Money Tip
Flee the 12b-1 Fee

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By Robert Brokamp (TMF Bro)
September 17, 2002

Most investors have heard that index funds, which seek to match the performance of the overall stock market as measured by an index such as the Standard & Poor's 500, stack up pretty well against other types of equity investments. There are many theories about why index funds, over the long term, beat most other types of stock funds, but one reason is very simple: low fees. While the average actively managed stock fund charges more than 1% a year in fees and expenses, index funds charge as little as 0.16% a year.

The bottom line is, fees matter. For example, $10,000 invested at 8% a year would be worth $46,610 after 20 years (ignoring taxes). However, if that money earned just 7% a year, because 1% went to fees and expenses, the 20-year result would be just $38,697 -- a $7,913 difference.

When it comes to expenses, one of the most pernicious leeches in the mutual-fund pond is the 12b-1 fee. Named after a rule added to the Investment Company Act of 1940, the 12b-1 was invented in 1980 in order to allow smaller fund companies to recoup the expenses of marketing and distributing their funds. The idea was, the marketing would result in more assets, eventually leading to an economy of scale that would allow mutual fund companies to lower expenses charged to shareholders.

Yeah, right. According to an article in InvestmentNews, 12b-1 fees totaled $9.5 billion last year, up from $6.5 billion in 1998. Seventy percent of all funds charge 12b-1 fees, according to mutual-fund rating service Morningstar. This is up from 62% in 2000. Some funds even charge 12b-1 fees after they're closed to new investors.

What does the Securities and Exchange Commission have to say about all this? In a December 2000 study on mutual fund fees, the SEC said:

[B]ecause it is unclear what expenses are properly considered distribution expenses, some funds, out of an abundance of caution, adopt "defensive" 12b-1 plans. Defensive plans exist solely to ensure that if a court found any fund operating expense to be also a distribution expense, the expense would be covered under a 12b-1 plan. The result: some funds have 12b-1 plans although no assets are used for distribution purposes. Similarly, other funds, that do use their assets to pay for distribution, extend their 12b-1 plans to cover operating expenses as well.

More recently, SEC Chairman Harvey Pitt announced in a speech to the Investment Company Institute -- the mutual fund industry's advocacy group -- that the SEC will begin looking into how 12b-1 fees are really used. But most experts agree that nothing will come of the inquiry. It is up to you, dear Fool, to take the real action: Avoid 12b-1 fees by steering clear of any fund that charges them.