Smith
Faculty Opinion Article
An Idea Whose Time Has Come
Written by John A. Haslem
Wednesday, 30 April 2008 10:38
The
principal reason for the differences in rates charged open-end companies and
other clients appears to be that with the latter group a normal procedure in
negotiating a fee is to arrive at a fixed fee which is mutually acceptable. In
the case of the fees charged open-end companies, they are typically fixed by
essentially the same persons who receive the fees, although in theory the fees
are established by negotiations between independent representatives of separate
legal entities, and approved by democratic vote of the shareholders.
Wharton School of Finance and Commerce (1962).
Chairman Christopher Cox's essential message at the Security and Exchange
Commission's (2007) annual forum for mutual fund directors was very clear: "It
is high time for a thorough re-evaluation . . ." of 12b-1 plans. He further
stated that it is also time for fund independent directors to review fund 12b-1
plans, which require their initial and annual approval.
Rule 12b-1 fees pay for fund advertising and distribution services provided by
broker-dealers and other intermediaries. The original justification for Rule
12b-1 (approved in 1980) was that it would enable mutual funds to attract new
shareholders through advertising and financial incentives to brokers. The fees
were promoted as a means of slowing the large net outflows that were seen as
threatening the survival of many funds. It was argued that fund asset growth
would benefit shareholders through increased economies of scale and reduced flow
volatility. These increased scale economies were supposed to provide
shareholders with expense reductions sooner than they would in the absence of
12b-1 fees. Haslem (2003) also provides background on 12b-1 fees.
The "bottom line" for shareholders of mutual funds with 12b-1 plans is whether
the cost reductions from economies of scale are large enough to pay the fees,
and, if so, whether the reductions are passed on to shareholders.
Over time, 12b-1 fees began to be used to substitute for front-end loads. In
this regard, Cox noted that the transformation from distribution subsidy to
sales load now totals $11 billion in broker compensation.
12b-1 Plans Pro And Con
The SEC's June 2007 roundtable also focused on regulation of mutual fund 12b-1
plans. The law firm of Willkie Farr & Gallagher (2007) was represented on the
panel and prepared a memorandum. The panelists generally agreed that 12b-1 plans
should continue, but with improved disclosure and increased board ability to
exercise supervisory authority.
But the real panel debate was over which party should pay the 12b-1 fees. The
pro and con summations follow in order:
. . . Rule 12b-1 contributes to investor choice in paying for costs
associated with the purchase of mutual fund shares.
. . . [M]any investors dislike paying loads. Rule 12b-1 fees are used to pay
broker-dealers and other intermediaries for distribution costs, the provision of
investor services, and other costs . . . so that investors can purchase shares
without loads.
. . . Rule 12b-1 fees depress mutual fund returns.
. . . [U]sing fund assets to compensate intermediaries increases a fund's
expense ratio
. . . [C]osts associated with distribution of shares should be borne by the
investor directly out of their own assets.
However, the pro 12b-1 fees side of the argument says nothing to justify the use
of mutual fund (shareholder) assets to pay for advertising and distribution
costs to attract new shareholders.
Earlier, Mahoney's (2004) study of mutual funds also provides a summation of the
pros and cons (in order) of the use of 12b-1 fees:
The mutual fund industry argues that these fees are a means by which
investors who purchase through brokers can spread out the broker's compensation
over time rather than bear it all at once in the form of a sales load.
Critics of 12b-1 fees note that they, unlike sales loads, are not paid directly
by the investor in connection with a transaction, but deducted from the fund's
assets. Thus, in effect, current shareholders bear the cost of attracting new
shareholders. Because the manager has a greater interest in maximizing the size
of the fund than do investors, the manager may spend more on marketing than the
shareholders would prefer.
This pro 12b-1 fees position does nothing to justify using mutual fund
assets to pay sales loads.
