"The original premises of Rule 12b-1 seem highly suspect in today's world," Cox said in his speech. "If ever it was justified to indulge an irrebuttable presumption in favor of using fund assets to compensate brokers for sales of fund shares, that time surely has passed."
He said collecting an annual fee from mutual fund investors that is supposed to be used for marketing is "no more consumer friendly than forcing cable TV subscribers to pay a special fee of $250 a year so that the cable company can advertise HBO and Showtime to lure potential new customers."
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.
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
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.