There are over 8,000 mutual funds in the U.S.* and virtually all of them charge fees to shareholders to help offset their operating expenses. This is a normal cost of doing business.
But the mutual fund industry considers itself special. Over the years, it has lobbied securities regulators for exceptional treatment, especially in the area of offsetting their large mutual fund marketing and sales expenses by charging these costs off to shareholders. The vehicle for this relief comes in the form of fees which fall under the esoteric name of SEC Rule 12b-1, which governs the fees paid to mutual fund dealers as compensation for selling a fund company’s products.
These fees were introduced as part of the Securities and Exchange Commission (SEC) 1940 Act. According to a paper from SEC financial economist Lori Walsh, “the original justification for the plans, as put forth by the mutual fund industry in the 1970s, was that such (12b-1) fees help attract new shareholders into funds through advertising and by providing incentives for brokers to market the fund.”
The corollary is that as the number of shareholders increased, it would reduce fund expenses by passing along any scale of economy which was generated from providing many of the same services to a larger body of shareholders. But that was largely theory.
In practice, there are many instances when 12b-1 fees pit shareholder interests against those of load fund companies. SEC economist Walsh’s study found that “while funds with 12b-1 plans do, in fact, grow faster than funds without them, shareholders are not obtaining benefits in the form of lower average expenses or lower flow volatility. Fund shareholders are paying the costs to grow the fund, while the fund adviser is the primary beneficiary of the fund’s growth.”
This is the inherent conflict of interest which places load mutual fund companies on a collision course with their own shareholders. Today, the way 12b-1 fees are being used raises serious questions about the fiduciary role of load mutual fund companies and their sales intermediaries.
In the case of too many fund companies, the misuse of 12b-1 and other poorly disclosed fee arrangements, such as shelf space deals and revenue sharing agreements, are legal, yet they have created serious ethical problems. These conflicts should justifiably raise the issue of whether shareholders can trust the hidden motives and judgment of the financial rep who sold them the mutual fund in the first place, as well as the fund company itself which pays for these practices.
12b-1: A Very Controversial Fee
These fees have always been controversial and debated at the highest levels of the mutual fund industry. The reason: they determine how billions of dollars of shareholder money is spent at load mutual fund companies on fund administration, sales/marketing expenses, salaries for portfolio managers, and something which is not publicly discussed, how millions in ancillary expenses are wasted on sales junkets, national wholesaler networks, excessive salaries, and trinkets for financial reps which range from golf balls, barbeque sets, wine, paperweights, key chains, clothing, umbrellas, to dinners, wine tastings, and “value-added events.”
The 12b-1 fee also points out the wide gap in fiduciary responsibility which exists under ERISA plans and the fiduciary role, however, weak, which exists between a financial representative and their investor client. Under ERISA, for example, a pension plan trustee or executive who diverted plan participant money to pay for personal expenses, triggered a serious set of repercussions, which could go as high as the U.S. Department of Labor or Justice Department.
I saw this first-hand during the mid-1970s when I worked at the notorious Teamster’s Central States Pension Fund in Chicago which, at the time, was under DOL trusteeship. At the time, the Central States Fund was the largest Taft-Hartley pension fund in the U.S. with $1.5 billion in assets (How times have changed.)
In one instance at the Teamsters Fund, some trustees were attending a board meeting in California and went to the pro golf shop where they bought golf supplies and charged it to their rooms. The room expenses were reimbursed with pension fund assets, which triggered an ERISA violation: diverting pension plan assets for personal use. The DOL then made sure the Fund was reimbursed and the trustees reprimanded.
Yet when I was working for a mutual fund company, a conference event planner said she reluctantly had to sign an expense account for a mutual fund wholesaler who bought $2,000 worth of wine and had it delivered to his room for personal use. This exact same violation would be impermissible and punished under ERISA standards, yet it went unpunished by the mutual fund company.
The wine was paid for using 12b-1 fees. Shareholders did not get a chance to sample this wine, they just paid the bill. This double standard between ERISA fiduciary standards versus laissez faire load mutual fund company spending raises the critical question: Who is the advocate for the mutual fund company shareholders?
Even worse, what happens when 12b-1 fees are used against shareholders, whether they are in the form of keeping fund expense ratios high as fund assets grow or the blatant abuse of fund spending on frivolous items?
The Role of 12b-1 Fees and Wholesalers
In an SEC-sponsored public roundtable on 12b-1 fees held in June 2007, panelists discussed the history, role of these fees in fund distribution, costs and benefits, and options for reforming this set of fees. An interesting memo issued by the law firm of Willkie Far and Gallagher summarizes this discussion.
