No cocktail party conversation about mutual fund reform would be complete without a discussion of the future of rule 12b-1.
Despite having originally been intended to help no-load funds finance their advertising and marketing campaigns, the controversial rule first implemented in 1980 has since been obscured to allow fund companies to use shareholder assets to pay for shelf space.
In fact, 92% of 12b-1 fee proceeds are used to compensate financial advisers and other intermediaries for providing shareholder advice and account servicing, according to a new study by the Investment Company Institute. In 2004, mutual funds took in $10 billion in 12b-1 fees, with only a small fraction of that cash being used for advertising and promotion.
The data reflects the massive marketing trend that has taken the fund industry by storm in the last 15 years, one that has successfully propelled fund assets to more than $8 trillion while allowing a number of new participants to enter the fray. This extraordinary growth has led to the crowding of distribution channels. With a larger number of players comes stiffer competition, and that puts increased pressure on funds to obtain better shelf space.
In order to reach a greater number of customers in such a crowded marketplace, many mutual funds have offered financial incentives to brokers to pitch their funds. This has created significant conflicts that divide the interests of fund management and fund shareholders. But in the aftermath of the trading scandal that sullied the industry's once impeccable reputation, the Securities and Exchange Commission has clamped down on some of these pay to-play practices, including imposing a ban on directed brokerage.
"There needs to be some clarity brought to the equation," said Jeff Keil, vice president of board analysis services at Lipper. "[12b-1] needs to be reconstituted to its original intent, or transparency needs to be elevated." Keil does not favor repealing the rule because he believes it would only drive advisory fees higher. If eliminated, investment advisors would pay for distribution out of their own pocket and then pass the cost along to investors as part of the advisory fee, he said.
The SEC has received more than 2,000 comment letters on its 12b-1 reform proposal, many of them urging the Commission to maintain the status quo.
The industry's departure from the original intent of rule 12b-1 and its inherently opaque nature have incited investor advocacy groups and academics to call for its repeal. They're opposed to using shareholder money to finance distribution, arguing that it does not benefit investors in any material way. Rather, they contend, 12b-1s generate higher fees for fund firms by helping them grow their asset base.
Further underpinning the call for reform, SEC Economist Lori Walsh published a study last year concluding 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."
Since the fees are part of the expense ratio, they are deducted at the fund level as a percentage of total assets. While broadly disclosed in a lengthy prospectus that nobody reads, 12b-1 fees are not spelled out in a fixed dollar amount, nor are the services investors receive in return.
"It's very difficult to determine what you're paying for," said Bridget Hughes, a senior analyst at Chicago-based fund researcher Morningstar. She suggested that better disclosure of the fees would help investors determine whether they need a higher or lower level of service from their fund, arming them with the information needed to shop for the right fund.
In addition, she favors moving 12b-1 fees from the fund level to the individual account level. "Why I should have to subsidize somebody else's financial planning services is a mystery to me," Hughes said.
But the ICI believes that deducting distribution costs at the shareholder level would have significant negative consequences for funds and their shareholders, including substantial transfer agent and accounting costs, expensive system upgrades to support those functions, bookkeeping burdens for fund distributors and added tax liabilities. The ICI also argues that investors do receive the benefit of 12b-1 fees in the form of advice and ongoing shareholder services.
"Academics completely discount the value of the [financial] adviser to the client. That really is what people are paying for. The academic literature is so stilted in favor of people [managing their portfolio] themselves. Really, a large portion of the investing public doesn't want to do it themselves and shouldn't do it themselves," said John H. Robinson, an independent financial adviser in Honolulu. "Eliminating 12b-1 would be extremely disruptive and injure investors."
Robinson further argues that investors would end up paying more for mutual funds and that money would flow into mutual fund wrap accounts, which tend to be more expensive.
Despite the industry's staunch opposition to eliminating 12b-1 altogether, ICI leadership has acknowledged that better disclosure is necessary. Paul Schott Stevens, president of the ICI, characterized the name 12b-1 itself as being "singularly uninformative" for investors at a recent service provider conference. He urged the SEC to provide further guidance on the issue.
The SEC is currently waiting to hear back from an NASD task force conducting a study of the issue. "If this was close to being resolved, Paul Roye might have stayed to see it through," said Bibb Strench, a partner with Sutherland, Asbill & Brennan in Washington.
"It would not surprise me if we're still several years away from a 12b-1 resolution," Lipper's Keil said, citing SEC staff constraints and the glut of regulatory issues on its plate.
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