The $12 Billion Problem

High fund costs will ruin your investing performance. Yet those who work in financial services seem determined to not only keep charging high fees, but also to do everything they can to hide them from public view.

One particularly egregious example is the 12b-1 fee, which has come under closer scrutiny recently as the SEC begins a roundtable discussion on the 1980 rule that created the fee. Originally designed as a way to let mutual fund companies collect revenue to pay for marketing and distribution costs, 12b-1 fees have instead become a way for brokers and financial advisors to collect additional compensation directly from the funds they sell to their customers. Many firms, including Morgan Stanley (NYSE: MS  ) , Merrill Lynch (NYSE: MER  ) , and Goldman Sachs (NYSE: GS  ) , charge 12b-1 fees on at least some of their funds.

Here's how it works: When you buy mutual fund shares from a financial professional, the fund company takes fees directly from your investment returns. The majority of that money stays within the fund to pay for its overhead and for the cost of buying and selling investments for the fund. But Rule 12b-1 allows mutual funds to pay a portion of the fees it collects back to whoever sold the shares. So as long as you own your shares, your broker gets a small but steady stream of income back from the fund company.

It may sound insignificant. But according to the Investment Company Institute, 12b-1 fees brought in $11.8 billion in revenue during 2006 for the companies that manage investors' assets. As you can imagine, the financial services industry doesn't want to lose that nest egg.

Fair pay
No one is arguing that financial professionals don't deserve to get paid for their work. But there are big problems with using 12b-1 fees to do it. The most serious problem is that 12b-1 fees create an explicit conflict of interest between you and your financial advisor. While you want the fund that will give you the best combination of risk and return, your financial advisor may recommend funds that will help pay for your services. Advisors who work for large institutions often feel strong pressure from their employers to sell proprietary funds and other investments that will generate additional revenue for the firm -- even when those investments aren't in the best interest of their clients. Ameriprise (NYSE: AMP  ) , for example, states outright in its disclosures that provisions of its mutual fund program "may create conflicts of interest or incentives for Ameriprise Financial to promote, and for an advisor to recommend, a fund from a family that participates in the Program over a fund from a family that does not participate in the Program."

Another problem is that 12b-1 fees encourage advisors to sweep the discussion of costs under the table. Ideally, all financial professionals would charge consultation fees based on the amount of work they do for clients. Doing so would allow customers to compare costs among financial professionals much more easily.

Instead, many financial services companies advertise "free" service, counting on revenue from 12b-1 fees and other less visible sources to allow them to profit from their work. Despite ongoing efforts to make the required fee calculations in fund prospectus materials easier to read and understand, many customers still don't see how they end up paying fund companies and advisors without ever seeing a bill or writing a check. This makes it nearly impossible for those advisors who are upfront about their fees to compete, as customers wonder why they should have to pay for something that someone else will supposedly give them at no cost.

Bring it into the open
The best solution for investors is to eliminate 12b-1 fees entirely. Some fund companies will argue that they'll have to raise other costs in order to compensate for the loss of revenue, and so investors won't benefit. Yet at the very least, getting rid of one method of quietly taking investors' money away from them may force financial services firms to be more clear with their customers about how they get paid. That will help investors make better decisions that will help them keep more of their money.

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Fool contributor Dan Caplinger learned about mutual fund fees the hard way. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy charges no fees.


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