Are You Overpaying to Invest?

Welcome back to another edition of Foolish mutual fund basics. This time, we're leaving behind the (really) high-rent world of multiple share classes for the dark alleys where 12b-1 fees live. Ready to get started? Good.

What it is
Fund investors are too often saddled with fees. The 12b-1 charge tops my list of the most insidious. Why? It's a charge for marketing and distributing the fund. In other words, with 12b-1 funds, current investors foot the bill to win new investors.

Sneaky, you say? You bet it is. So is its origin. Like the 401(k), the 12b-1 is named after a section of a federal law -- in this case, the Investment Company Act of 1940. But it took 40 years for the fee to reach prominence. Funds that initiated the charges in 1980 reasoned that better marketing would lead to more assets and lower expense ratios.

Twenty-two years later, the results were anything but encouraging. Foolish colleague Robert Brokamp, editor of our Rule Your Retirement service, reported at the time that 12b-1 fees had reached $9.5 billion, up 46% from four years earlier.

It's no better today. Recent research from Zero Alpha Group and Fund Democracy found that an investor with a $10,000 stake in a no-load fund carrying a 12b-1 fee would pay $3,744 in expenses over 20 years, assuming a 10% annual return. That's appreciably more than the $2,582 the researchers said an investor would pay to hold a no-load, no-12b-1 fee index fund over the same period.

No wonder Robert and Shannon Zimmerman, who co-advises Motley Fool GreenLight and runs our Champion Funds service, suggest that you flee from funds that include a 12b-1. "I'm against 12b-1s on principle, because I don't think shareholders should bear the cost of marketing and distribution," Shannon wrote to me in an email interview.

"That should come out of the fund company's cut," Shannon added. "That said, this fee is baked into a fund's reported expense ratio, and if that price tag is reasonable (i.e., substantially below its category average), I'm willing to give a fund with a 12b-1 a look."

How it works
Among the few 12b-1-carrying funds that Shannon likes is Loomis Sayles Global Bond (FUND: LSGLX), which, after expenses, is up more than 1.5% on its benchmark. Why wouldn't you want to know about a fund like that?

Of course you would. More often, though, you'll hear about closed funds that still charge a 12b-1. Consider MainStay Equity Index (FUND: MCSEX), which has large stakes in ExxonMobil (NYSE: XOM), General Electric (NYSE: GE), Citigroup (NYSE: C), and Bank of America (NYSE: BAC). This three-star performer has had the same manager for a decade, and it sports a 0.74% expense ratio, including a 0.25% 12b-1 fee. Frustrating, yes, but not entirely unreasonable, right?

It would seem so. Unfortunately, MainStay charges a load and a 12b-1 fee. After accounting for them both, the fund has returned 6.91% annually since 1996. That's roughly 1% a year less than the return of the S&P 500 over the same period.

Go under the hood
Fund industry observer Chuck Jaffe says it best in his recently published wish list for the fund industry, "The 12b-1 fee is supposedly for sales and marketing costs, but it primarily functions as a trailing commission for the advisor who brokered the initial purchase ... It's the gift that keeps on taking." Exactly.

Next time an advisor pushes a fund at you with a 12b-1 fee, check the expense ratio and the sales load. Then check its five- and 10-year track record after these charges are accounted for. If the fund still outperforms, give it the consideration it deserves. If not, politely move on. Let someone else line your advisor's pockets.

Follow the money
I've often thought of fund advisors as those goons who run a protection racket. You pay up, while they come over to kick your dog and raid your fridge.

Of course that's not entirely fair. Some advisors are committed to helping clients earn market-crushing returns -- just not enough of them. More often, you'll overpay for what you don't need. Like, you know, a 12b-1 fee.

Interested in more moneymaking tips? Consider GreenLight. Shannon and co-advisor Dayana Yochim are offering 30 days of free access to the service right now. Click here to get started.

Fool contributor Tim Beyers, ranked 1,528 out of 17,066 in Motley Fool CAPS, hates paying extra for anything. Don't you? Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. Loomis Sayles Global Bond is a Champion Funds selection. Bank of America is an Income Investor pick. The Motley Fool's disclosure policy is a bargain at any price.