Selling funds through mutual fund supermarkets may start taking a larger bite out of profits for the companies which advise mutual funds.

A top SEC official has warned mutual fund advisers that they should not raise the fees they charge for running funds to pay for sales through mutual fund supermarkets. Douglas Scheidt, chief counsel of the Division of Investment Management, said the SEC will "closely scrutinize" any fee increase "that appears to be for the purpose of compensating the fund's investment adviser for paying the fund's supermarket fee."

Scheidt made his comments in an letter dated Oct. 30 to the Investment Company Institute (ICI), the mutual fund industry's trade group. Scheidt was unavailable for comment but warned in the letter that fund directors must make certain that the fees which funds pay an adviser are not "a conduit for the indirect use of the fund's assets for distribution...."

Fund advisers can use charges imposed under rule 12b-1 of the Investment Company Act to pay for distribution expenses such as fund supermarket fees. Alternatively, advisers can pay for distribution out of their own pockets. Supermarket charges can range from 0.25 percent to 0.40 percent of assets, the SEC said.

The issue of how supermarket fees get paid affects the profitability of fund advisers, particularly for no-load fund groups which increasingly have relied on sales through mutual fund supermarkets to build their assets. A report last year by Cerulli Associates, an industry consultant in Boston, said no-load, no-12b-1 fund advisers find themselves cutting into profits when they distribute through fund supermarkets. Advisers are squeezed by a combination of the expense of distribution through supermarkets and the caps funds put on their own fees to remain competitive, the Cerulli report said.

Companies have tried to respond to the business pressures. Earlier this year, for example, the Daruma Funds -- a no-load, no-12b-1 fee mid-capitalization fund based in New York -- asked shareholders to approve an overhaul of the company's fee structure which increased some expenses and decreased others because of the cost of supermarkets.

Fund supermarkets and their customers cannot be ignored, Daruma said in a regulatory filing. But the supermarkets "unfortunately do not provide (their) services for free," Daruma said. "For 100% no-load funds, the investment adviser picks up the tab." A Daruma representative was not available for comment.

Scheidt said that an SEC examination of fund supermarkets found that some funds pay for part or all of their supermarket fees through a 12b-1 charge. In some cases, fund advisers have paid a portion of the fee. In other cases, the funds themselves pay a portion of the supermarket expense, characterizing the payment as a cost not related to fund sales.

Scheidt said fund directors should insure that fees paid by a fund for distribution are characterized as 12b-1 fees.

"If a fund has not adopted a rule 12b-1 plan, then it cannot use fund assets to pay for services that are primarily intended to result in the sale of the fund's shares," Scheidt said.

A spokesman for the ICI said the group welcomed the guidance from the SEC on fund supermarket fees. Fund company officials and attorneys who advise funds have complained about ambiguity in what is an appropriate expense for the purposes of rule 12b-1.

SEC lawyers and the industry are awaiting a court ruling on the issue in a case involving the Permanent Portfolio Family of Funds in Petaluma, Calif. and their adviser, World Money Managers. In that case, the SEC contends that expenses the SEC characterized as travel and entertainment were improperly paid with 12b-1 fees.

World Money Managers has denied the allegations, arguing that the agency's guidance on what constitutes an appropriate expense for 12b-1 fees is ambiguous. The case is pending before an SEC administrative law judge.

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