'Unjustified' Fund Fee Faces Extinction

People who favor index-style mutual funds and exchange-traded funds wage a holy war on fees, arguing that the more you pay in expense ratios and other fees, the more it undermines your returns. Both are correct.

Millions of investors pay higher-than-minimum fees, compensating brokers and financial advisers for their help in choosing investments. Professional help comes at a price. But what fees are reasonable?

The Securities and Exchange Commission trained its sights on what it considers to be one of the least justifiable fees, the 12b-1 fee. This fee cost investors more than $9.5 billion in 2009, according to the Investment Company Institute. And sometimes as high as 1% of the investor’s holdings a year, it pays for a variety of costs incurred by the fund company, including broker’s commission, advertising, sales and marketing.

The fee’s defenders claim it ensures small investors get the advice they need.

But critics feel it’s wrong to charge fund shareholders for expenses that add nothing to the value of their holdings. Long-term shareholders pay the 12b-1 fee year after year, regardless of whether they receive long-term investment advice. In effect, they’re subsidizing the fund company’s marketing to other, less than savvy investors.

The ordinary expense ratio, in contrast, covers expenses like salaries for analysts and stock pickers — people trying to enhance the fund’s performance. This too is paid every year, but the long-term shareholder continues to get a benefit, assuming those managers do a good job.

The SEC has proposed scrapping the old 12b-1 rule in favor of one that limits the annual marketing and service fee to 0.25% of the investor’s holdings. This move would make fee disclosure clearer. The SEC says its proposals, currently in the midst of a 90-day comment period before a final vote, would enhance competition, allowing brokers to set their own sales fees rather than rely on those dictated by the fund companies.

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