The debate over 12b-1 fees initiated by the SEC offers an opportunity for improvement.
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Mutual fund accounting is a mess. Many distribution costs are labeled as manage- ment fees, some management costs are masked by soft dollars, and fees such as brokerage costs are simply omitted from stated expense ratios because they are difficult to quantify. Is this any way to track how billions of dollars of shareholder money is being dispersed in our nation's primary retirement-savings vehicles?
Fortunately, the debate over 12b-1 fees initiated by the Securities and Exchange Commission offers a fleeting opportunity for improvement. If this chance is fumbled, as it very well may be, it will be many generations before fund investors get the kind of financial statements that they deserve.
Accounting categories created by accountants are bad enough; 12b-1 fees represent something far worse, an accounting category created by fund-company attorneys. Therein lies the root of the problem. This category of fund expense exists to provide asset managers a legal safe haven (to spend shareholder money on distribution); it was not created to do what financial statements should do--to document how a company (in this case, an investment company) spends shareholder capital.
As an accounting category, 12b-1 fees are an utter farce. In theory, breaking out these fees should give shareholders an idea of how much of their money is spent on distribution costs, but 12b-1 fees fail to do even that. In many cases, 12b-1 fees capture just part of a fund's real distribution costs. For example, the major fund platforms charge funds 40 basis points to be listed. A fund can label 25 of these basis points as 12b-1 fees and still be classified as a "no-load" fund. The other 15 basis points of expense are typically paid out of the management fee. It's as if a household arbitrarily decided to label the first $250 of its electric bill as its monthly energy costs and then paid the balance of the electric bill, plus the gas bill, out of the food budget. The categories become worse than meaningless; they imply a discipline that doesn't exist. Small wonder the lingering impression most investors have of 12b-1 fees is that they are something sneaky and nefarious. It's time to recast fund expenses, to throw aside what fund attorneys would like them to be or what fund officials think investors want them to be. Instead, the overarching principle should be this: What information does the owner of the fund, the investor, have a right to know?
Business accounting divides expenses into three simple categories: the cost of goods sold, the cost of sales and distribution, and general and administrative costs. Every small business in America manages to get its costs into these three basic buckets. Why can't the fund industry? For funds, the costs of goods sold would be the fees paid to the investment manager for research and management. Benefits the manager receives from soft dollars should be included in this total, so shareholders see the full cost of management. Distribution costs would include what funds choose to pay to be on fund platforms or pay to 401(k) record-keepers, as well as any trail commissions paid to advisors. And, yes, I do think that distribution costs are a legitimate fee that should be allowed to be paid out of a fund's expenses, so long as it's properly documented. Finally, general and administrative fees would include all overhead, such as custodial or transfer agency fees, and operational costs, such as paying for fund boards.
Industry executives have two frivolous objections to this proposal. First, they argue that it's difficult to classify some costs. Well, that's true for any business, but far more complex entities than mutual funds manage it. Second, they argue that investors already see the overall cost, so why do they need to see the breakdown? That answer is easy--because it's their money being spent. An investor would look very differently at two pharmaceutical firms with equal total costs, but where one spent heavily on research and development and the other spent most of its money on commissions to sales reps. No one would suggest that investors don't have a right to see that breakdown. To suggest that investors shouldn't worry about such distinctions is offensive.
Mutual funds have staked out a rarified position in the investment markets. They are the first vehicle that millions of Americans will use in saving for retirement. These investors aren't experts at decoding financial statements. At a minimum, they deserve accounting that is simple, jargon-free, and designed to help them understand where their money goes. Today's standards fall laughably short of that goal. Let's hope the SEC thinks boldly in addressing the issue of 12b-1 fees and moves not only to address the issue of whether distribution costs can be included among expenses, but also to finally make fund accounting useful to investors, not just to fund-company lawyers.
Don Phillips is Morningstar's managing director, corporate strategy, research, and communications.
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