Summary In periods of market volatility, investors are becoming more aware of the ways that small things can affect their portfolio and keep them from achieving their investment objectives. For investors who prefer to receive advice from an investment advisor, they are becoming more aware of the transaction fees that they pay for the investment advice they receive, which is why the 12b-1 fee is being scrutinized.
The 12b-1 fee is a fee that mutual funds and exchange-traded funds charge to shareholders to help offset the marketing costs of the fund. The 12b-1 fee is capped at a maximum of 1% of a fund’s assets under management, of which only 0.75% can be dedicated to covering marketing costs. The other 0.25% is dedicated to service fees. This fee is charged whether a fund is actively managed or not. That’s because the fee is not based on the fund’s performance in any way.
Although the 12b-1 fee is considered a standard practice and, in fairness, most funds charge far less than the full 1%, it is becoming a source of controversy for two reasons. First, the Securities and Exchange Commission is questioning if the 12b-1 fee is accomplishing its objective, which was to bring down the overall fund expenses as service providers were able to bring more investors into the fund. The argument was that through economies of scale, the costs associated with the fund would go down. This argument is gaining traction because the popularity of mutual funds begs the question of if the funds need to be marketed at all. Another argument is that the presence of a 12b-1 fee is, in reality, a commission that benefits an advisor but may not be in the best interest of their clients.
Most mutual fund investors understand that one of the biggest threats to the growth of their portfolio is fees. Share prices go up and share prices go down, but the annual fees charged by a fund are constant, and they only move portfolios one way – down. Over time, these fees can total thousands of dollars on even fairly modest portfolios. This is because fees are not performance based. They are expenses that the fund charges shareholders simply for investing in the fund. One such fee is the 12b-1 fee. This fee helps funds offset the marketing and distribution costs associated with the fund. In theory, it’s a fee that helps attract other investors into the fund.
But does it actually meet this objective? That is a source of debate and investigation by the U.S. Securities and Exchange Commission (SEC). In this article, we’ll break down what you need to know about 12b-1 fees including what they are, how much they can be, why they were created and the impact they can have on your portfolio.
What is a 12b-1 fee?
A 12b-1 fee is a fee charged by a mutual fund that covers the marketing and distribution costs of the fund as well as some service fees. According to the Securities & Exchange Commission’s website, “These fees are dedicated for a mutual fund to compensate securities professionals for sales efforts and services provided to the fund’s investors”. A 12b-1 fee is one part of a fee’s expense ratio. The exact percent ratio of this fee and what the fee covers must be included in a disclosure to shareholders as part of the “Annual Fund Operating Expenses” section of their prospectuses.
The marketing and distribution costs include such things as:
- Marketing and paying brokers and financial advisors
- Advertising expenses
- Mailing fund brochures and/or prospectuses
The service costs associated with this fund include such things as:
- Paying for hiring employees to answer investor questions and distribute information
- May be required even without a 12b-1 plan
In some cases, a 12b-1 fee may include “other” fees, such as legal, accounting and other administrative costs associated with the fund.
How much is a 12b-1 fee?
A 12b-1 fee is capped by the National Association of Securities Dealers (NASD) at an annual rate of 1% of a fund’s balance. The fee is further capped as follows:
- Marketing and distribution of the fund – 0.75% annually
- Service fees – 0.25% annually
A fund does not have to charge the full 1% as a 12b-1 fee. In fairness, the average mutual fund 12b-1 fee is 13 basis points which, when expressed as a percentage is 0.13%. However, a 12b-1 fee is part of an overall fund’s expense ratio. If a fund charges the full 1%, a fund could easily have total expenses above 2%.
How does a 12b-1 fee affect fund performance?
Here’s an example of the effect a 12b-1 fee can have on a portfolio. If an investor were to put $1,000 into a mutual fund that paid out an average annual return of 10% and had a 12b-1 fee of 1%, they would have $23,457 after 10 years. However, without the 12b-1 fee, they would have $25,679 – a gain of over $2,000. And keep in mind that this does not include other fees associated with the account.
Taking a broader look at the overall fund industry based on data from the Morningstar Principia database, there are approximately 1,500 funds that had 12b-1 fees. These funds had an average 12b-1 fee of 0.31% with an average overall net expense ratio of 1.45%. The fifteen-year average annualized performance of these funds was 6.96%. This was below the average of all mutual funds (those with and without 12b-1 fees) of 7.27%.
One of the common problems that investors have is a failure to understand how that slight difference can add up over time.
The effect of 12b-1 fees on different classes of shares
Many mutual funds are divided into share classifications (for example Class A, Class B, or Class C). Class B or Class C shares are more likely to have 12b-1 fees, with Class C having the greatest likelihood of charging these fees. However, there is a trade-off between the types of fees associated with each class.
Class A shares are more likely to charge a front-end load (i.e. sales fee) but do not charge a back-end load. However, they are less likely to charge a 12b-1 fee and if they do, it is typically well below the full 1%.
