Unless you are a financial advisor, work in the mutual fund industry, work for a regulator, or are a personal finance geek, chances are pretty good that you haven’t heard of 12b-1 fees. These fees are charged by mutual fund companies to pay for the annual marketing and distribution expenses related to selling the mutual fund. Yes, you read that correctly, you are charged a separate and specific fee to help compensate mutual fund marketing and sales people. The fees are also sometimes referred to as distribution fees. And lest you get too confused, note that the numeric moniker comes from a section of the Investment Company Act of 1940.
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It is a little misleading to use the phrase “you are charged”above, as 12b-1 fees are taken directly out of a mutual fund’s assets — not charged directly to the investor. This form of compensation (taking the fee directly out of the fund’s assets) is also another very good reason why you might never have heard of the fee, because it doesn’t appear on your monthly statement. Instead, if you want to know what your fund company is charging in the way of 12b-1 fees for that mutual fund you are holding, you’ll need to go back and read your fund prospectus; yes those long, densely written, deathly dull documents most people never do more than skim.
Part of the Expense Ratio
Another thing to keep in mind with 12b-1 fees is that they are part of the expense ratio associated with a mutual fund. In a nutshell, the expense ratio is used as a yardstick to track the costs associated with the operations of a mutual fund. The expense ratio is calculated on an annual basis and, simply put, you take a fund’s operating expenses and divide them by the average dollar value of the fund’s assets under management.
The maximum 12b-1 fee allowed by regulators is 1% of a fund’s net assets annually. Typically, these fees range somewhere between 0.25% at the low end and up to that 1% maximum. Financial industry reformers and investor advocates have complained about this fee for years because it really provides you, the investor, with no tangible benefit and increases the expense ratio of the mutual fund. In the end, this serves to lower a fund’s return. While 0.25% to 1% of annual net assets might seem like a small amount, when you consider the magic of compounding, this amount can still result in millions of dollars of overall reduced return for the fund’s investors over its lifetime.
The Advisor Connection
In addition to its previously mentioned general marketing and sales uses, the fee also covers the expense of marketing the fund to financial advisors. Advisors, you might be dismayed to note, often get paid for selling or marketing a particular fund to you the investor. The attention among investor advocates and industry watchdogs to this aspect of the fee’s use has moved the Securities and Exchange Commission to action, with ongoing probes and investigations into how 12b-1 fees are being used.
So how have sales, marketing and advisors made out over the years? The pinnacle of 12b-1 fees dates to 2007, yes the year before the big crash. According to the Securities and Exchange Commission, 12b-1 fees that year amounted to a whopping $13 billion. By 2009, they had dropped to a mere $9.5 billion. It’s worth noting that this largess has grown along with the many other excesses of the financial industry. Back when first introduced in 1980, 12b-1 fees amounted to just a few million dollars industry wide.
How Can You Identify These Fees?
FeeX can quickly and easily show you the expense ratio of the mutual funds you own and offer you an alternative. Illustrated here is a real world example of an expensive fund (blurred out) held by the author and an alternative from PowerShares with very similar holdings (93% the same according to FeeX’s similarity algorithm). Note the much lower expense ratio and annual fee of the alternative, and its better past returns. Also take note of the estimated potential future balance based on current expense ratio as well as the estimated potential long-term savings over 30 years. Keep in mind that this is only an example of one fund and an alternative and does not represent all users’ accounts.
Sadly, only a few mutual fund companies avoid passing these fees onto those investors that directly purchase mutual funds on their own. When you get down to it though, 12b-1 fees are but one small fee among many that make up the financial services industry’s fee ecosystem. If you are interested in seeing what the expense ratio is for the mutual funds you hold, try out the FeeX service —its free! And stay tuned to the FeeX blog for additional coverage of the industry’s costly fee menagerie.
Nothing in this article should be construed as investment advice, or a solicitation or offer, or recommendation, to buy or sell any security. Investing in mutual funds, exchange traded funds, and other securities carries risk of all or part of the amount invested. Past performance is no guarantee of future results. FeeX assumes no responsibility for the tax consequences to any investor of any transaction. Investors should confer with their personal advisor or tax professional regarding their particular circumstances.