Freeman (2007) recalls that when Rule 12b-1 was adopted it was argued that
mutual fund shareholders would benefit from the scale economies generated when
new investors buy shares. The source of this asset growth was to be the
diversion of fund assets to stimulate new sales. However, the results have not
proven to be in the best interests of fund shareholders, which thereby provides
a general response to the pro and con summations of the 12b-1 fees controversy:
The idea that sales to new investors financed out of fund assets are
beneficial to existing fund shareholders is dubious and not supported by the
literature. No credible evidence exists demonstrating shareholders receive a
pecuniary benefit from 12b-1 fees.
Cuthbertson, Nitzsche, and O'Sullivan (2004) explicitly add mutual funds sold by
direct distribution to Freeman's conclusion. Direct distribution funds with
12b-1 plans use these monies to pay for advertising or shelf space at fund
supermarkets. The authors conclude: "To the extent that the 12b-1 fee is used
for advertising, this implies that current shareholders bear
the cost of attracting new shareholders [bold added]."
So why has the mutual fund industry gone to such lengths to protect the basics
of current regulation of 12b-1 plans? Mahoney (2004) provides a realistic answer
to this question. In 2003, fund investors paid some $9.5 billion in 12b-1 fees
(63 percent to brokers) and $12.3 billion in broker marketing, distribution and
account services. Writing in The Wall Street Journal, Anand (2007) reports that
the payment of 12b-1 fees has risen further to $12 billion.
Any argument supporting 12b-1 plans must explain why mutual funds that are
closed to new shareholders increasingly continue to charge 12b-1 fees. This
behavior perhaps more than anything shows the hypocrisy in arguing that 12b-1
plans benefit shareholders. The reality is that fund advisors benefit greatly
from this practice.
The hypocrisy of the mutual fund industry's support for 12b-1 fees is perhaps
best stated by Gogerty (2007) in his Morningstar "memo" to the SEC:
The fact that closed funds continue to charge 12b-1 fees clearly illustrates
that the fees are no longer primarily used for their intended purpose—to market
and promote a fund. A 2005 survey conducted by the Investment Company Institute
revealed that less than 5% of the estimated $10.9 billion collected in 12b-1
fees that year were used for promotion and advertising…
Haslem's (2004) summation of the implications of 12b-1 fees concludes this
section:
. . . Rule 12b-1 fees . . . allow fund managers to use fund assets to pay
distribution expenses, including sales fees and commissions, customer servicing
fees, administrative expenses, advertising and promotion. However, fund managers
have not used 12b-1 fees to provide shareholders with the promised reductions in
expenses due to economies of scale . . . . The irony in this is that it is the
fund managers who have reaped the bonanza from larger funds,―larger amounts of
investment advisory fees, larger amounts of 12b-1 fees, and larger expense
savings from scale economies. In fact, stock and bond funds with 12b-1 fees have
lower returns, higher expenses, and more risk. Further, the justification for
the use of multiple share classes rests on the weak foundation of 12b-1 fees
[bold added].
Empirical Research: Various Issues
Siggelkow's (1999) empirical analysis identifies 12b-1 plans as representing
abusive conflicts of interest. But, first, he presents the mutual fund
characteristics that should reduce these conflicts:
- The ease of investor exit from funds at net asset value.
- The huge amounts invested in funds provide incentives for investors to
monitor agency conflicts.
- The availability of many choices of funds in each investment category.
- The importance of investor trust and fund reputation to the success of
funds helps deter agency conflicts.
- The ready access of investors to fund performance (but not to agency
costs).
Siggelkow next identifies two major conflicts of interest: the shifting of
mutual fund marketing expenses (12b-1 fees) and research expenses ("soft dollar"
commissions) to shareholders. He suggests that fund managers are exploiting
retail shareholders' ignorance of these abusive practices.
Even if mutual fund shareholders were aware of these abuses, they lack the
market power to correct them. The ability of shareholders to achieve solutions
to these abuses through effective monitoring is limited due to wide dispersal of
share ownership among large numbers of small investors. Thus, shareholders would
have to rely on fund directors to monitor abuses. But, so far, this would be a
"weak reed" to rely upon.