The memo correctly notes that 12b-1 fees are charged to some degree by fund companies, including no-load funds, as a means of compensating intermediaries for selling their funds, shareholder communications and other administrative costs. If a fund charges a small 12b-1 fee and works to keep expenses low, it can call itself a no-load fund. This category of fund company usually adopts the direct sales model in which investors buy directly from the company
In contrast, load fund companies often sell their funds using a national sales force of wholesalers, supported by internal sales support staff, and a marketing department which produces materials for both shareholder and broker-dealer use.
From my experience, the load-fund sales model has an entirely different focus versus the direct sales (no-load) model. At load funds, the most important audience is the company’s own national wholesaler sales force, followed by the financial intermediaries (brokers and financial reps) which directly interface with shareholders.
Despite much of the load fund industry rhetoric, the least important audience is individual shareholders. I estimate these two groups (wholesalers and financial intermediaries) receive about 90% of the marketing department’s attention, while individual shareholders receive 10%. (From a budget perspective, these proportions differ since a national wholesaler and internal sales support staff could number around 250 people, while there may be hundreds of thousands of individual shareholders.)
And what do wholesalers do? In the words of an industry publication, “wholesalers spend their lives attending conferences for financial advisers, taking advisers out to swank restaurants, criss-crossing the country to give presentations to advisory firms or to help an adviser give a seminar on investing to prospects.” The problem is that the majority of these presentations are fund specific. The vast majority of wholesalers are not CFAs and most will not or cannot discuss other strategies and products, such as ETFs or no-load funds, which often are better suited to client needs.
Yet despite the narrow focus of mutual fund wholesalers, they are exceptionally well compensated. According to a January 2006 report from the mutual fund research firm, Kasina, total external wholesaler compensation can range from $225,000 for an average-performing wholesaler to over $500,000 annually for top performers.
A salary comparison from the firm Saleslogix found that mutual fund wholesalers are among the most highly paid professionals in the nation, ranking as high as doctors and lawyers. However, even this salary figure understates the remuneration since 100% of any mutual fund wholesalers’ expenses are reimbursable by their mutual fund company employer. This includes all meals, gasoline, travel, office, auto, and telecommunications expenses.
One fund wholesaler was so inconvenienced from putting in his car expense reports that he leased one and had the fund company pick up the entire tab instead. Plus, unlike doctors and lawyers, mutual fund wholesalers do not pay for expensive malpractice or professional indemnity insurance. The money to pay for these salaries and expenses comes from 12b-1 fees which, you guessed it, all comes from the shareholders.
At the time of the SEC conference on 12b-1 fees held in June 2007, then-Chairman Christopher Cox said the Commission would act on 12b-1 rules later in 2007. Nothing significant happened. At a conference in April 2009, I asked SEC Chairwoman Mary Shapiro about 12b-1 fees and she again repeated that they were high on the SEC’s agenda and some action would be taken in the second half of 2009. This will be a high-level debate, but if the past serves as any example, individual shareholders’ interests will not be represented.
This is because Wall Street reform is inherently evolutionary. Given the powerful lobbying from the Investment Company Institute, the Profit-Sharing Council of America and various law firms representing individual load fund company clients, this debate could easily result in actions which will reduce shareholder returns in direct proportion to a load fund company’s high expense ratios. In practice, this means that it will take shareholders years longer to recoup their market losses since they will have to first pay for the expenses of their load fund company before they see any return posted to their personal fund accounts.
To ad insult to injury, after the shareholder pay the 12b-1 fees and the wholesalers bring in new investors regardless of the costs, the fund company often does not pass along any scale of economy they achieved from adding more shareholders to their existing service model. This was a main reason for charging the fees in the first place, yet these scales of economy are often never passed along to reduce overall fund expenses.
Since the 12b-1 issue is so esoteric and involves billions of dollars, many shareholders will not even be aware it is happening. This will be a costly mistake since the current economic imbroglio, which combines the decline in housing wealth and portfolio assets, has effectively wiped out a generation of wealth.
Reducing 12b-1 expenses will benefit shareholder by allowing fund returns to post slightly greater gains at a faster rate as fund expense ratios are reduced. If this occurs, fund companies would have to re-shape their business practices to become more competitive and less commoditized. But maybe that is exactly what they are trying to avoid in the first place.
*Source: Investment Company Institute, 2007 Fact Book, May 1, 2009