Of all the costs involved in investing in mutual funds, perhaps none is more controversial than so-called 12b-1 fees, named for the Securities and Exchange Commission rule under which they may be imposed.
Adopted in 1980, the rule allows a fund to pay certain expenses out of its assets -- your assets, if you're a shareholder -- for promoting sales of its shares.
To do this, a written plan, describing how the money would be used, must be approved by a vote of shareholders, the fund's board of directors, and, in a separate vote, its independent (or "outside") directors, those who not work for the company.
For a 12b-1 plan to remain in force, it has to be approved annually by the board and by the independent directors. Independent directors can kill it at any time.
Almost one-half of all funds, including some that don't charge a front- or back-end sales load, now have such plans.
The charges permitted under these plans are controversial for at least two reasons:
1. They may carry high rates.
2. They may be difficult to justify at any rate.
The SEC set no limit on the charges. Today, some funds charge as much as 1.25 percent of net assets annually. Many charge only 0.25 percent. Others charge less than their plans authorize them to do and can raise the level to the approved limits.
A 12b-1 fee of, say, 1 percent can double a fund's total operating expenses, once you add the investment adviser's fee for managing the portfolio and other costs, from printing to safekeeping of securities.
That may not seem like a lot of money if a bull market is giving you a yearly total return of 20 percent or 30 percent.
But you can't count on such returns from equity funds every year, and bond funds rarely do that well. In a year when a fund earns 10 percent, the difference between total operating expenses of 1 percent and 2 percent is significant.
This isn't the only problem with 12b-1 fees.
They are annual charges, you'll remember. They come out of your income, before payment of dividends, year after year as long as the directors vote to retain the 12b-1 plan.
If a fund charges 1 percent and you hold its shares for 10 years, the cost can amount to 10 percent, which is more than the maximum sales load of 8.5 percent that you can be charged on your initial investment.
Whether 0.25 percent or 1.25 percent per year, how can 12b-1 fees be justified? Not easily.
What's the principal justification for asking current fund shareholders to pay for the cost of attracting new shareholders? It's similar to the concept that the part of a new car's cost that goes into advertising actually holds prices down by encouraging mass sales, which leads to mass production, which brings down the cost of making a single vehicle.
Savings attributed to large-scale production of goods or
services, known as economies of scale, are possible in some of the funds' operating costs.
Sometimes, a fund manager's fee will drop when assets rise above certain levels. Accountants' and lawyers' fees may not rise as share sales increase. And so on.
But do such economies of scale offset the costs of the 12b-1 fees -- or exceed them? That's a question that independent directors should weigh when they review expenses under 12b-1 plans and one that you, as a shareholder, can raise when you vote on such plans.
Charging fees to attract new shareholders, to be sure, is not limited to funds that have 12b-1 plans. Those funds are simply the only ones allowed to pay such expenses from fund assets. In the cases of other funds, these costs are usually paid by investment advisers.
A portion of 12b-1 fees also can be used for payments to stockbrokers and others who sell fund shares. That's designed to help compensate them not only for attracting new investors, but also for keeping in touch with customers who just hold shares.
Other shareholders are said to benefit from maintaining brokers' interest in their customers. The reasoning: It holds down share redemptions, which could hurt a fund's performance.
Whatever the rationale, you'll want to keep an eye on any 12b-1 fees charged by your funds -- they're cited in prospectuses and shareholder reports among operating expenses -- and to scrutinize any 12b-1 plan proposals when you're asked to vote on them.