"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.

"Unless a person closes his eyes and covers his ears and doesn't read the press coverage, information on 12b-1 fees is readily available," said John Collins, a spokesman for the ICI.

While disclosure of 12b-1 fees isn't the problem, clarity and quality of that disclosure is, and that brings us to the second misconception: the function that 12b-1 fees serve.

Though 12b-1 fees began life as an advertising/marketing tool to help a fund gather assets, they have evolved into an ad hoc load, or sales charge. "It's not a temporary thing to drive up assets; it has much more to do with paying brokers or paying

Schwab

(SCH)

to push the fund," said Morningstar's Kinnel.

The ICI agrees with this characterization, and in July it issued a report, "Mutual Fund Distribution Channels and Distribution Costs," in part to explain 12b-1 fees. According to the report, 12b-1 fees are "largely used to compensate sales professionals for investment advice and ongoing service to fund shareholders."

The ICI said 63% of all 12b-1 fees were used to compensate broker-dealers and other sales channels, 32% were used for administrative services, and only 5% were used for advertising and promotional activities, which was the original function.

ICI's Collins acknowledges the need for greater clarity regarding 12b-1 fees, but he defends their evolution as a necessary way to pay the intermediaries who peddle funds. Collins said the evolution of 12b-1 fees into unofficial loads makes the question of why certain funds that are closed to new investors still levy 12b-1 fees a moot point.

"About 63% to 64% of all fund investors use intermediaries, and they have to be paid," Collins said. "When people pay through an intermediary, they have the choice of paying upfront with a load or spreading it out over time."

Mercer Bullard, a University of Mississippi securities law professor and founder of fundholder advocacy group Fund Democracy, doesn't believe 12b-1 fees are inherently wrong, but he would like to see greater disclosure on how they are used.

"When you pay distribution fees such as 12b-1 fees, it's essentially an ignorance meter," Bullard said. The flip side, he said, is that some people can afford to pay for advice and don't mind doing so. "There are conscientious brokers who are providing good advice, and some people need that advice." Other investors might not need that advice, and regulation should "make it clear exactly what people are paying for."

Buy American. Or, Are You Being Served?

While many brokers are indeed conscientious, many fund-industry watchers raise concerns that 12b-1 fees create a misalignment of interests that doesn't serve the individual investor well. At issue, in a nutshell, is cost: If brokers get paid to sell one fund and not another -- such as a low-cost index fund, for instance -- why should they sell the cheaper fund?

"The adviser has a lot to gain in selling funds that charge 12b-1 fees, so there's a conflict of interest right off the bat," said Jeff Kiel, vice president of Global Fiduciary Review at Lipper and point person on Lipper's ongoing study on 12b-1 fees and how reform might take shape.

Once investors understand that their brokers get a commission to sell a particular fund, "there's no way of knowing for certain whether they're selling you the fund for them or for you," said Larry Swedroe, director of research at Buckingham Asset Management and author of

Rational Investing in Irrational Times

.

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Swedroe said the American Funds family has solid funds, but he notes that part of the reason it gets such prominent placement from brokers is that it typically charges front-end loads and 12b-1 fees. "American pays brokers more money to get the shelf space," Swedroe said.

12b or Not 12b?

Another major issue with 12b-1 fees is exactly what falls under the 12b-1 banner. "If fund assets are being spent for distributions, it clearly falls under 12b-1," said Lipper's Kiel. "If they're spending their own resources, then it comes out of profits. That is a very fine line."

It is a line that regulators say many in the industry are clearly crossing. The SEC says funds can use as much as 1% of their assets annually for 12b-1 fees, which typically run about 0.25% to 0.75%. However, under the rules set down by the

National Association of Securities Dealers

, the portion of the 12b-1 fee that goes to marketing and distribution costs can't exceed 0.75% of a fund's assets. Many funds are perilously close to that level and may be leaving items that are clearly related to distribution off the 12b-1 ledger.

