September 28, 2010
The SEC has proposed sweeping changes to the way commission-based advisors will be compensated for the services they provide. Those changes will rename and modify the 12b-1 fees that many mutual funds now charge.
The evolution of 12b-1 fees since their inception 30 years ago has led to many problems, accurately documented in Michael Edesess’ article two weeks ago. The core cause for concern is that the opaque nature of 12b-1 fees makes it likely that most fund purchasers will be unaware of their existence or, if they are aware, will be unable to accurately assess the extent to which advisors are being compensated through those fees for the services they provide.
Does the SEC’s 12b-2 proposal solve those problems? Does it create additional problems? To answer those questions, I spoke with Avi Nachmany, the co-founder and director of research at Strategic Insights, a NY-based consulting firm and data provider that serves over 300 major mutual funds.
Nachmany believes the existing 12b-1 fees serve an important and valuable purpose, and he worries that the SEC’s new proposals could cause many fees to be “externalized” – charged directly by advisors, and not deducted from a fund’s assets – causing the cost of advice to increase.
We’ll take a close look at Nachmany’s claims and I’ll offer my own thoughts, but first let’s quickly review how 12b-1 fees work and the changes that the SEC has proposed.
The SEC’s proposal
Approximately 40% of assets across mutual funds are subject to 12b-1 fees; approximately 33% of the fund assets has 12b-1 fees less or equal to than 0.25% of assets. The remainder has fees greater than that. In 2009, funds charged $9.5 billion in 12b-1 fees.
Rule 12b-1 allows fund companies to take those fees from fund assets and pass them on to broker-dealer firms for the services they provide. A portion is kept by the broker-dealer firm, and the remainder is paid to individual advisors.
Advisors and their broker-dealer firms are paid 12b-1 fees for services such as the investment advice by the advisor, and marketing, recordkeeping and account servicing by the broker-dealer.
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