Witness Post: 12b-1 Fees
The number / letter combo 12b-1 may sound like a vitamin regime; however, in finance it refers to a regulation which requires investment companies to disclose in their documentation any and all annual marketing and distribution costs that the investment funds charge their customers. Usually the range of these fees is from 0.25% to 1.0% of the investment costs. Prior to regulation, many mutual fund companies were “hiding these and other fees” and taking advantage of the poor disclosure loophole to extract additional fees from their investors.
Now that you know these fees are fully disclosed, how do you know it is worth the extra expense? As many can attest, these “marketing fees” can pack a punch!
The Basics
To put it simply, 12b-1 fees are a separate fee investors pay to their mutual fund or investment fund for the marketing and distribution of the funds. These fees are considered “operational expenses”, which means it is included in the overall expense calculation. The total fees are used by funds to explain their expense ratios for all to see. The fee is paid by fund managers taking client assets under management and using them to pay service providers.
Typical 12b-1 fees can be as high as 1.0% annually for most mutual funds. Clients consider these as “hidden fees” because they are included in the mutual fund expense ratio. As an example: say, an investor who owns shares in a fund, reads that the fund earns a 9 percent annualized return over a 30-year time-frame and investors will end up with more than 13 times their original investment, if they didn’t contribute any additional money along the way. But if that same investor had to pay an additional 1 percent in annual marketing costs, that fee would lower the return to 8 percent, and they’d end up with just 10 times their original purchase. That is, over time these costs can really add up.
Jack Bogle, the late founder and former chairman of the Vanguard Group, often reminded investors of the importance of tracking these seemingly inconsequential costs. The small, incremental costs can have a major impact on total returns over many years. “The record could hardly be clearer: The more the managers and brokers take, the less the investors make,” Bogle wrote.[1]
The Theory
A look back at the history of the marketing and distribution fees is illustrative. In the 1970’s, many mutual funds were struggling because individual stock pickers were successful and they tried to convinced investors to abandon the weaker performing funds. Fund managers felt harmed and desperately wanted a way to attract new investors, while also protecting existing investors and assets. The SEC came to the rescue in the 1980’s when they wrote new laws that helped in fee collection as they became part of the public disclosures.
Known as “Rule 12b-1 of the Investment Company Act of 1940” the regulation granted mutual funds the ability to pay for marketing and distribution expenses directly from the investment assets of shareholders. The new law in effect gave fund managers the ability to extract these expenses directly from the investors. The mutual fund companies claimed that the fees actually helped their clients in the long run. In theory, if the fees paid by current investors for marketing and distribution could bring in more investors, then over time these fixed costs would be spread over a wider group of investors and the total fee percentages would be brought down, benefiting everyone involved.
The Reality
The theory of 12b-1 fees has not proven true. Instead of bringing the costs down, many mutual funds have become more expensive, and the benefits that were expected for current investors have disappeared in the ether. Current investors are often paying money for the fund to market it’s shares to new investors. The marketing and distribution fees can be to an investor’s own detriment!
In addition to negatively impacting an investor’s retirement funds, the 12b-1 fees can also create a conflict of interest between investors and their advisors. For example, if your financial advisor has the option of choosing between a lower-cost share class of a fund (good for you as the investor), or a higher-cost share class of the same fund (allows them to make more money), how can you be sure the advisor will choose what’s best for you?
Unfortunately, advisors do not always acting with your best interests at heart. Many Registered Investment Advisors (RIA’s) have been fined by the SEC for not properly disclosing to their clients that they were choosing to invest in higher-cost mutual fund classes specifically because these funds charged higher 12b-1 fees. Because the fee is “hidden” in the overall expense ratio, clients may not realize that they are paying for the fund to acquire more customers, at the cost of their own earning potential. These fines stay in the RIA’s record for 10 years, so be sure to check into the background of your advisor before buying any mutual funds through them or their firm.
How to Protect Yourself Around 12b-1 Fees?
While you cannot prevent these fees from occurring, you can always research your prospective mutual fund to determine its expense ratio. The lower the ratio, often the lower the marketing and distribution costs. Described in the fund’s prospectus as “shareholder fees,” the SEC requires that these fees be calculated and disclosed to investors. The funds with the lowest fees are often indexed funds or “passively managed funds” which have fewer managers charging their time into the expense ratio. The typical mutual fund charges 12b-1 fees of about 0.25% – 0.50%. Remember that the maximum charge for 12b-1 fees that a fund can charge is 1.0% annually.
Another way to protect your investments from hidden fees is to work with a fiduciary financial advisor, who are legally obliged to act in your best interest. They must avoid the conflicts of interest, mentioned above. There are also fee-only fiduciary advisors, who charge you for their advice, not a commission on any trading in your account. If you are not sure if your financial advisor is a fiduciary, ask them! If they are not, consider switching to someone who is. You could save yourself a lot of money in the long run and you may sleep better at night.
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[1] https://www.fidelity.com/news/article/investing-ideas/202106151809BANKRATEBANKRATE1504732553
Henry E. Hooper 
