The nature and genesis of 12b-1 fees.

• Author: Freeman, John P.
• Position: The Mutual Fund Distribution Expense Mess

Though 12b-1 fees are not essential to a mutual fund's operation, (59) they are nonetheless very common. More than 60% of the American mutual funds feature 12b-1 shareholder charges. (60) As noted above, in 2006, 12b-1 payments amounted to an amazing $11.8 billion, (61) draining from shareholders' assets almost $1 billion per month.

Despite yielding a truly impressive financial haul for fund managers, dealers, and sales representatives, the fund industry's twenty-plus years of Rule 12b-1 usage has failed to generate any tangible, positive financial benefits to fund shareholders. However, the rule has worked beautifully for fund sponsors and sellers who collect Rule 12b-1-generated money. Still, it is not clear why, as a legal matter, the rule should exist at all given the absence of compelling evidence that the payments made under it create or foster shareholder wealth. A government-sponsored levy yielding dubious, if any, benefits for shareholders in an extremely highly regulated industry (62) is a topic that deserves serious study, particularly when the levy approaches $1 billion per month.

Even in the face of some recent lackluster stock market performance, times are still flush in the fund industry. Attached to the fund industry's $10 trillion in assets is a weighted average expense ratio for all mutual funds of around 0.91% annually.63 This combination of size and fee structure generates a huge yearly payout, more than $90 billion in fee payments annually, and does not include amounts paid at the time of purchase by fund investors who buy "load" funds or amounts paid by the funds themselves in brokerage commissions to buy or sell portfolio investments. The mutual fund management business was not always so lucrative.

1. The 1970s--Marketing Problems Plague the Fund Industry

   Thirty-some years ago the fund industry was a small fraction of its present size. Its total assets stood at only $55 billion. (64) The industry was in trouble. It was suffering net redemptions, meaning it was shrinking. (65) Prompted by the phenomenon of fund sales not keeping pace with redemptions, the SEC commissioned a special study of fund distribution problems. (66) Drawing on written submissions and testimony from industry participants, the SEC staff reached various conclusions. Those findings are worth noting because they affirm the SEC staff's understanding that the sales push was linked to compensation and its appreciation that fund assets (under the...