It's time for a sweeping overhaul of mutual fund 12b-1 fees and expense ratios.
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On Oct. 20, Morningstar submitted the following comment letter to the SEC in response to its 12b-1 fee reform proposal, Mutual Fund Distribution Fees, File No. S7-15-10.
We applaud your attention to 12b-1 fees as well as your desire to increase transparency and encourage better competition for the benefit of fund investors. Your distribution-fee proposal takes a few steps forward, but in our opinion does not go far enough in addressing shortcomings of fund-fee transparency. Until various expense categories are labeled and accounted for consistently across mutual funds, investors will not have the information they need to make well-informed decisions. Capping one part of the expense ratio will do no good until all costs are forced into the right buckets and labeled accurately. This is a once-in-a-generation opportunity to clean up a broader problem with fund expense ratios and help investors understand how their money is being spent.
As it stands, your proposal will have the biggest impact on C shares, effectively making them a less-attractive alternative to a fee-based platform for receiving advice. That trend has already started without the help of your proposal. American Funds already converts its C shares to A shares after a period of time to make the fees charged between the two comparable. And C shares are only a small, and shrinking, part of the fund industry. At the end of 2009, assets in C shares represented less than 5% of industry assets. We ask you to consider that the largest impact of your proposal will be aimed at only a small corner of the industry, and thus touch a small number of investors. Given the role that mutual funds play in the futures of millions of Americans, wider-sweeping review is necessary.
Billions of dollars are collected and spent each year to manage, sell, service, and market mutual funds. A complicated and deliberately opaque web of revenue sharing, broker incentives, platform fees, and consulting fees exists in the background.
Cleaning up and limiting 12b-1 fees will make some difference, but these costs have historically found new life in other parts of the expense ratio. Consider the Jones v. Harris Supreme Court case. One takeaway from the ruling was that management fees charged on a mutual fund are not comparable with those charged on an identically managed institutional account. Why? Because mutual fund management fees pay for a lot more than just investment management. It should cost no more or less to manage institutional assets as it does to manage mutual fund assets. When pressed on the differences, fund companies point to service and distribution-related costs, which are unrelated to the research resources needed to manage the money. The Jones v. Harris case also found that the Oakmark fund's board of directors had been left in the dark regarding many of the details needed to make a true comparison. The SEC has an opportunity to eliminate such disconnects between fee labels and reality.
Take another example: Shareholders buying "no-transaction-fee" funds on supermarket platforms such as Fidelity or Schwab pay 0.40% for the privilege. Funds often pay for some of the charge with 12b-1 fees, but a portion always comes through the management levy. Participating in a supermarket platform has nothing to do with management. It is a distribution strategy. What's troubling is that a very significant component of fund expenses is not being properly documented. Investors transacting on those large platforms don't realize the true cost of fund distribution, even though it's their money being spent.
While it is true that investors are receiving benefits from the services layered into their funds' expense ratios today, they have no way to tell if the value received is commensurate with the price paid. Unless the full expense ratio is cleaned up, fund investors, fiduciaries, board members, and analysts will never have a way to judge. Better clarity around fund expenses will happen only if you mandate it.