Mutual Fund 12b-1 Fees Explained (Expert FAQ)

October 10, 2013 Investing

When choosing a mutual fund, you should first analyze its expense ratio. The costs of owning a fund are called the expense ratio, and one potential cost comes from 12b-1 fees. 12b-1 fees are annual marketing or distribution fees on a mutual fund.

The fees were originally allowed in the Investment Company Act of 1940. Legislators believed that that if mutual funds were able to advertise, they would be able to increase their assets under management and thus lower their expenses because of economies of scale. In practice, however, 12b-1 fees are used to as incentive for brokers to sell certain funds. In fact, most experts recommend avoiding funds that have 12b-1 fees.

When NerdWallet asked some finance professors for their opinions, they pretty much agreed:

  • University of Texas at Dallas Professor David Cordell believes investors willing to do their own research can find well-performing funds without 12b-1 fees:

“Many mutual funds charge 12b-1 fees, which are revealed in the prospectus and which are supposed to pay for a mutual fund’s marketing and distribution expenses. Almost two-thirds of all 12b-1 revenues go to the salesperson and his/her broker dealer as a quasi-commission. 12b-1 fees can be as large as 1% of an investor’s balance per year, although they are actually deducted from accounts daily. Even a no-load fund can charge up to 0.25%. If you invest in a fund with a 12b-1 fee, you are paying a small commission every year on the fund you own, so your salesperson should be willing to provide advice to earn that compensation. A portion of the fee goes into advertising, also. But why should an investor pay for advertising that might attract new investors but that reduces the value of the current investor’s account without increasing the per share net asset value of the fund?

“Even if the salesperson receives only 0.10%, the income from 12b-1 fees can be substantial. If he/she has “assets under management” (AUM) of $100 million, which is not extraordinary, revenue from 12b-1 fees would be $100,000 per year, and that revenue stream grows as (AUM) grows. And consider that, in a rising market, a 1% 12b-1 applied for five years takes a larger piece of the investor’s pie than a 5% front-end load.

“Investors who like to do their own research rather than seeking a salesperson’s advice can find plenty of mutual funds that do not have 12b-1 fees. Still, many investors consider the 12b-1 to be a simple cost of doing business in which they more-or-less have the salesperson on retainer as an advisor.”

  • University of Alabama Professor Robert McLeod notes that most research has found 12b-1 fees to be a deadweight cost for investors:

“12b-1 fees are charges for marketing or distribution that are assessed on the assets in a mutual fund.  The 12b-1 fee is expressed as a percentage and is included in the mutual fund’s expense ratio. The original purpose of the 12b-1 fee was to provide an incentive to sellers of mutual funds to continue to service the accounts that held these funds so that the investor would keep his/her money in that fund.  If money were to stay in these funds, then the fund’s assets would grow and there would be the opportunity to achieve economies of scale thereby reducing the expense ratio.  This reduction of the expense ratio would benefit all of the investors in the fund.

“Unfortunately, most of the academic research shows that the 12b-1 fee is a dead weight cost that did not achieve a reduction in the expense ratio that was promised when the Securities and Exchange Commission allowed them.  As such, the SEC is reviewing the 12b-1 fee with the possibility of limiting the amount and/or requiring additional disclosure as to how the fees are used by the mutual fund.”

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Mutual Fund Postcard, 1983 via CreativeCommons

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