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Rekenthaler Report

Repeat Offender

The 12b-1 fee fails at everything it does.

Four-Time Flop
It's no secret that the mutual fund 12b-1 fee failed its original promise. The fee was pitched as a cost savings: If mutual fund shareholders paid more to fund companies, fund companies would charge shareholders less. Scratching your head? Good reaction. Unfortunately, fund-industry lobbyists were skilled at removing people's hands from their heads, and the rule was passed in 1980. Sure enough, it led to fund expenses rising rather than falling.

It turned out that for-profit fund companies sought increased profits. Who could have guessed? So, if the addition of a 12b-1 fee enabled a fund to gather more assets and thus increase its revenues, the fund did not use most of those new revenues to reduce operating costs for existing shareholders by passing along its economy of scale. Instead, it used most of its new revenues to boost fund-company profits. That anybody was surprised is surprising.

These facts have long been known. Nearly a decade ago, SEC economist Lori Walsh studied the subject in "The Costs and Benefits to Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses and Returns." (SEC economists tend not to write zippy headlines.) Her devastating conclusion: "The paper finds that while funds with 12b-1 plans do, in fact, grow faster than funds without them, shareholders are not obtaining benefits in the form of lower average expenses or lower flow volatility. Fund shareholders are paying the costs to grow the fund, while the fund adviser is the primary beneficiary of the fund's growth."

Less discussed has been the 12b-1 fees' collateral damage. Breaking the original promise and raising shareholder costs is an offense worthy of termination on its own. But 12b-1 fees have harmed investors--and the fund industry--on three additional counts.

First, 12b-1 fees brought the mess of share-class soup. Confused by B, C, D, R, and Z shares? Blame 12b-1 fees. Traditional fund expenses cannot vary according to shareholder; therefore, in the absence of 12b-1 fees, one share class tends to serve all. The introduction of multiple share classes via different levels of 12b-1 fees complicated what had previously been a straightforward industry pricing system. Now, mutual funds started to look and feel like variable annuities. In addition, the growth of multiple share classes forced financial-advisory firms into calculating what share class would best suit a given investor, thereby increasing both the firms' costs of compliance and their legal risks.

Second, 12b-1 fees led to bait-and-switch sales tactics. Before 12b-1 fees existed, investors either purchased a fund from a financial advisor and paid a front-end load charge or they went directly to the fund company and bought a no-load share. Either way, it was clear what they paid (or did not pay). The introduction of B and C shares, carrying high ongoing 12b-1 fees, muddied those waters. Now investors might buy a fund that had a high sales charge without realizing they were doing so. The sister of Morningstar's president of research Don Phillips was scarcely the only buyer to crow about owning her "no-load" B share.

Finally, 12b-1 fees became part of the murk that are platform fees--that is, payments from mutual fund makers to the distributors of their funds. To be sure, 12b-1 fees are not the only source of platform fees, which can also come from other areas of fund expenses or even from the fund company directly (that is, not from the funds themselves.) But they have heartily participated in the trend. If you see a fund that is not sold through a financial advisor carrying a 12b-1 fee, those monies are likely being used to pay various undisclosed platforms.

None of these three items represent proud moments in the fund industry's history. Indeed, investors and/or regulators have roundly rejected all of them. No-load (including institutional) share classes now dominate fund sales. The market prefers a single, low-cost share to alphabet soup. Sales of B and C shares, in particular, have dried up because of overwhelming distaste among both investors and advisors. And a backlash against platform fees is occurring with 401(k) plans. That movement hasn't yet spilled over to retail brokerage platforms--for example, Schwab's No Transaction Fee program--but it may well over the coming years.

In summary, wherever the 12b-1 fee has gone, it has disappointed. Several times now, it has reinvented itself--and each time it has been rejected. The time has long since passed when this turkey should be slaughtered.

On Investor Returns
marklewis (screen name) comments on the Hedge Fund Follies column:

"John, you said 'target-date funds [investor returns] are higher than the funds' actual returns; that is, there was more money invested in target-date funds when they were rising (that is, post-2008) than when they were sinking (2008).' This explanation, while true, I believe is misleading. This would only be true while the funds are rising in price. When they (inevitably) fall in price even if no new cash flowed in by the time prices were below the average price paid on the way up the investor returns would be below that of the funds' actual returns ..."

There's more, which you should read if you wish to learn about the nuances of the investor return calculation. For here, suffice it to say that marklewis is correct. I was dancing when writing that target-date funds' investor returns (that is, dollar-weighted returns) have been higher than their actual returns. This is true because target-date funds have enjoyed steady cash inflows through thick and thin (my point), but also because over the time period examined, the investment performed relatively better near the end than near the beginning (marklewis' point).

I'm fine with my footwork. The note on target-date investor returns was a side issue for my argument, and marklewis' clarification doesn't change the point that target-date funds have indeed enjoyed tremendous investor loyalty. But marklewis' insight does point out the difficulty of interpreting investor returns. When comparing the level of a fund's investor returns with those of its actual returns, the results will vary widely by time period. That is, the calculation is highly time-period sensitive. A conclusion drawn from one period may be reversed in the next.

Investor returns are best used in studies with large groups of funds, over long and multiple time periods, rather than for an individual fund over a single time period. For that reason, Morningstar treads lightly when publishing investor returns. When the calculation was first launched, the thought was to show the returns much more prominently, but their instability demands that they be displayed quietly.

Topic Emails
It's best if comments such as marklewis' are made in the article's Comments section. Should you have a topic idea, however, feel free to email me directly at john.rekenthaler@morningstar.com. As you might imagine, I'm always looking for topics on which to write, as well as for topics that interest the readership. So, send them along! They won't go unnoticed; I save all topic emails in a file.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.