Ultimately, however, effective monitoring is essential to the self-interest of
mutual funds, if they hope to maintain the investor trust upon which they have
grown and prospered greatly. Tufano and Sevick (1997) examine the relationship
between fund board structure and the size of advisory contracts. Fund directors
are legal fiduciaries, and independent directors have clearly defined legal
responsibilities, including, most importantly, approval of advisory contracts.
The directors most likely to be effective in approving lower-cost advisory
contracts are found to be those who serve on (1) smaller boards, (2) boards with
larger percentages of independent directors, and (3) many boards for the same
fund sponsor. The opposite appears true for those independent directors who
receive overly generous compensation packages.
Mutual fund directors are less likely to approve lower advisory contracts when
they are selected or influenced by fund management. In these cases, fund
managers must take responsibility for effective monitoring of abuses to have the
best chance of retaining investor trust. Thus far, they have not seen their own
long-term self-interest bound up in so doing.
The issue of 12b-1 plans also comes into play in Elton, Gruber and Busse's
(2004) research on index mutual funds. They find that investor returns from S&P
500 mutual funds are much lower than expected by the rational behavior paradigm
of financial economics. The expectation that these investors would be among the
most knowledgeable is found to be false. These investors violate the rationality
paradigm and, at a minimum, ignore the indicators that predict fund returns.
What then are the nature of and implications for index mutual fund shareholders
who act inconsistently with the rationality paradigm? These unsophisticated
shareholders are more influenced by fund salesmanship and marketing than by
their own financial analysis. The funds they hold have higher 12b-1 fees, loads
and expenses, less management fees, than the "best" funds.
Index mutual funds pay brokers and financial advisors for fund flow, but 12b-1
fees, loads and expenses less management fees do not explain all of the flow.
The residual flow reflects the actions of brokers and financial advisors who are
often motivated by compensation systems that are not in the best interests of
shareholders.
Unsophisticated mutual fund shareholders pay higher 12b-1 fees (and other
expenses and loads) than do sophisticated shareholders whose behavior is
consistent with the rationality paradigm.
In such a market, all that is necessary for inferior funds to exist and grow
is a set of uninformed investors and a set of distributors who have an economic
incentive to sell inferior products.
Hogue and Wellman's (2006) research complements that by Elton et al. (2004).
They note that mutual funds aggressively advertise performance, but rarely
compete on expenses. The industry has become very adept at segmenting investors
by level of sophistication, which allows fund advisors to sell high-cost funds
to unsophisticated investors. The use of 12b-1 fees allows funds to reduce
front-end loads, and places them in the expense ratio where they are less likely
to be noticed by investors.
But, in addition, they conclude that there is another serious implication of
mutual fund market segmentation: "Market segmentation to extract higher fees
from less-knowledgeable investors raises ethical concerns."
Thus, the issue of 12b-1 fees involves more than just mutual fund expenses.
The SEC's View
In Chairman Cox's message at the forum for mutual fund directors, he took care
to point out the developments that make ". . . the original premises of Rule
12b-1 seem highly suspect in today's world." These developments include:
- Fund growth is no longer in question and large size can create
shareholder problems as funds lose flexibility and produce lower returns.
- " Collecting an annual fee from mutual fund investors that is supposed
to be used for marketing is no more consumer friendly than forcing cable TV
subscribers to pay a special fee of $250 a year so the cable company can
advertise HBO and Showtime to lure potential new customers."
- Independent director decisions to approve 12b-1 fee plans has to be
decided "no" unless existing shareholders will benefit.
- There is need for a broad review of all investor disclosures.
Finally, Cox concludes that the current regulation of 12b-1 plans falls
"tragically short" of meeting the needs of mutual fund shareholders:
To far too great a degree, and in substantial part because of a regulatory
cumbersomeness . . . our financial services industries are able to skim off much
more of the assets they handle than would be the case in a well-functioning
market.
Nonetheless, the SEC's past failures to eliminate 12b-1 plans indicate the
mutual fund industry's strength in Washington. Wall Street recently opposed any
significant changes in Rule 12b-1, which allows fund managers to pay marketing
and distribution costs out of fund assets.
