March 1, 2006

Some Closed Mutual Funds Are Charging 12b-1 Fees

Of more than 19,000 mutual funds (including all share classes), there are currently 579 which are both closed to new investors and still charging 12b-1 fees [as of February 8], according to data from Standard & Poor's. These fees range from 0.02% to the SEC-enforced maximum allowable rate of 1.00%, with an average of 0.66%

In addition, a handful of exchange-traded funds (ETFs), including the Select SPDR ETFs, charge 12b-1 fees of between 0.07% and 0.09% (see table below).

"12b-1 fees were intended to pay marketing costs for funds," said Phillip Edwards, managing director of Standard & Poor's Investor Services. "Under the original intent, if the fund raised more assets, economies of scale would kick in and the overall fees could be lower. So they dedicated a fee to increasing the size of the funds' asset base." However, he explained, eventually the definition of "marketing expenses" broadened and now includes payments to intermediaries, such as brokers and advisors, for selling the funds.

"Like any fee, the company charging it got 'addicted' to the revenues generated from them," Edwards said. "So they became difficult to eliminate. You would think that a fund that is closed to new investors no longer needs to spend as much money on marketing the product and the 12b-1 fee would be reduced, if not eliminated. However, because of the 'addiction,' reality doesn't follow logic."

Louis Harvey, president of Dalbar Inc., a Boston-based mutual fund consultant, said that the justification for closed funds charging 12b-1 fees is "somewhat convoluted." He noted that without these fees, advisors "would not bring assets into the fund and, if removed, they would take assets out of the fund. Reducing the growth in assets or increasing withdrawals would reduce the size of the fund. This would mean that fixed costs would be distributed across a smaller base of investors; consequently, the remaining investors would each pay more."

Edwards indicated that an evaluation of fees should be a very important consideration when selecting a mutual fund. "Our studies have consistently shown that the lower the fees, the better the performance of the fund," he said. "The less the fund sponsor takes, the more there is available for the investor. Keeping fees competitive is also a very tangible sign of the fund sponsor keeping the best interest of shareholders in mind."

However, Harvey said that 12b-1 fees are always included in a fund's total expense ratio, thus it is not a "hidden cost." For example, he would view two funds with the same expense ratio equally, even if one had a 12b-1 fee and the other did not.

While Edwards does not suggest that mutual fund fees should be regulated, "there should be more transparency around the pricing in order to allow consumers to better evaluate products."

The situation with respect to ETFs is completely different. The 12b-1 fees were used to aggressively market ETFs, and resulted in a rapid rise in assets. Fortunately this escalation in assets also resulted in a decrease in overall expense ratios. For example, the sector SPDR ETFs cited below have in recent years lowered their overall expense ratios from 0.30% to 0.25%. Moreover, ETFs, by their very structure, can never be closed to new investors.

"ETF's have 12b-1 fees for the same reason other funds do, to pay advisors to sell and maintain the client accounts in those funds," Harvey noted. "Their justification is also the same."

ETFs Charging 12b-1 Fees

ETF

12b-1 Fee (%)

Expense Ratio (%)

S&P Sel Materials SPDR Fund (XLB)

0.07

0.25

S&P Sel Financial SPDR Fund (XLF)

0.07

0.25

S&P Sel Health Care SPDR Fund (XLV)

0.07

0.25

S&P Sel Industrial SPDR Fund (XLI)

0.07

0.25

S&P Sel Consum Staples SPDR Fund (XLP)

0.07

0.25

S&P Sel Technology SPDR Fund (XLK)

0.07

0.25

S&P Sel Utilities SPDR Fund (XLU)

0.07

0.25

S&P Sel Energy SPDR Fund (XLE)

0.07

0.25

S&P Sel Consum Discretion`y SPDR Fd (XLY)

0.08

0.25

Fidelity Nasdaq Comp Index ETF (ONEQ)

0.09

0.30

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

Reprints Discuss this story
This is where the comments go.