12b-1 Fees Can Wreck Your Returns

Source: Flickr user kev-shine.

You probably know that mutual funds charge fees and that, in general, you should pay as little as possible. But you may not fully realize what a difference a seemingly small fee can make in your investment returns. For a perfect example of not-so-harmless charges, look at 12b-1 fees.

In a nutshell, 12b-1 fees are meant to cover marketing and "distribution" costs. (They can also sometimes cover shareholder services expenses.) Mutual funds are often purchased through brokers, financial advisors, and other services, and these middlemen expect the mutual funds to compensate them for delivering a sale. That payment is covered by 12b-1 fees. The fees also cover marketing expenses such as printing up brochures, buying online ad space, and distributing sales literature and prospectuses.

Most investors know to avoid load funds, which require you to surrender a chunk of our investment as a front-end or back-end fee that can sometimes top 5%. No-load funds do have fees, though, and they often charge 12b-1 fees, which are typically 0.25% but can be as high as 1%.

When small is big
Here's why you should care about 12b-1 fees -- and other fees, too -- when seeking funds for your portfolio: Even a modest 0.25% fee will shrink your return each year. Check out the below example of a fund that earns an annual average of 10% over many years versus one that earns 9.75% due to a 0.25% fee:

Even if you invest only $5,000 -- a tenth of the example above -- you can still lose out on thousands of dollars over the years.

The differences can be far greater if you're deciding between a fund with a total annual fee ("expense ratio") of, say, 1.4% versus one that charges a total of 0.79%. (Remember that 12b-1 fees are just part of the total fees; funds also charge administrative fees, among other things.)

These 12b-1 fees are a big deal for mutual fund companies, too. They're estimated to total between $12 billion and $15 billion annually. As John Rekenthaler, vice president of research at Morningstar.com, has noted: "For perspective, annual U.S. box-office receipts for domestic film sales are $10 billion, and NBA revenues are $7 billion. That is a very large amount indeed for an expense item that few people even know exist, and that fewer still can even vaguely describe."

Rekenthaler also pointed out that the Securities and Exchange Commission is looking into whether many funds are properly using the 12b-1 fee.

Oh, the irony
There's a bit of irony in the situation, too. Fund companies will argue that spending more on marketing and distribution will bring in more investor dollars, which can lower overall fees for fund shareholders. But that silver lining comes with a big, ugly cloud: Funds can get too big. When they have more shareholder dollars than fund managers know what to do with, the managers will have to either invest in less promising ideas or close the fund to new money.

You may not be able to avoid paying 12b-1 fees when you find funds that look perfect for your portfolio, but be sure to find out just how much you're being charged in fees -- because they can make a big difference. Many broad-market index funds are extremely low-cost, with total annual fees lower than 0.25%, and they often outperform managed stock funds. Some good examples include the SPDR S&P 500 ETF (SPY -1.25%), Vanguard Total Stock Market ETF (VTI -1.23%), and Vanguard Total World Stock ETF (VT -0.94%). Respectively, they distribute your assets across 80% of the U.S. market, the entire U.S. market, or just about all of the world's stock market.

Here are a few things to know about the ETFs above:

Source: Morningstar.com, Vanguard.com, Yahoo! Finance. *Since inception in 2008.

Don't just assume that the top two funds are better because of their stronger recent performance. Future performance is what will matter to any stocks or funds you buy today, and it's smart to include exposure to international businesses, which the Total World Stock ETF can offer, in order to diversify your portfolio and potentially benefit from the rapid growth of foreign economies.

Diversified, low-fee ETFs like these can make great core holdings for investors who want respectable returns for relatively low cost and risk. When it comes to fees, investor beware!