Are You Paying This Hidden Fee?

Actively managed mutual funds have definitely taken their knocks over the years. It's true that a great number of funds simply don't beat the market over the long run and that many investors are worse off for being charged excessive fees for lagging performance.

For all their drawbacks, mutual funds have still managed to give millions of Main Street investors wide access to the stock market in one quick stop. Unfortunately, there is one widespread practice in the mutual fund industry that still has a shade of suspicion about it, and it's finally getting some well-deserved attention from the SEC.

Sneaky fees
A great majority of investors know to examine annual expenses for any mutual fund before they buy in. After all, with thousands of funds competing for your investment dollars, why should anyone pay more for a fund? And studies have shown that funds with lower expense ratios do tend to outperform their more expensive peers over time. But there is one aspect of a fund's expense structure that typically gets overlooked by a great many investors: 12b-1 fees.

12b-1 fees are annual marketing and distribution fees that the fund shop charges investors so that the firm can pay for sales and marketing efforts, including commissions to advisors that recommend its funds. At first glance, this may make sense. After all, if a fund shop can garner additional assets, overall administrative costs should go down as the asset base expands. The problem is that rarely happens in practice. And should that really be the fundholders' financial responsibility in the first place?

We're not talking about chicken scratch here. These 12b-1 fees amounted to nearly $10 billion in 2009. That's $10 billion that could have been earning money for investors instead of paying for funds' marketing, not to mention the discomfort some investors feel footing the bill for commissions to financial advisors that push a certain fund company's products.

Fund companies must disclose any 12b-1 fees they charge, which typically clock in at about 0.25% of assets but can run as high as 1.00% for certain share classes. But even with this disclosure, many investors ignore or don't really understand these fees. And even if you know your fund is charging a 12b-1, it's nearly impossible to find out exactly how your money is being spent.

Bucking the trend
Fortunately for investors, there are a number of mutual fund shops that do not charge 12b-1 fees within their fund offerings. Not only do the folks over at Dodge & Cox offer one of the most well-run management teams in the business, they also offer a line-up of funds free of these charges. For example, Dodge & Cox Stock (DODGX) is a top-ranked large value fund that has outperformed 97% of its peers in the past 15 years. The fund's managers are big on health care right now, including drug makers with attractive yields and low valuations relative to their product pipelines. Names like Pfizer (NYSE: PFE  ) , Merck (NYSE: MRK  ) , and Novartis (NYSE: NVS  ) are among fund managers' favorites in the industry. Investors can access the fund for a low 0.52% expense ratio and no 12b-1 charges.

Similarly, fund giant Fidelity does not charge 12b-1 fees on many of its offerings. Investors do need to be careful here, though, because the shop does include 12b-1 fees on many of its Advisor funds, so steer clear of those options.

But other category-topping Fidelity funds, such as Fidelity Low-Priced Stock (FLPSX), come free of 12b-1 expenses. This mid-cap gem has been skippered by manager Joel Tillinghast for more than two decades, a rarity among the constantly changing manager structure at many Fidelity funds. The fund has racked up an annualized 12.1% return over the past 15 years by investing in low-priced mid-sized companies like current portfolio favorites Ross Stores (Nasdaq: ROST  ) , insurer Unum Group (NYSE: UNM  ) , and Abercrombie & Fitch (NYSE: ANF  ) , all of which have outpaced the Russell Mid-Cap Index so far in 2010.

Make your voice heard
If nothing else, investors should take a closer look at their funds' expense structure and determine whether or not they are being charged any 12b-1 fees. Fund companies are required to break out and state these fees in their prospectus, so make sure you know where your funds stand on this issue. And pay attention to these fees when looking to make new fund purchases.

Ultimately, change may be in the air for 12b-1 fees and the fund companies that love them. The SEC is currently considering legislation that would alter how 12b-1 fees are utilized and disclosed in the industry. While an outright ban on 12b-1 fees is unlikely, the SEC may institute rules that force fund companies to make these fees more prominent to investors or spell out in more detail exactly how the fees are being spent. If you'd like to contribute to the conversation, you can voice your opinion to the SEC here and let them know what you think.

Having a 12b-1 fee doesn't necessarily make a fund a bad choice for investors, but greater awareness and more clarity on these fees may help investors better understand exactly where their hard-earned dollars are going and whether or not they want to own funds that charge this expense.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Pfizer is a Motley Fool Inside Value selection. Novartis is a Motley Fool Global Gains pick. Try any of our Foolish newsletter services free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


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