The 12b-1 fee has been described as one of the darkest secrets of the mutual fund industry. While we think the industry has much darker secrets, the 12b-1 fee is one investors need to keep a close eye out for.
The 12b-1 fee is an annual fee that generally ranges from 0.25% - 1% and is included in the expense ratio of the fund. It is ostensibly used to cover the marketing and distribution expenses of the fund. In that vain it’s basically a way to collect an additional fee from investors to pay for the TV ads and glossy brochures they produce to attract new money to the fund. However, as we'll discuss in a moment, that's not the only thing mutual funds use this fee for.
The 12b-1 fee is an example of what can happen to the best of intentions. The SEC authorized the creation of this fee in 1980 thinking that it would help investors. The idea was that in marketing a mutual fund, the fund would increase its assets, which in turn would lead to lower annual operational expenses through economies of scale. Investors are still waiting for their lower expenses.
As for the dark secrets about the 12b-1 fee:
- Very little of the 12b-1 fee typically goes toward marketing expenses. It’s more commonly used as a hidden way to pay brokers for using the fund in their clients’ portfolios.
- There are closed funds (funds that no longer are taking money from new investors) that still charge 12b-1 fees. Why would a fund that isn’t accepting new money need to market itself? Good question. However, a closed fund would sure want to keep paying the brokers who’ve invested their clients’ money in the fund happy!
- Some no-load funds charge 12b-1 fees. The fee can be a way of implementing a hidden load that drains money from investors’ returns. There’s a good illustration of how this works here: http://mutualfunds.about.com/od/fundfees/l/bl12b1fees.htm
Where to find information about 12b-1 fees
In our last few posts in this series we’ve sent you to Google Finance to see the fees associated with mutual funds. Google Finance, however, does not have information on 12b-1 fees. Morningstar.com does, however. Here’s the fee information on a Franklin Templeton Fund. On the right side of the table, the very first fee listed is the 12b-1 fee. You can see for this fund it is 1%.
This information is also available in a fund’s prospectus.
The Bottom Line
Whether it’s used to market a fund and/or pay a commission to brokers, the 12b-1 fee does nothing good for investors who pay this expense. There are plenty of funds out there that don’t charge this fee. And with no evidence funds that charge 12b-1 fees outperform those that don’t, investors are better off avoiding these fees.
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