The Unbearable Meaninglessness of 12b-1 Fees

Regarding mutual fund 12b-1 fees, SEC chairman Mary Schapiro recently noted that:

"Investors may have no idea these fees are being deducted from their mutual funds, what services they are paying for, or who they are ultimately compensating."

Indeed, the meaning of 12b-1 fees, like the meaning of "bipartisan" in the political realm, no longer has any common foundation. When someone is talking about 12b-1 fees, you can't be sure what they are talking about. The term "12b-1 fees" is full of sound and fury, signifying nothing.

Nondistribution Distribution Fees
Consider the regulatory term "distribution fees" that funds use to describe 12b-1 fees in the fund fee table. 12b-1 fees actually pay for a grab-bag of services--not just distribution. For example, 12b-1 fees may cover record keeping and the tracking of shareholders' purchases and sales of fund shares. Yet the SEC tells funds to label this administrative service as "distribution."

The explanation for this is regulatory. Rule 12b-1 says that, if you charge fees that could be viewed as primarily intended to result in the distribution of fund shares, then they must be treated as a 12b-1 fees. Fees paid to a broker who distributes fund shares therefore are 12b-1 fees.

But the same broker might also provide administrative services. Lawyers worry that this blurs the separation of fees between distribution and administration. To avoid the risk of leaving what regulators might consider a "distribution" fee out of the 12b-1 fee, funds dump administration and distribution fees in what is known as a "defensive" 12b-1 plan. So a large chunk of 12b-1 "distribution" fees are not for distribution.

Financing Old Sales With New Money
The nondistribution aspect of 12b-1 fees is not their only misunderstood feature. For example, many have decried and even sued funds that charge 12b-1 fees while the fund is closed to new investors. If the fund is not distributing new shares, why is it charging a distribution fee?

One answer, as noted above, is that the administrative services that a 12b-1 fee may cover continue when a fund is closed. Another answer is that part of 12b-1 fees reflects "service fees" paid to brokers to manage the ongoing relationship with existing shareholders. 12b-1 fees are also paid on new shares sold to those existing shareholders. This still counts as distribution.

In addition, closed funds' 12b-1 fees often are attributable to sales to new shareholders. How can that be? When a broker is paid, for example, a one-time, 3% commission for selling shares to a new shareholder, and the fund receives only an annual 1% 12b-1 fee on that sale, someone must front the full 3% commission. Some funds borrow the 3% from a bank and use the stream of 12b-1 fees to repay the loan. So some 12b-1 fees collected by a closed fund are being used to finance earlier sales to new shareholders.

The 12b-1 Fee Screen
Some commentators suggest that 12b-1 fees be used as a negative screen when choosing funds. There are two problems with this well-meaning recommendation. First, the presence of a 12b-1 fee does not necessarily distinguish one fund from another.

Consider two funds with identical 1% expense ratios. Fund A's expense ratio is made up of a 0.75% management fee plus a 0.25% 12b-1 fee. Fund B's entire 1% expense ratio is the management fee. As discussed above, part of Fund A's 0.25% 12b-1 fee may be for administrative services. Fund B provides the same services, but covers their cost in its management fee (having decided against the conservative "defensive" 12b-1 plan discussed above).

 

The rest of Fund A's 12b-1 fee that is used to pay brokers may also be paid to Fund B out of its management fee. These payments out of Fund B's management fee are known as revenue-sharing fees. Fund A and Fund B may be using their 1% expense ratios in identical ways, but Fund A gets arbitrarily screened out because of its 12b-1 fee while Fund B remains in play, although their actual services and total fees are identical. Adding insult to injury, the screened-out Fund A discloses the 12b-1 fee in the fee table, whereas the unscreened Fund B is not required to disclose its matching revenue-sharing payments.

Second, the argument for screening out 12b-1 fee funds is somewhat circular. An investor who is doing his own screening is less likely to be using a broker, so there would be less reason for the investor to be paying 12b-1 fees in the first place.

The 12b-1 fee screen is just another way of saying: Do it yourself!

To be consistent, the screening recommendation should not be limited to 12b-1 fees. It should apply to all forms of compensation for advice, including standard commissions and hourly and asset-based fees charged by "fee-only" financial planners. Screening out 12b-1 fee funds as a way of avoiding unnecessary fees doesn't really make sense.

Distribution and the Fall of Man
The 12b-1 fee screen, and much of the criticism of brokers, arises indirectly from the populist view that distribution expenses are inherently evil. If we would all just educate ourselves about investing, we could rid the world of the scourge of salesmanship.

This argument recalls Shakespeare's oft-misused phrase: "Let's kill all the lawyers." Yes, a utopian society would have no lawyers because the civilizing force of the law would not be necessary, just as a financial services utopia would not have salesmen because all investors would be well-informed and self-directed.

But law and salesmanship are the unfortunate and necessary crutches of fallen man. Investors exist in relative states of imperfection. Some investors will never buy a no-load fund. They are going to buy what is sold to them through the traditional broker channel, and if that is going to be a mutual fund, rather than some inferior product, it will happen only with the economic incentive that sales compensation creates. (By the way, a "no-load" fund can charge up to a 0.25% 12b-1 fee, so even the term "no-load" is somewhat meaningless).

No-Transaction Fee Transaction Fee Funds
To return to the inherently misleading nature of 12b-1 fees, consider the role of 12b-1 fees in hiding the cost of fund supermarkets such as Schwab's OneSource. Schwab, Fidelity, and other supermarket sponsors advertise fund options as no-transaction fee (NTF) funds, in contrast with funds available through their supermarkets that trigger a charge with every purchase of fund shares.

Supermarket investors don't pay transaction fees on NTF funds because Schwab and Fidelity are paid by the funds, primarily through 12b-1 fees. These fees are paid by fund shareholders, of course, so they are ultimately paying the same fees as shareholders who buy transaction-fee funds. An NTF fund is actually a transaction-fee fund whose transaction fees are buried in the fund's 12b-1 fees.

Nonetheless, the SEC allows supermarkets to use the NTF label and the confusion of 12b-1 fees to persist. This is not a fault of supermarkets, which are a great product innovation, but yet another illustration of the meaningless construct that the SEC has allowed the 12b-1 fee to become.

The Language of Mutual Fund Fees
When a regulation's terminology loses its meaning, the regulation itself loses its purpose. Critics cry: "Let's kill all the 12b-1 fees" without really knowing what it is that they want to abolish. The SEC should begin the process of reforming 12b-1 fees by returning to fundamentals. Fees must be recharacterized to reflect the types of services that shareholders actually receive before we can re-establish a common language of mutual fund fees.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. The views expressed in this article do not necessarily reflect the views of Morningstar.com