The 12b-1 fee is the obscurely-named outrage that dings investors in mutual funds so that management can market the fund. In 1980, the mutual fund industry successfully lobbied the SEC to allow this fee with the justification that a larger fund lowers the expenses for everybody. In theory, the logic is right when you take into account the same expenses being spread over a larger pool of assets. However, there are several problems with this thinking:
1) A larger fund does not necessarily become easier to manage. Over the last 25 years, multi-billion dollar mutual funds have become the norm. When I worked for Fidelity in the early 1990's, the largest fund in the world at the time, the famous Fidelity Magellan, was around $25 billion. Even then, concerns had set in that it had become too large to outperform the market. Since then, Magellan's size has been a deterrent. Like a large barge, meaningful changes in its trajectory take too long to implement. Of the funds with in excess of $5 billion, most of them track the S&P 500 minus their outsize fees because that is all they can do. Yet, even these large funds continue to charge the 12b-1 fee.
2) Certainly, if a fund is closed to new investors (which makes the fund easier to manage), the existing shareholders should be relieved of the 12b-1 fee. But, as of November 2003, when the House introduced HR 2420, 139 closed funds still levied the fee. The funds are charging a marketing expense for funds that no longer accept new investors. Huh? Like crack cocaine, fund management firms just became addicted to the stream of poorly disclosed fund fees.
3) A fund is able to call itself "no load" as long as the 12b-1 fee is 25 basis points (.25%) or lower, although many funds charge the max-allowable 100 basis points.
In practice, the 12b-1 fee is partially shared with advisers who tout the funds, and the rest is gravy to the fund firm. They do not disclose this fee as part of their management fee, and even obscure the fee in their overall expense ratio.
Two thirds of mutual funds charge this fee, and I would bet that few investors know about it. HR 2420, introduced by congressman Mike Castle of Delaware, sought to ban this fee for closed funds only, and even that was stalled in the Senate, despite broad bi-partisan support and backing from the white house.
Economies of Scale Mean Lower Costs For Shareowners. On paper, the explanations sound great, but let us look at the evidence. What expenses are involved in running a fund?
1. Trading Commissions. This should be the primary benefit, but the evidence shows that mutual funds are not getting better prices than any ordinary investor can get. In fact, in many cases where soft dollar arrangements are concerned, they are getting far worse. Before commissions were de-regulated in the 1970's, this factor was reasonable. Getting cheaper commissions meant having a technology and trading infrastructure that was too prohibitive for the small investor. Today, this technology is available to everybody. Discount brokers use ECN's to execute their customers? trades, just like the mutual funds do.
2. Shareowner Communication such as statements, proxies, confirmations, etc. There are expenses for printing and mailing these confirmations to be certain. However, proxies are only necessary because of the mutual fund structure. Statements and confirmations are required by regulations. Your broker sends these for free as part of the commission you paid.
3. Management Salaries. Certainly, these cost money, but the evidence shows that shareowners are paying way more for these than they should. A multi-billion dollar fund manager is likely to have a salary in the high six figures if not in the seven figures. Who sets these salaries? The fund board. Although they are supposed to have a fiduciary duty to protect investors, their salaries are probably determined by two factors: their achievement versus the benchmark and their ability to attract assets. As we have seen, the latter factor has been more bane to existing shareowners than benefit. So, why is he worth millions, especially when most of them fail to reach their benchmarks?
4. Administrative Expenses such as office space, office technology, travel, lodging, meals for staff, etc. Often, these expenses get paid by third party vendors in exchange for trading flow, and investors end up paying far more for these items than they should. Furthermore, there is no rational reason for the fund manager to be parsimonious with his shareowner's money. These expenses should come out of the management fee, but instead they are passed on to investors. So, ask your fund operators if they are flying coach instead of first class.
5. Stock Research. This would be a worthwhile expense if the research enabled the fund to outperform, but as we have seen, it has too seldom been a difference maker. In the last few years, the public has seen how little value professionals place on this research. In fairness, it's difficult for any buy-side investor to know if what is coming out of analysts? work is worthwhile or fluff.
The second reason for a fund's existence, as touted by the industry, isnstant diversification. I am absolutely on board with diversification being necessary and worthwhile. But, is getting diversification within the structure of a mutual fund worth the two percent or so that most investors are paying in management fees and expenses? The answer here is less clear, so one must look at the alternatives. Index funds provide the ultimate diversification at a much lower cost. Exchange Traded Funds (ETF's) provide diversification, although many of these charge a management fee as high as 1.5 percent as well. Most of them charge well below one percent, and the biggest ETF's are in line with the least costly index funds. On this point, the question hinges on whether active management is worth getting dinged several times what one would be charged otherwise with passive management. As we've seen, very few active managers are able to outperform their benchmarks over the long term.
To see if the mutual fund industry is drinking its own Kool Aid, one need not look any further than the long term trend in expenses and management fees. In the last twenty five years, assets under management have skyrocketed from the low billions to approximately $4 trillion today (down from about $7 trillion at the peak of the market). Using their rationale, fund expenses should have decreased dramatically. Instead, they have gradually increased, before you take into account off-balance-sheet expenses such as soft dollar arrangements.
I am an advocate of Folio Investing. This style means that an individual investor, after consulting an adviser, buys into a diversified, asset-allocated portfolio that is appropriate for the individual's stage in life, risk tolerance, and spending goals. Technology enables us to buy fractional shares of individual stocks, making it possible to create your own little mutual fund without the exorbitant fees and self-dealing.
Mark Brandon has sinced written about articles on various topics from Best Mutual Funds. Mark Brandon is the Managing Partner of First Sustainable (), a registered investment advisory catering to socially responsible invest. Mark Brandon's top article generates over 3600 views. to your Favourites.