You might think you can't avoid running into a new mutual fund scandal every few days. Here's a good one for you: In Mutual Funds 101, you'll learn that a fund's "expense ratio" reflects its overall annual fee bite. That fee includes several fees, such as a management fee and also a "12b-1" fee.
This latter fee was created in 1980 with the intent of permitting funds to charge a little money to cover some administrative and marketing costs. The reasoning was that by attracting more investors, funds would become bigger and could lower their expenses by realizing some economies of scale. There's some logic in that, but it also offers some irony, in that investors are being charged a fee in order to lower their fees.
A bigger problem is this: The bigger a fund gets, the harder it often becomes for the managers to deliver market-beating results. As a fund swells to contain many billions of dollars, it's no longer able to easily make a profit on smaller companies. Even if it bought some exciting, fast-growing companies outright (which it can't do), they would still be a drop in the bucket overall, performance-wise.
So, by that logic, when big funds charge 12b-1 fees to get bigger, they're asking investors to cough up money even though it may make the fund perform more poorly. Oy. Worse still, some funds that have closed their doors to new investors have continued to charge 12b-1 fees!
As an example, according to Morningstar.com, the Principal Investors MidCap Growth J (PMGJX) fund has a solid five-year average return of almost 14%, with holdings that include McDermott
At the University of Maryland, John Haslam recently studied 12b-1 fees and concluded:
There is no evidence that mutual fund shareholders benefit from Rule 12b-1 plans, which provide a serious conflict of interest. The promise that 12b-1 fees would be used to increase mutual fund assets and thereby lower fund shareholder expenses appears to have been a cynical industry effort to gain SEC approval, while the intended beneficiary was (and is) fund management.
He also noted that there's a great opportunity right now, as SEC chief Christopher Cox is interested in fixing this problem -- if he can prevail over the mutual fund industry. Since the fee generates $12 billion annually for the industry and its related parties, so as you might imagine, folks there are not eager to let it go. As it often does, the SEC invited comments from the public on the topic, and it received more than 1,400 of them, with some thousand coming from broker-dealers who profit from the fee, arguing against changing the status quo.
What to do
You'll likely improve your investment performance if you take the time to learn more about the fees your funds are charging you. And if you're shopping for funds, be sure to look closely at the fees. Fortunately, amid the thousands of mutual funds out there, are many that charge reasonable fees, with many not charging any 12b-1 fees at all.
As an example, Fidelity Contrafund -- which happens to be closed at the moment -- sports a market-beating three-year average annual return of 15%, top holdings that recently included MasterCard
To find top-notch funds that are still taking new money, you can screen for good ones and learn how to avoid stinkers. Or let us help you. I invite you to test-drive our Motley Fool Champion Funds newsletter, where I've found a bunch of winners, myself. Last time I checked, its recommendations were beating the market, on average, by 20 percentage points.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Gap is a Motley Fool Inside Value and Motley Fool Stock Advisor recommendation. Try our investing services free for 30 days. The Motley Fool isFools writing for Fools.