Investors Still Awaiting Decision on Critical Issue of Fee Reform.


Note: This article was originally published in July 2010.  Investors are still waiting for a decision.

After decades of wrangling, false starts, and back room intrigues, it looks like the SEC is finally addressing the long-over due, critical issue of mutual fund fees.

Today, these fees charged to fund shareholders amount to $12 billion, according to the SEC. Yet, despite this huge amount, shareholders have no idea what they are paying for.

Also known as 12b-1 fees in the fund industry, SEC Chairwoman Mary Schapiro said in a July 21 release:

SEC Chairwoman Mary Schapiro

“Despite paying billions of dollars, many investors do not understand what 12b-1 fees are, and it’s likely that some don’t even know that these fees are being deducted from their funds or who they are ultimately compensating. Our proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds.”

What the Fees Pay For
Ostensibly, these fees were introduced in the late-1970s to pay for fund marketing expenses to help funds gather more assets. The cover story at the time was that as funds grew in size (gathered more assets under management), they could reach a scale of economy and reduce their overall fund expense. As a result, shareholders would pay less in expenses and have more money in their fund accounts.

That was the theory.

In the intervening years, however, fund expense ratios generally have risen, but fee reductions have not been reduced proportionately. Instead, these fees support very differnt activities. On the negative side, they promote bloated marketing operations, pay near-unlimited expenses for fund wholesalers, support top-heavy sales organizations. But they also pay for beneficial activities, such as a basic level of shareholder communications, redemption processing, and account servicing departments.

The problem is that the needed and extravagant services are bundled together, so it impossible for shareholders to separate the two. Another problem is that fund expenses have not been reduced proportionately as fund assets have increased.

As a result, the bottom line is that shareholders are paying for a fund company’s growth, yet they are not receiving the benefits of this growth in the form of reduced total expenses.

It’s Just a Proposal
While this problem is well-defined and has been well known within the fund industry for decades, it has now just reached the proposal stage. The powerful fund lobbying organization (the Investment Company Institute) will certainly work against any significant fee reform.

But given the climate in Washington and the passage of the financial reform bill, the SEC’s actions are a beginning.

Here is what the SEC would like to accomplish:
–Protect investors by limiting fund sales charges.
–Improve transparency of fees for investors.
–Encourage retail price competition.
–Revise fund director oversight duties.

Of these, the most important goal is price competition. As a matter of fact, any form of competition in the mutual fund industry will be a welcome change from the vast commoditization among look-alike funds with index-like returns which exist today.

If funds compete, it will revolutionize the entire fund industry. However, for those funds which seek to make the change into a new, competitive environment, it will be a wrenching experience. It will require the entire revamping of many fund marketing departments, and possibly a fund company’s entire culture.

This is because too many fund companies do not have a competitive mentality. As it stands today, many fund marketing professionals and wholesalers think they are competing when they show an ad touting their fund’s latest change in a Morningstar or Lipper ranking. That may constitute sales literature, but it in not competing.

On the plus side, competition has come from ETFs (Exchange Traded Funds) which are index products which have specific benefits in terms of trading (they are continuously priced) and fees (they are invariably cheaper than mutual funds.) This explains why ETFs are now more popular than mutual funds.

While the ETF choice benefits many investors, millions of other investors cannot access ETFs via their 401(k) plans. This puts them at a disadvantage not only in terms of restricting their access to more specific sectors of the markets (both equities and fixed), but also in terms of gaining the benefits of long-term costs savings from paying lower expenses.

DIsclosure Is Long Overdue
In an earlier report, Ms. Schapiro said 12b-1 fee reform would be done by the end of 2008, so we can assume the SEC has had many tense meetings over this issue. While the end result remains uncertain, it’s clear that any fee reform which puts more money into the hands of shareholders is decades overdue.


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