Mutual Fund Distribution Fee Reform, Part I

Mutual fund fees are very confusing.  And, confused investors have no way of knowing whether they are paying too much. The SEC wants to change that. In late July, the SEC announced a much-anticipated rule proposal designed to make more clear to investors the visible and hidden fees they pay that have nothing to do with managing the fund assets.

Most investors choose mutual funds because of the benefits of professional management and diversification that they provide.  However, few understand the non-management-fee charges they pay that go to sales, marketing and other services. Some of these charges are visible and some are "hidden."

The rule proposal targets both the visible and hidden fees.  An example of a visible fees is an up-front sales load. Under the proposed rule, mutual fund families can elect to offer funds where they give up the power to dictate the amount of up front sales loads. Instead, for these classes of funds, brokers that sell fund shares to investors will independently decide what sales fees to charge. 

Moreover, under the proposal, investors have a choice. They can pay all of the sales charges up front, upon redemption (both out-of-pocket) or over time through deductions from fund assets. But if they select to pay on an ongoing basis, the payments will be finite. So in no case will the investors pay more in ongoing payments than if they had elected the up-front or back-end sales charge.

The proposed rules also addresse the various "hidden" mutual fund sales, marketing and service fees. Of particular focus is the  30-year-old practice by fund advisers of using fund assets to pay for ongoing marketing, sales and service expenses. According to SEC Chair, Mary Schapiro, investors unwittingly paid a total of $13 billion of these "hidden" fees in 2007 and about $12 billion and $9.5 billion in 2008 and 2009 respectively.  These 12b-1 fees are above and beyond any "visible" initial sales load that investors pay directly out of pocket, not out of fund assets.

Disclosures of "hidden" ongoing fees will improve. Instead of using the confusing term "12b-1 fees," funds will have to be far more clear and break out the expenses. They will need to disclose the amount of "ongoing sales charges." And they will have to separately disclose "marketing and service fees." Investors will see in trade confirmations how much they will pay over time for all of these fees.

In addition, regarding one category of the "hidden" ongoing fees, the proposal caps at 1/4% the maximum total amount that can be deducted from fund assets to pay for "marketing and service fees" provided to investors. This is consistent with an existing NASD rule that caps service fees at that level. Anything above and beyond this 25 basis points cap will be considered an “ongoing sales charge” and will be, as noted above, capped so that an ongoing sales charge won’t exceed what would have been paid as an up-front or back-end charge.

What remains to be seen, however, is whether, if enacted, this will result in any significant savings for investors. Some, including Vanguard founder, John C. Bogle are skeptical. Bogle told the New York Times, that, “It appears to be a small step in the right direction, but it won’t change the world."