One example is a widespread industry practice known as "directed brokerage" -- when mutual funds use trading commissions to pay brokerages to distribute their funds. The compensation to broker-dealers, as an in-depth article in the June

Institutional Investor

noted, "should be done within the context of 12b-1," but it hasn't been, said the SEC's Scheidt. "There are funds that are doing this because they would otherwise be up against a cap."

Scheidt also voices concern about "cross-subsidization" -- when a larger fund's brokerage commission could be used to subsidize a smaller fund within that fund family, for instance.

The SEC is reviewing a variety of such "soft dollar" deals that take place within the industry. "We think soft dollars is a perfect subject to study," said ICI's Collins, who also acknowledged that the industry has to do more work to "reinforce investor confidence."

Cost Matters. Enter the Regulators

Now, regulators have to sort through this muck to determine how to revamp 12b-1 regulations and practices to adjust for the changed mutual fund landscape -- while also cracking down on any malfeasance. Regulators as well as critics and industry insiders acknowledge that that is no small task.

"It would be wonderful to hear that a button could be pushed and all would be revealed," Collins said. "But it isn't that easy."

Nonetheless, reform-minded folks are pressing hard for giving investors greater clarity when it comes to how much they spend when they buy a fund, and how the money is employed. "That's really the role of regulation -- make it clear what you're paying for," said Bullard. "What you should have is a total expense ratio set apart, then a pie chart that shows you how much you pay for marketing."

Swedroe agrees. "I don't have a problem with Fidelity charging 1.5% for a fund. I have a problem with the investor being stupid enough to pay 1.5%," Swedroe said. "Let the consumer judge as long as they're giving clear data. Right now, funds costs are a black box meant to obfuscate."

Meantime, Kinnel noted that 12b-1 fees shouldn't be something investors automatically read as a red flag. "The bottom line is still expense ratio," Kinnel said. "There are some shops that have 12b-1 fees and still have lower costs. American Funds has 12b-1 fees and still gives people a good deal."

While 12b-1 reform may not mean much to most investors, they should understand how much they stand to lose as seemingly nickel-and-dime costs eat into their long-term returns. Consider the difference to an investor's portfolio from a meager 0.5% annual distribution fee.

After 40 years, a $10,000 investment that returns 7% annually would leave you with $149,743. The same $10,000 investment -- minus the 0.5% annual distribution fee -- would be worth $124,160, 17%, or $25,583 less.

"Some funds that have built very high marketing costs into their system are awfully pricey for what may well be a low-return environment," said Morningstar's Kinnel. "You could hide it when you were getting 15% a year in stocks and 10% in bonds, but not anymore."

Of course, industry professionals can't even agree on whether fund costs are rising or declining. Vanguard's John Bogle laments that costs, thanks in part to 12b-1 fees, are soaring: He says the average fund's expense ratio was 0.97% in 1981, now it is 1.6%. The ICI, meanwhile, notes that overall fund costs have declined significantly since that time period.

Who's right? In a way, they both are. Expense ratios are indeed on the rise. ICI's numbers, meanwhile, include loads, front-ends and back-ends, in their number. "Pull out the loads, and it becomes much more stark," Kinnel said.

The ICI also measures costs by asset-weighting funds. In other words, a tiny micro-cap fund that has a 2.4% expense ratio doesn't carry the same weight as an index fund that sports a 0.2% expense ratio, such as those run by Bogle's firm.

In this instance, at least, Bogle's low-cost index funds are the industry's friend.

What Do Investors Care?

Of course, the most sustainable reform movement might have to come not from regulators in Washington or at fund firms in Boston, Chicago and Denver, but on Main Street. An increasing migration among fund investors to lower-cost funds may speed any change.

"This comes down to forcing the individual investor to read their fund disclosures, which isn't an easy task," said Lipper's Kiel.

Bullard said that whether by legislation or investors voting with their wallets, the fund industry has to change its cost structure, suggesting a move to an asset-based fee model might be the template. "In the long term, their business model is dead."

Editor's note: Stephen Schurr will be appearing on CNBC's "Kudlow & Cramer" at 8 p.m. EDT tonight to share his insight on mutual funds.

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