Fund Probe May Lead to Attention on Obscure Fees

Something good will come out of the mutual fund industry’s current mess: More shareholders will start asking questions about fund practices that have nothing to do with abusive short-term trading but cost the average investor far more over time.

Take, for example, the widespread imposition of so-called 12b-1 fees.

These are expenses that come right out of your pocket: They are deducted annually from many funds’ portfolios to pay marketing and distribution costs -- mostly to compensate the brokers and other financial advisors who hawk funds. A 12b-1 fee can reduce your fund return by as much as 1 percentage point a year.

It’s all legal, even if most fund owners don’t realize they’re paying these fees (on top of general portfolio management expenses) because they don’t bother to read the details in their funds’ prospectuses.

But the history of 12b-1 fees is an interesting tale that explains a lot about how the fund industry got to the troubled state it’s in.

In 1980, when fund assets totaled $135 billion, or about 2% of the current amount, the Securities and Exchange Commission decided that the business could use some help to boost its growth.

So the SEC approved Rule 12b-1, which allowed funds to begin charging existing shareholders a new fee to pay for increased efforts to market the portfolios.

In theory, faster asset growth would mean that a fund would realize economies of scale in its overall expenses. That is, if assets rose a fund could reduce its management fee as a percentage of assets, because the managers would automatically be earning more dollars on a bigger portfolio base. If the percentage management fee fell, shareholders’ returns would rise by the same amount.

It sounded win-win for management and shareholders. And when the SEC approved 12b-1 fees, it did so with the idea that they would be temporary -- lasting only long enough to make the win-win scenario real.

Yet 23 years later, 12b-1 costs are as permanent a fixture as any on the fund industry landscape. About two-thirds of all stock and bond funds levy the fees.

When New York Atty. Gen. Eliot Spitzer, the fund industry’s principal nemesis these days, rails that fund fees are “grossly out of control,” he helps to inflame other critics’ condemnation of Rule 12b-1 in particular.

“You could make a very good case that they [the SEC and the fund industry] lied to Congress” about 12b-1 fees in 1980, said Don Phillips, managing director of fund research firm Morningstar Inc. in Chicago.

But it’s an exaggeration to say that 12b-1 assessments amount to a wholesale fleecing of fund shareholders. Not surprisingly, the industry argues just the opposite: It says that 12b-1 costs did indeed result in lower overall costs for many investors.

Nonetheless, there is enough controversy over 12b-1 fees to warrant the SEC revisiting them. The agency’s staff recommended just that in a lengthy report in 2000, though the commission didn’t follow through.

Amid the scandal that has rocked the industry since early September, involving widespread allegations of improper trading of fund shares by insiders and by favored clients, the SEC is under pressure to do a comprehensive review of fund practices and expenses.

Fund investors, however, don’t have to wait for the SEC. They can easily check on their own what they’re paying to own mutual funds, including 12b-1 fees -- and whether a fund is worth the cost.

The key question for fund shareholders is, what is 12b-1 money being used for? According to a survey last year by the Investment Company Institute, the funds’ trade group, 63% of 12b-1 fees went to compensate brokers and pay related “distribution” expenses.

In other words, the money probably is going primarily to pay whoever sold you your fund.

The vast majority of investors seek advice in buying funds. Do-it-yourselfers are a rarity.

Before 1980, investors who bought a fund from a broker typically paid an upfront commission of as much as 8% of the purchase amount.

But the industry, and Wall Street, knew that such commissions posed a marketing problem, said Kathryn McGrath, a Washington attorney who spent much of her career in the 1970s and 1980s at the SEC.

“Americans like to pay on ‘time,’ ” meaning credit, she said. “They don’t like to pay a big wad up front.”

With the dawn of 12b-1 fees, that problem was solved: Brokers could sharply reduce their commissions or get rid of them entirely. In place of the commissions, investors would pay up to 1% a year in 12b-1 fees to compensate their brokers.

Morningstar calculates that the average stock fund’s 12b-1 fee takes 0.42% of assets each year. Added to general portfolio management expenses, that lifts the total annual “expense ratio” of the average stock fund to 1.58%, the firm says.

That comes right out of shareholders’ returns each year.

For the average bond fund, the 12b-1 fee is 0.39% and the total expense ratio is 1.11%.

Industry critics say fund expense ratios haven’t come down much, if at all, since 1980, even though industry assets have ballooned to nearly $7 trillion.

Fee levels may not have mattered much during the booming markets of the 1990s, critics say, but they’ll matter a lot if average market returns are in the single digits in this decade.

The Investment Company Institute sees the fee issue in a different light. Its studies say that the overall distribution costs of mutual funds are lower today than in 1980 if the imposition of 12b-1 fees is weighed against the decline in upfront commissions.

Whether fund shareholders feel that they’re getting their money’s worth from 12b-1 fees ought to come down in part to how much help they’re getting from their broker or other financial advisor, especially in terms of monitoring their funds.

If you’re still paying him or her, what do you get back?

Some industry analysts raise another concern: the proliferation of share “classes,” usually designated A, B, C, etc.

With 12b-1 fees as a fallback, the funds and brokers created an alphabet soup of choices for buyers. Class A shares charge an upfront commission but have lower annual expenses, including 12b-1 costs. Other classes generally allow an investor to avoid upfront commissions but have higher, and varying, ongoing 12b-1 and other fees.

Mutual fund prospectuses clearly spell out that an investor may find it much more costly in the long run to buy a Class B or Class C share compared with a Class A share.

The question that has troubled many industry critics for years is whether brokers have adequately explained the differences to investors, who in many or most cases would be inclined to simply go with the transaction that doesn’t take a dime from their pockets at the start.

Max Rottersman, a New York-based industry watchdog who operates the FundExpenses.com Web site, believes that fund share classes other than the A-class have allowed many brokers to feather their nests with fees from investors who perhaps should never have bought stock or bond funds.

“They were used to get reluctant late-1990s investors into funds,” Rottersman said.

As brokers and other third parties came to rule the fund distribution process, the fund companies increasingly lost the ability to deal directly with their own customers, he and other critics say. The fund trading scandal is an outgrowth of that.

There is a more basic problem with ongoing 12b-1 fees, some analysts say: If the purpose of the fees has been to help a fund grow in size, has that served the fund’s existing investors?

“Growth for growth’s sake is not necessarily useful” to shareholders, said Geoff Bobroff, head of fund research firm Bobroff Consulting in East Warwick, R.I.

As funds grow larger their performance often suffers, Bobroff notes. Owners of large funds may end up with portfolios that at best track major market indexes -- but at higher net cost to the investors.

The original SEC 12b-1 rule requires the directors of any fund company imposing the fee to revisit the merits of it every year. But in practice, no directors ever tell fund managers to terminate the fee.

The SEC staff, in its 2000 report on 12b-1 fees, raised questions about whether the provision had become misused.

That’s still a good question for the commissioners in 2003.

Tom Petruno can be reached at tom.petruno@latimes.com.