Faculty Opinion Article
An Idea Whose Time Has Come
Written by John A. Haslem
Wednesday, 30 April 2008 10:38
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
. . . Rule 12b-1 fees depress mutual fund returns.
. . . [U]sing fund assets to compensate intermediaries increases a fund's
. . . [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
. . . 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
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:
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with the permission of the Journal of Indexes, which is the publication
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John A. Haslem,
Professor Emeritus of Finance, University of Maryland.