The Problem With The Modern 12b-1 Fee

The Problem With The Modern 12b-1 Fee

Unfortunately, while in the decades since the 12b-1 fee was first adopted the mutual fund complex overall has grown larger and mutual fund expenses on average have declined, researchers haven’t been able to find much of a link between the existence and use of 12b-1 fees and a subsequent decline in the operating expense ratios of those particular mutual funds.

In other words, if 12b-1 fees “worked”, funds that use a 0.25% 12b-1 fee to grow should eventually see their expense ratios fall by 25bps or more, and overall mutual funds that use 12b-1 fees should end up either being cheaper (as the expense ratio drops by even more than the 0.25% fee as the fund scales its operating expenses), or at least finding other cost efficiencies (e.g., amortizing trading costs over more investor dollars)… both of which would help to improve their returns.

Yet instead, even an SEC study found that mutual funds with 12b-1 fees are becoming much larger, but not cheaper; in the end, they’re just larger funds that are more expensive, by almost the entire cost of the 12b-1, as existing investors continue to pay the marketing costs to reach new investors, which enriches the mutual fund company but not the current fund investors who are paying for it. In other words, the 12b-1 fees investors payare effective at incentivizing salespeople to distribute mutual funds and grow their assets under management, but there are no operational economies of scale coming back to benefit the investor themselves. Despite the fact that the investor is paying for it.

Furthermore, the irony is that even though 12b-1 fees were supposed to help mutual funds grow, in recent years the greatest growth is actually flowing specifically for no-load mutual funds that do not have a 12b-1 fee anyway (e.g., Vanguard). This seems to be driven in part by the growing recognition that since investment costs have such an impact on long-term performance, the best funds to choose are the ones with the lowest expenses (which disproportionately are funds with no 12b-1 fees). But it’s also simply driven by the fact that as investors get more tools to implement their own portfolios, they are effectively cutting out the middleman, pursuing fund share classes that don’t pay sales commissions and assess distribution expenses. At the same time, there’s a shift amongst financial advisors towards independent RIAs, who charge AUM fees but can’t accept 12b-1 fees and instead pursue cheaper institutional share classes on behalf of their clients. Which may only be further accelerated if/when the DoL fiduciary rule come to pass, further winnowing down the number of higher-cost share classes with 12b-1 fees anyway.

Thus, as the chart below from Investment Company Institute (ICI) datashows for the last decade that fund data was available, retail no-load funds (with either no 12b-1 fee, or only a 0.25% 12b-1 servicing fee) have dramatically outgrown the net flows to all loaded funds combined (and it’s even more dramatic when you include all no-load funds, both retail and institutional!). And notably, the data would be even more dramatic if the rapid growth of ETFs, which also have no 12b-1 fees, were included as well!

Net Cash Flows To Load Vs No Load Mutual Funds

In addition, the situation is further complicated by the fact that paying “distribution” costs is more complex in the modern investment world. For instance, while 12b-1 fees are paid to brokers who sell a mutual fund, they are also paid to many online investment platforms to offer “No Transaction Fee” (NTF) mutual fund offerings. In other words, rather than having new investors pay the transaction fee to buy the fund (i.e., the mutual fund ticket charge), current investors subsidize the new investor’s cost to purchase by paying the 12b-1 fee to the brokerage firm to make the fund available as an NTF fund. Ultimately, this is a form of distribution cost to incentivize new investors to invest into the mutual fund… but, again, it appears to be more effective at bringing in new investors, than actually scaling up the mutual fund to bring down operating expense ratios for existing investors.

On the other hand, in today’s modern world, some mutual funds use 12b-1 fees to cover more “nondistribution” administrative services that third-party investment platforms help facilitate, including record-keeping and tracking shareholders’ purchases and redemptions (since those transactions are happening on the third-party platform instead of directly with the mutual fund). Arguably, this form of 12b-1 fee is at least less of a distortion, as it’s paid by existing investors to fulfill the record-keeping needs for those existing investors. Still, the fact that some investment companies cover these costs from 12b-1 fees, while others pay the costs directly from the fund company, or simply let the investor pay their platform directly (in the form of transactional or custodial or wrap fees), means that the uneven use of 12b-1 fees can potentially distort the cost of mutual funds in the marketplace.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s