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| Will New 12b-1 Rules Bring Clarity and Competition to Funds? |
| by
Russel Kinnel
| 07-26-10 |
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We're still sifting through the SEC's ambitious rules proposals for mutual fund distribution fees; our initial thoughts follow, and we'll have more on this in the weeks to come.
First a little background. The fund industry has developed a rather odd fee setup over the decades, which differs from the more straightforward commissions you see with ETFs and stocks. One key feature is that the fund company collects broker commissions along with its own fees at the same time. If you buy a stock or an ETF, the per-share commission goes directly to the broker, not through the corporation or ETF provider. In addition, stock commissions were once mandated, but that was dropped in the 1970s. Today there's competition, and commission size is based on the level of service.
In the fund world, the fund company collects broker commissions along with its own fees at the same time. Then, the fund company deducts fees from your fund assets and funnels continuing service fees to brokers. The sales load is the same everywhere; brokers don't have to compete. Nor do they compete for the service fee, the 12b-1, which stays the same no matter the size of the fund, size of the investor, or level of service. Fee-based planners represent a notable exception to this system: They set their price and charge clients directly outside of the fund's fee structure.
Meanwhile, fund supermarkets such as Schwab and Fidelity add to the fee layers because they charge fund companies between 30 and 40 basis points to be included on their no-transaction fee platforms. Some funds pay part of this cost with a 12b-1 fee, and others pay it from their management fee. The supermarkets prohibit fund companies from offering the same fund for a lower price to retail investors elsewhere. Thus, even if you buy directly from the fund company, you're paying a fee that has the supermarket's services baked in. It's a clever trick that means investors have no incentive to go directly to a fund company that's in an NTF plan. It also boosts fees artificially for those direct sold shares.
This complicated web of payments between funds and intermediaries has played a large role in keeping expense ratios largely unchanged even though the fund industry has grown by trillions of dollars over the past 20 years. In 1989, the asset-weighted average expense ratio was 0.93% and in 2009 it was 0.89%. The industry's assets under management grew more than tenfold and it produced only 4 basis points of benefit to investors. Economies of scale are real in the finance world--just look at the tools and low commissions available for online stock trading compared with what was available 10 years ago, but middlemen have limited competition in the fund world.
The SEC's Fix
The SEC's more than 250-page proposal seeks to fix a long-standing problem with 12b-1 fees--they are considered marketing fees and must be approved by the fund's board of directors after the trustees determine that the fees are in fund investors' best interests. They are neither true marketing fees, nor are they in shareholders' best interests. The 12b-1 fee is used to pay for servicing accounts and as a primary way to pay brokers and some advisors their services. So, it takes a lot of mental and legal contortions to justify approving them under the current rules.
The proposal aims to fix the 12b-1 in three ways: cap the amount any fund can charge as a sales charge, improve fee transparency, and open the door for increased competition.
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| Russel Kinnel is Morningstar's director of mutual fund research. He can be reached at russel_kinnel@morningstar.com. |
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