NEW YORK -- Using 12b-1 fees to pay brokers for selling mutual funds has morphed the fund business into a massive marketing machine, a development that has sparked controversy over the best way for fund companies to finance distribution.

In 1980, the Securities and Exchange Commission implemented rule 12b-1, allowing mutual funds to use shareholder assets to defray the costs of marketing and help build economies of scale. But the industry has since experienced extraordinary growth, and the rule has become obscured to the point where it is no longer used for the intent that regulators had envisioned.

In light of what has transpired, the North American Securities Administrators Association of Washington last week hosted a roundtable discussion on the subject to hash out some of the problems that exist under the current 12b-1 rule and what should be done to address them. While it remains a divisive issue with varying viewpoints, experts agree that it is the source of more confusion than any other feature of the mutual fund industry.

Headlining the "NASAA Listens" panel of industry figures was Jack Bogle, founder of The Vanguard Group, who has not been shy about criticizing mutual fund practices in recent years. Bogle characterized the 12b-1 issue as "a clash between an irresistible force and an immovable object." The irresistible force, in this case, is the giant marketing machine that mutual funds have become, replete with advertising and marketing campaigns, salesmen, branding and premiums. It has become a "supply push" industry, he said, one in which funds compete to be sold, rather than bought.

The immovable object pit against that irresistible force, Bogle said, is fund costs draining investors' returns. In other words, the higher the fees, the lower a fund's return. Over the last 10 years, the market has returned 13%, while the average equity mutual fund has earned roughly 10%, a three percentage point shortfall, which is nearly identical to the total amount of fees investors pay for money management. Bogle noted that over the past decade, the lowest-cost quartile of any Morningstar style box has outpaced the return of the highest-cost quartile by 3.5% per year.

He also pointed out that while mutual funds have seen a 1,700-fold increase in assets in the last 50 years, fund fees have exploded by 3,800 times. In his opinion, it doesn't cost that much more money to manage $5 billion than it does to manage $1 billion because of the economies of scale. Still, the average expense ratio of an equity mutual fund weighted by assets skyrocketed from 0.19% in 1951 to 1.6% today. This, he said, is due largely to the use of 12b-1 fees to pay for distribution. He noted that of the $70 billion investors pay in expenses each year, $10 billion is allocated to marketing.

"The multi-class structure has produced complications in the industry and made it more difficult for investors to know what their costs were and the performance of their fund has been, given the multiplicity of different classes," said panelist Dick Phillips, senior partner and head of securities at law firm Kirkpatrick & Lockhart. "More important, investors simply have not gotten the same kind of dollars-and-cents transparency in paying for the sales charge in an asset-based fee as they would have gotten had they paid a front-end load."

Patricia Struck, NASAA president-elect and administrator of the division of securities of the Wisconsin Department of Financial Institutions, condemned 12b-1s for their opaqueness, saying that most investors don't know how much they're being charged and what they're getting in return. "The [12b-1] rule has become a mechanism for fund managers to take advantage of shareholders," Struck said. She also criticized the rule for allowing funds to charge marketing costs to shareholders even after the fund has been closed to new investors

NASAA has urged the SEC to rescind the rule because it has outlived its original intent, which was to create a means for start-up funds to expense marketing costs equally among shareholders. Struck is pushing for the Commission to replace the current system with a process that shifts marketing costs to fund managers, a move she believes would fulfill their fiduciary obligation to reduce costs for investors. As an alternative to abolition, Struck suggested that fund firms be allowed to charge 12b-1 fees only on those funds that do not charge a front-end or deferred sales charge. She maintained that even if the SEC determines that there are merits in retaining rule 12b-1, it should specify which items fall under the marketing expenses umbrella.

Investment Company Institute Senior Counsel Elizabeth Krentzman supports the SEC's review of 12b-1 but offered a much different perspective, disputing claims that 12b-1 fees are unnecessary expenses imposed on shareholders. "Like all products from a can of soup to an automobile, mutual funds involve marketing and distribution costs that are necessary for the delivery of the product," she said.

She also argued that 12b-1 fees are not hidden or opaque. Calling them "a functional equivalent to a front-end sales charge," Krentzman said the fees are reflected in investors' ongoing performance and are adequately disclosed in the fee table of the prospectus. A fund's expense ratio includes 12b-1 fees and can be easily evaluated on Morningstar so that investors can make comparisons when shopping for a fund. Further, she said that the SEC proposal requiring point-of-sale disclosure would clear up any confusion as to where investors' dollars are being allocated and what they are receiving in return.

Perhaps the biggest opponent to abolishing 12b-1 was Stuart Kaswell, a partner and chair of the broker/dealer practice group at Dechert LLP. "I don't think there is anything hidden about rule 12b-1 or anything that the mutual fund industry or brokerage community should be ashamed of," Kaswell said. "There's no attempt to play hide the ball' here."

He characterized the services retained through 12b-1 fees as "not glamorous but necessary services." His take is that many investors like choosing to go through an intermediary and receive enough good information to make sound decisions. He stressed the importance of advice when choosing the appropriate fund. "If you pick the wrong fund and it has low expenses and the return is lousy, then it is like getting a great buy on a pair of shoes that are the wrong size." He strongly disagreed with the notion that taking 12b-1s out of the fund expenses and making them individual expenses wouldn't help shareholders because of the tax implications of such a move.

Bogle's solution to the problem is to eliminate share classes and move the 12b-1 expenses from the fund level to the individual account level, which "eliminates all the complexity of the multi-class system." That would translate into fewer fund offerings, trimming the number of listed funds to 6,549 from 17,145, he calculated. It would also decrease confusion by providing investors with an easier-to-read menu of funds.

Krentzman, however, reminded Bogle that eliminating 12b-1s does not eliminate the cost of distribution.

"Sooner or later, the investor will end up paying for the various services that are provided," Kaswell argued. "Investors have choices and great diversity in the marketplace. Let's not throw the baby out with the bath water," he added. Phillips suggested that 12b-1s either be abolished or moved to the shareholder level as an alternative to paying a front-end load.

The SEC is expected to hold a meeting to discuss revamping rule 12b-1 later this year.

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