The Wall Street Journal's
Hughes (2007) reports the financial industry's Securities Industry and Financial
Markets Association as stating that "such fees support legitimate and necessary
administrative and investment services for fund shareholders." One must wonder
how these fees represent "legitimate" services to current fund shareholders.
SEC staff economist Walsh's (2004) empirical analysis of 12b-1 plans derives
from the question of whether mutual fund shareholders benefit from the assumed
increase in fund assets and reduced flow volatility. She states:
The use of fund assets to market the fund leads to an inherent conflict of
interest between fund advisers and shareholders. Fund advisers earn fees based
on assets under management. Asset growth increases the fees collected by the
adviser. Thus, while current shareholders incur the costs to grow the fund, it
may be that the adviser is the primary beneficiary of the resulting growth.
If 12b-1 plans did provide a net benefit, mutual fund shareholders should
recover their fee payments through higher fund net returns, and these returns
would derive from either lower expense ratios due to scale economies or higher
gross returns. Higher gross returns would come from less volatile fund flows,
which would require smaller cash reserves and permit investing a larger
proportion of assets in higher returning assets at lower transactions costs.
However, Walsh's (2004) analysis finds that 12b-1 fees are inconsistent with
increased net mutual fund returns to shareholders, and also may not provide
higher gross returns to funds:
12b-1 plans do seem to be successful in growing fund assets, but with no
apparent benefits accruing to the shareholders of the fund. Although it is
hypothetically possible for most types of funds to generate sufficient scale
economies to offset the 12b-1 fee, it is not an efficient use of shareholder
assets. No shareholder will be better off investing in a small 12b-1 fund in
hopes of helping the fund grow to attain these scale economies.
Furthermore, these higher expenses do not translate into higher gross returns.
Indeed, fund flows may be more volatile and gross returns may be lower for funds
with lower 12b-1 plans. Fund advisers use shareholder assets to pay for asset
growth from which the adviser is the primary beneficiary through the collection
of higher fees.
For a contrary view on 12b-1 fees, see the Appendix. Comments on this statement
are welcome.
Conclusion
The stated and objective empirical findings in this study (and others) are
generally consistent. There is no evidence that mutual fund shareholders benefit
from Rule 12b-1 plans, which provide a serious conflict of interest.
The promise that 12b-1 fees would be used to increase mutual fund assets and
thereby lower fund shareholder expenses appears to have been a cynical industry
effort to gain SEC approval, while the intended beneficiary was (and is) fund
management—and what a bonanza it has been.
The opportunity to prohibit 12b-1 fees, as both abusive and costly conflicts of
interest to mutual fund shareholders, will never be better than now. The major
question is not whether Chairman Cox is determined to prohibit or drastically
change 12b-1 fees for the better, but, rather, if he will be able to prevail
over the opposition of the industry and its Washington supporters.
References
Anand, Shefali, "Review of 12b-1 Fees May Be Far-Reaching," Wall Street
Journal, June 19, 2007, p. C13.
Cox, Christopher. Speech by SEC Chairman: Address to the Mutual Fund Directors
Forum, Seventh Annual Policy Conference. U.S. Securities and Exchange
Commission, Washington, D.C., April 13, 2007.
Cuthbertson, Keith; Dirk Nitzsche; and Niall O'Sullivan, Mutual Fund
Performance, Working paper, SSRN, December 12, 2006.
Elton, Edwin J.; Martin J. Gruber; and Jeffrey A. Busse. "Are Investors
Rational? Choices Among Index Funds," Journal of Finance, Vol. 59, No.
1, (February 2004), pp. 261–288.
Freeman, John. John Freeman's Working Paper Responding to the Advisory Fee
Analysis in AEI Working Paper #127, June 2006, "Competition and Shareholder Fees
in the Mutual
Fund Industry: Evidence and Implications for Policy," by John C. Coates, IV, and
R. Glenn Hubbard. Working paper, SSRN, 2007.
Gogerty, Andrew, "Memo to SEC: 12b-1 Fees Must Go," Morningstar.com, April 19,
2007.
