More on How 12b-1 Fees Subsidize Advisers

When a financial adviser sells a mutual fund to a shareholder, does the adviser deserve a commission for as long as the shareholder owns the fund?

Most shareholders would say “no,” since the research and subsequent purchase was only done once. But the mutual fund industry, which writes the rules, says otherwise.

That is why some fund shareholders are paying 12b-1 fees to their financial professional for as long as they own the fund. In some cases, these 12b-1 fees can be more than what the shareholder actually earned on the entire fund purchase over the same period.

Even worse, we are taking about substantial sums of money being paid to people who aren’t providing anything in return. For instance, if a shareholder owns a $100,000 portfolio and is being charged 12b-1 fees of 0.25%, the fees amount to $250 per year most of which goes to the adviser. This is paid annually, regardless of whether they adviser even makes a phone call to the shareholder. That’s not bad for 30 minutes of work.

As reported in a recent story by MarketWatch mutual fund columnist Chuck Jaffe, investors pay 12b-1 fees long after they have ended a relationship with an adviser or their firm. For as long as the shareholder owns the fund, the 12b-1 fee is paid even if there is no contact or professional advice exchanged.

In short, the 12b-1 fee becomes an annuity for the financial professional who often spends under 30 minutes scanning a list of possible funds. For that work, they can earn years or commissions or what the industry calls a “trail commission for years

Where’s the Outrage?
While Jaffe should be commended for even writing about 12b-1 fees, he categorizes them as a “Stupid Investment of the Week.” That’s a gross understatement. 12b-1 fees are part of the mutual fund industry’s unspoken netherworld of hidden fees, revenue sharing deals, extra commissions, and obscure share classes which all have one goal: To burden as many shareholders as possible with hidden fees.

While 12b-1 fees are ostensibly used for “sales and marketing,” they become part of a fund’s total expense ratio and fall under the accounting category of “distribution costs.” As other posts on this site have noted, these expenses support mutual fund wholesaler fests, which include events ranging from wine tastings and dinners to the mass distribution of logoed shirts, BBQ sets, and gold accessories.

By design, shareholders pay for these events and trinkets, but they don’t receive them. Instead, they are used to gain the fleeting attention of investment professionals, so a fund wholesaler can try to explain how their fund is different from scores of other similar funds.

None of this benefits shareholders. If the mutual fund distributor really wanted to do that, they would simply reduce the expense ratio by cutting marketing and distribution costs, including the 12b-1 fees. But that would mean a fundamental shift in the way load funds are sold, including the elimination of wholesaler perks and commissions. That directive would be career suicide in almost every load fund company in the U.S., so no marketing executive would dare recommend it.

So while the load fund industry understandably wants to evade this painful discussion for as long as possible, the financial press should not consider 12b-1 fees a “Stupid Investment of the Week.” If anything it is a structural weakness in the entire load fund industry which hurts shareholders and prevents them from recouping their financial losses.