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:

“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.

One of the biggest problems facing the mutual fund industry’s relationships with its millions of shareholders is justifying fund wholesalers’ salaries.

This is a contentious and sticky issue for a few reasons:

First, mutual fund wholesalers really don’t add anything that directly benefits shareholders, especially their net portfolio returns.

Second, maintaining a national wholesaler network in the COVID world is more expensive than ever.

Third, Robo-advisors and better technology make the door-to-door mutual fund wholesaler job a relic of the horse-and-buggy age.

In theory, they should be reducing overall fund expense ratios by increasing the asset base of mutual funds. They should also be reducing the overall costs of administering 401(k) plans. 

This would then lower the overall expense ratio for all shareholders. That was the original theory and rationale behind allowing 12b-1 fees to be charged in the first place about 30 years ago.

But since then, fund wholesalers have been selling funds, receiving huge salaries, having all of their expenses paid by the fund companies, and(in many cases)receiving commissions based on revenue sharing deals with registered reps.

Salaries That Cannot Be Justified

The problem today is how to justify these huge salaries when they do not directly benefit shareholders.

It’s a dilemma that has not been publicly discussed before and that is surprising due to the abundance of financial journalists and financial media outlets, which are supposedly working to educate investors about the optimum ways to invest.

Yet almost everyone agrees that the best way to increase overall fund returns is to invest in funds with low expenses.  Since that is the case, how can so many funds justify these large salaries without decreasing their expense ratios?

So with that as a brief background, this salary chart (which comes from U.S. Department of Labor statistics and Kassina) shows the salaries of various professions, many of which provide specific, tangible societal benefits.

Since the late 1990s, mutual fund asset growth has declined significantly from the record levels seen during the mid- to late-1990s.  Yet according to Kassina, a mutual fund consulting group, wholesaler compensation has not declined despite the downturn in the industry and the significant layoffs.

Data from Kassina shows external wholesalers typically receive an average annual base salary from $65,000 to $98,000, with an average of $83,000.  Total target compensation can range broadly from $225,000 for an average-performing wholesaler to over $500,000 annually for top performers.

This puts mutual fund wholesalers at the top of the compensation list, based on government and fund industry statistics.

What Benefits Do Wholesalers Provide Shareholders?
Now, the mutual fund industry’s largest funds should justify why, and how much, mutual fund wholesaler salaries benefit their own shareholders.

Ideally, this should be shown using correlations between wholesaler salaries and a specific fund company’s decrease in its total expense ratio over time. If such a correlation exists, it would make a great marketing message and allow some fund marketing exec to differentiate their fund.

This would be a historic revelation.

It also would be especially welcome now since the fund industry is so openly antagonistic and has vehemently lobbied against all issues related to fiduciary responsibility, transparency, fee reduction, and any modicum of financial reform.

But this again raises the simple question:  What benefits do fund wholesalers deliver directly to their fund companies’ individual shareholders to justify their large salaries?

It’s a simple question that deserves a simple answer.