Haslem, John A., Mutual Funds: Risk and Performance Analysis for Decision
Making. Oxford: Blackwell Publishing, 2003.
Haslem, John A., "Are Mutual Fund Expenses Too High? A Commentary," Journal
of Investing, Vol. 13, No. 3 (Fall 2004), pp. 8–12.
Houge, Todd, and Jay Wellman. "The Use and Abuse of Mutual Fund Expenses,"
Journal of Business Ethics, Vol. 70, No. 1 (January 2007), pp. 23–32.
Hughes, Siobhan, "Wall Street Resists Efforts to End Fund Fees," Wall Street
Journal, July 20, 2007, p. C11.
Mahoney, Paul G., "Manager-Investor Conflicts in Mutual Funds," Journal of
Economic Perspectives, Vol. 18, No. 2 (Spring 2004), pp. 161–182.
Siggelkow, Nicolaj, Expense Shifting: An Empirical Study of Agency Costs in the
Mutual Fund Industry. Working paper, Wharton School Center for Financial
Institutions, University of Pennsylvania, Jan. 4, 1999.
Tkac, Paula A. "Mutual Funds: Temporary Problem or Permanent Morass?" A paper
presented at the Financial Markets Conference, Federal Reserve Bank of Atlanta,
Sea Island, Ga., April 2004.
Tufano, Peter, and Matthew Sevick, "Board Structure and Fee-Setting in the U.S.
Mutual Fund Industry," Journal of Financial Economics, Vol. 46 (1997),
pp. 321–355.
Walsh, Lori, "The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An
Examination of Fund Flows, Expenses and Returns. U.S. Securities and Exchange
Commission," Office of Economic Analysis, Washington, D.C., 2004.
Wharton School of Finance and Commerce. "A Study of Mutual Funds." Prepared for
the U.S. Securities and Exchange Commission. Report of the Committee on
Interstate and Foreign Commerce, 87th Congress, Washington, D.C.: GPO, 1962, p.
493.
Willkie Farr & Gallagher. SEC Holds Roundtable on Rule 12b-1. Client memorandum,
Washington, D.C., June 22, 2007.
Appendix
A Statement On 12b-1 Fees As
Valuable Services
". . . [C]oncerns regarding the cost to
investors can be raised regarding the proposed elimination of 12b-1 fees in the
Mutual Fund Act of 2004. These fees are not hidden actions by the advisory firm;
they are observed implicitly in the net performance earned on fund shares and
reported explicitly as part of the expense ratio and in shareholder reports.
Many academics have argued that these fees are a deadweight loss for investors
but this misses the point that 12b-1 fees are largely deferred payment for
brokerage services. These brokerage services package together investment advice,
information, convenience, and other intangibles, like reputation, that are of
value to investors. The elimination of 12b-1 fees would impose costs on
investors via an impact on the market for these services. Put succinctly, these
valuable services will continue to be demanded and thus provided, and ultimately
investors will bear the cost. Two obvious possibilities that might follow from
the elimination of 12b-1 fees are increases in management fees to advisory firms
and a shift to more fee-based broker-investor arrangements. It is not possible
to eliminate 12b-1 fees and leave investors enjoying the same bundle of services
at a lower price [italics added]."
Source:
Paula A. Tkac. "Mutual Funds: Temporary Problem or
Permanent Morass?" A paper presented at the Financial Markets Conference,
Federal Reserve Bank of Atlanta, Sea Island, Ga., April 2004.
This article is reprinted
with the permission of the Journal of Indexes, which is the publication
of record for the index industry. Any rebroadcast or distribution of this
content requires the expressed permission of the Journal of Indexes. All
Journal of Indexes content, including past columns by Professor Haslem
can be accessed on
www.indexuniverse.com/JOI.
John A. Haslem,
Professor Emeritus of Finance, University of Maryland.
