Chances are mutual fund managers collectively shuddered when President Joe Biden chose Gary Gensler to chair the Securities and Exchange Commission. Gensler is the co-author of The Great Mutual Fund Trap, a book detailing fee abuses and conflicts of interest in the fund industry. In 2004, he testified before Congress that certain fund fees should be curtailed or abolished.
Some of the industry’s fears have been realized. This March, the SEC issued a report of its 2022 “examination priorities” for registered investment advisors (RIAs) and broker-dealers. Among the stated concerns were RIAs’ use of funds with 12b-1 marketing and distribution fees for clients. The SEC has also aggressively pursued some recent enforcement actions against RIAs related to such fees, and it’s possible the regulator may ultimately eliminate the fee.
The SEC created Rule 12b-1 permitting the fee in 1980 to help the mutual fund industry defray distribution costs. The fee is often used to compensate commission-based brokers, providing an incentive to hold on to a fund after they have already sold it to a client and received their commission—called a front-end load. With the $157 billion
American Funds Washington Mutual Investors
fund (ticker: AWSHX), for example, there is a 5.75% commission to buy the fund and a continuing annual 12b-1 fee of 0.25% to compensate advisors—on top of 0.22% for the management fee and 0.09% for other expenses.
Despite the fund industry’s original claims that the 12b-1 would ultimately save investors money by creating “economies of scale” for large funds, critics say that hasn’t been the case. Gensler testified before Congress in 2004: “The evidence clearly shows that funds with 12b-1 plans simply have higher expense ratios and poorer performance than non 12b-1 funds. The time has come to look seriously at repealing rule 12b-1.”
Now Gensler has the power to do that.
“It’s definitely a Democratic majority [in the SEC] right now,” says Amy Lynch, a former SEC examiner and president of consulting firm FrontLine Compliance. “If Chairman Gensler wants something, he’s going to get it.” Lynch points out that according to its public agenda, the SEC will publish a proposed rule on “fund fee disclosure and reform” sometime in October. If the 12b-1 fee is to be repealed, it would likely happen then.
Yet Lynch isn’t sure Gensler will kill it. “He’s already fighting the [financial services] industry on a lot of other proposals that he’s released over the past year,” she says. “I think at this point, [the SEC] has to decide what battles they want to fight.” She thinks additional restrictions on how 12b-1s can be used and additional disclosure required to use them is more likely than outright repeal. The SEC didn’t respond to a request for comment.
One of the primary conflicts of interest addressed by SEC’s enforcement actions involve dual-registered advisors. In a 2019 study called “The Worst of Both Worlds? Dual-Registered Investment Advisers,” Nicole Boyson, a professor of finance at Northeastern University, wrote how 12b-1s influence “dual-registered” advisors who operated as both commission-based brokers and RIAs.
Fund Fees Migration
12b-1 fees may be disappearing, but new revenue-sharing arrangements are cropping up.
|Total Assets (bil) – Jan. 2018||Total Assets (bil) – June 2022||Total Share Classes – Jan. 2018||Total Share Classes – June 2022|
|Funds bundled with 12b-1 fees||$3,645||$3,167||13,023||11,011|
|Semi-bundled funds with no 12b-1 but revenue sharing||10,104||12,576||12,052||12,790|
|Unbundled funds with no 12b-1 or revenue sharing||5,870||8,049||2,081||2,226|
As fiduciaries, RIAs have a higher regulatory burden than commission-based brokers, requiring them to put their clients’ financial interests before their own. Most RIAs charge a percentage of assets under management, historically 1%, instead of commissions, so they’re not supposed to favor a load fund over a no-load one. But Boyson found that dual-registered advisors still favored higher-cost 12b-1 funds for their RIA account clients. Even though those funds didn’t charge an upfront commission, the 12b-1 fee would still compensate the advisor by 0.25% of assets a year.
“If I’m a registered investment advisor, and I typically charge 1%, I’m going to, almost all the time, use funds that have a 12b-1 fee, so that I’m effectively getting paid 1.25%—1% directly from the client, and 0.25% indirectly from the client,” says Boyson.
Yet much has changed in the fund industry since Gensler’s 2004 testimony. According to the Investment Company Institute, a fund trade group, 89% of gross sales of mutual funds went to no-load funds without 12b-1 fees in 2021, compared with 46% in 2000. There’s been a dramatic shift toward low-cost index funds and away from commission-based brokers.
Still, that doesn’t mean funds are now conflict-free. In fact, in some ways, eliminating 12b-1s could make things worse. “12b-1s introduce a level of transparency that is not present with share classes that have other kinds of revenue sharing,” says Aron Szapiro, head of retirement studies and public policy at Morningstar.
“Revenue sharing” is a more-generalized form of compensation fund managers pay for distribution that includes 12b-1s but can also include far-less-transparent payments. Often, for instance, fund advisory companies pay brokers out of their profits for favorable treatment instead of directly from an individual fund’s expense ratio.
Szapiro calls funds with no 12b-1s but other revenue-sharing agreements “semi-bundled.” Such funds can still be high-fee ones, but the reason is largely invisible, as there is no standardized disclosure for such arrangements. So while Edward Jones discloses it received $98.7 million from American Funds in revenue sharing in 2020, for example, Morgan Stanley doesn’t provide specific numbers for each fund family.
Assets in semi-bundled funds have grown from $10.1 trillion in January 2018 to $12.6 trillion in June 2022, while assets in funds “bundled” with 12b-1s shrank from $3.6 trillion to $3.2 trillion.
Much like that old Whac-A-Mole game, every time the SEC brings the mallet of regulation down on an unsavory fee, a new one pops up someplace else.