Class B and Class C shares typically do not have a front-end load, but they will have a back-end load. They are more likely to have a 12b-1 fee with Class C shares being most likely to charge up to the full 1%.
12b-1 fees do not have any effect on whether a fund is considered a no-load fund. The NASD allows a mutual fund to be designated a no-load fund if the combined assets of all fees (including its 12b-1 fees) are less than 0.25% of the average annual net assets of the fund. In some cases, this means that an investor may actually enjoy a higher return from a fund that carries a front-end load.
How prevalent are 12b-1 fees?
70% of mutual funds charge a 12b-1 fee in at least one share class. As of this writing, 12b-1 fees total approximately $10 billion annually.
The history of 12b-1 fees
Mutual fund fees were enabled by the Investment Company Act of 1940. This was done to add a regulatory function to the Securities Act of 1933. Whereas the Securities Act was created to provide more transparency for investors, the Investment Company Act was created to give the SEC authority to establish rules for how the financial products issued by investment companies to public investors would be registered and regulated.
However, a specific need for 12b-1 fees did not arise until the 1970s when investors began to pull large amounts of money out of mutual funds. Mutual fund providers needed to offset this loss of funds by either attracting new investors or charging fees to avoid having to sell shares at a loss. This makes sense because the intention of the 12b-1 fee is to, in effect, market the fund to new investors.
For this reason, the SEC allowed mutual funds to implement 12b-1 fees in 1980. This was intended to be a short-term fix that would help them achieve the specific goal of increasing the economies of scale for these funds. Of course, as is usually the case, once the fees were implemented, fund managers were able to use the wording to turn the 12b-1 fee into an opportunity to charge what effectively becomes a front-end load by another name.
However, in the fallout surrounding the financial crisis, the SEC has taken a closer look at the need for these fees. This is stirring a debate in the industry that is still ongoing.
Arguments against 12b-1 fees
The function of a mutual fund is to manage assets from different investors and distribute them according to a specific investment strategy. When 12b-1 fees were initiated the thinking was that as more investors could be added to a fund, it would bring the overall cost of the fund down due to economies of scale. However, when investors weigh the effect that this fee has on their fund balance, it is reasonable for investors to wonder if these fees are having the desired effect. These fees are also becoming controversial because many investors don’t understand what these fees are.
Another argument against a 12b-1 fee is that, rather than serving a role as a marketing tool, it really acts as more of a commission for financial professional and fund managers. This is leading detractors to argue that the 12b-1 fee is at best ineffective, particularly when it can take away from a fund’s performance, and at worst a conflict of interest for the financial professionals who were receiving money for recommending specific funds.
A third argument against 12b-1 fees is that they are not relevant. Unlike when they originated in the 1970s, more money is flowing into mutual funds, which raises the question of whether these funds need to be marketed. The reality seems to be that there some of the largest, most successful funds have a rock-solid history of delivering returns without the need for these fees. Most of these funds don't charge fees based on the principle that they detract from the return they provide for their shareholders.
On the other side of the debate, proponents of the 12b-1 fees say that the fees are fully disclosed. Therefore, there is no intention to deceive investors. Also, these fees are included as part of a fund’s expense ratio so they are not a separate charge, such as a load. Finally, the Investment Company Institute argues that 12b-1 fees help investors in vital ways and are actually driving down fund expenses over time. This is part of what the SEC is currently looking into as they attempt to determine what a reasonable and fair 12b-1 setup will look like.
The bottom line on 12b-1 fees
One of the leading predictors of mutual fund performance is the expenses associated with the fund in terms of fees. One of the more recent fees added to mutual funds is the 12b-1 fee. This fee is primarily focused on the marketing and distribution of funds to individual investors. In addition to marketing and advertising costs, 12b-1 fees include service fees and potentially “other” administrative fees.
The National Association of Securities Dealers (NASD) caps the total percent cost of 12b-1 fees at 1%. With up to 0.75% allowed for marketing and distribution and up to 0.25% allowed for service fees. In reality, most funds that have a 12b-1 fee do not charge up to the full 1% (the current average is around 0.13%), the ratio can increase greatly between Class A, Class B, and Class C shares.
By some studies, up to 70% of all mutual funds charge a 12b-1 fee in one share class or another. This currently accounts for up to $10 billion in charges that are flowing out of investor’s portfolios. In fact, in some cases, it would be a better option for investors to choose a fund that has a load rather than one that includes a 12b-1 fee.
The SEC first allowed 12b-1 fees to be charged in 1980 in response to the industry’s need for a short-term mechanism to prevent the flight of money from mutual fund accounts and allow the investment companies to avoid having to make trades that would put their shareholders at a disadvantage. However, as time has gone on, critics argue that 12b-1 fees have become little more than a commission to incentivize financial professionals to stir investors into particular funds. That potential conflict of interest, in addition to the effect that these fees can have on an investor's portfolio, is causing the SEC to take a closer look at 12b-1 fees. The SEC’s investigation into 12b-1 fees is ongoing; however, it’s likely that these funds will undergo some type of meaningful, thoughtful reform.