July 26th, 2010.

Will New 12b-1 Rules Bring Clarity and Competition to Funds?

The SEC takes aim at some big mutual fund problems.PrintReprintsCommentRecommend (2)By Russel Kinnel | 07-26-10 | 06:00 AM | E-mail Article

 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.

About the AuthorRussel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Kinnel would like to hear from readers, but no financial-planning questions, please.Contact Author | Meet other investing specialists

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. Setting a Maximum Sales Charge

The SEC proposal would ensure sales charges paid would be capped at the lower rate of 6.25% or the highest level charged in a different share class of the same fund. For example, if a fund offers A shares with a 5.25% front load, other classes of that fund that spread the sales charges out over time couldn't charge more than 5.25% in aggregate. This would impact C class shares that charge sales and distribution fees in the range of 0.75% to 1.00% each year with no expiration date. Under the proposal, after an investor has paid the maximum sales charge, the investor's C shares would be converted into a fund share class with no continuing sales charge. Under the proposal, 12b-1 fees would be renamed "marketing and service fee." These fees would be limited to 0.25% of fund assets per year. Any distribution-related expense above that would be considered a sales charge and fund directors would be spared the gymnastics needed to sign off every year.

Truth in Labeling

The proposals take a step toward truth in labeling of fund costs but they stop well short of accurate accounting that tells fund investors where their money is going. On the plus side, this rule would require that sales charges and service/marketing fees are tracked for and disclosed to each investor. So, for the first time, investors would see the dollars and cents they pay for their fund's sales and marketing activities. This is a welcome boost in disclosure.

The waters are still muddied, however. In March, the Supreme Court ruled on Jones v. Harris, a fund fee case that took issue with the management fee portion of funds' expense ratios. The case highlighted the problems caused by throwing a wide range of miscellaneous charges in the management fee for mutual funds. That makes it hard for investors and even fund directors to know what's being spent managing the funds. It also makes any comparisons between retail funds and institutional funds difficult. We'd like to see an accurate accounting of costs in which actual costs are labeled correctly. When invited to participated in an SEC roundtable on this topic a few years ago, Morningstar's Don Phillips suggested that fees be divided into three simple buckets: management, sales/distribution, and administrative overhead.

Investors have the right to know how their dollars are being spent. Funds that spend big bucks selling and skimp on management have different prospects than those that don't. Stock investors are given that level of detailed information by reviewing standard corporate accounting. Fund investors should have it, too.

It's Time for Some Competition

The new proposals don't stop at tweaking 12b-1 fees. They also aim to open the door for brokers to compete on the sales charges they levy clients. Currently, all brokers are required to charge the same sales fee, but under this proposal, some could negotiate lower fees and offer better deals to their clients. If these changes are enacted and embrace by brokers, the distinction between load and no-load funds might go away. Fees beyond the basic fund management level and servicing fees would depend on the level of service investors wanted. That would be healthy competition and that makes for a more compelling offering from the fund industry.

The proposals now move to a comment period in which investors, industry mouthpieces, and advisors will get to weigh in. Then, the SEC will decide what form the final rules should take.