This month the Supreme Court took up a case to determine whether mutual fund fees are being determined correctly and whether investors get enough information to adequately understand the fees they are paying.
The case, Harris Associates v Jones, pits a well-known mutual fund family against individual investors who claim they are charged twice as much in fees as institutional investors. This, they claim, has violated the fiduciary responsibility that fund managers and other Registered Investment Advisors owe to investors as set forth by Congress under Investment Advisors Act of 1940 and most recently under ERISA.
The argument from the little guy’s side is that they take the same risks as the big institutional investor, but their returns over time can be radically different because of the size of the fees they pay. As a purely fictitious example, let’s say Money Bags Capital Management invests a dollar and is charged a fee of 0.7% by Falafel Mutual Funds. Bill Schmick, an individual investor, invests the same dollar but is charged a 1.40% fee. The Falafel fund returns 8% a year for a decade generating $2.01 for Money Bags but poor Billy only receives $1.87. Is that fair, asks the plaintiffs?
From the institutional investor’s point of view; when you buy in bulk, no matter what you’re buying, you should get a discount. Mutual fund managers also argue that servicing the individual investor is more expensive since each account has to be processed; mailing costs are higher as is communicating with all these shareholders.
However, what no one appears willing to bring up is Rule 12b-1, which allows mutual fund advisers to make payments from fund assets for the costs of marketing and distribution of fund shares. These fees increase the expense that we the individual investors pay by a substantial amount. They can add anywhere from 0.30 to 0.50 basis points to a fund’s expense.
Back in 1980 when the rule was passed, the mutual fund industry claimed that these fees would help attract new shareholders into their funds through advertising and by providing incentives to brokers and others to market their funds. Since then, several variations of the theme have evolved, called “revenue-sharing arrangements” and “advisor paid fees”. Although some mutual fund companies do use these fees for legitimate marketing or advertising, in my opinion, most of these so-called fees and arrangements have evolved into nothing more than a kick-back to your broker, financial planner or money manger for using one fund family over another, regardless of performance, expenses or anything else but the lining of their own pockets. Sure, it’s legal but is it ethical?
A few years back, Lori Walsh, a financial economist at the Securities and Exchange Commission studied the costs and benefits to fund shareholders of 12b-1 plans. She concluded that the investor is never explicitly told the amount of 12b-1 fees they are paying. The information is usually buried in the fine print under “disclosures” that your advisor is required to give you. The study also found that these plans provide even less control over the amount that investors pay, and that these funds, unlike commissions or loads, are charged for as long as the investor remains in the fund and usually increases as their holding period increases.. In conclusion, she stated these fees also establish “conflicts of interest” between fund advisers and shareholders:
“Given the lack of evidence that these fees benefit shareholders in any other way, one has to question whether the level of 12b-1 fees is in the interest of shareholders.”
So what does this mean for you the investor who may, for example, have your money managed by an investment advisor for a fee, or a financial planner or broker who may charge you both a fee and commissions? If they are using mutual funds that participate in 12-b-1 fees or revenue-sharing (and 60% of all mutual funds including no load mutual funds do) then your ‘trusted’ advisor is also getting a direct kick-back from the mutual fund they have you invested in at your expense. To add insult to injury, many of these funds are poor performers compared with other funds that don’t provide a kick-back; so not only are you paying higher expenses but your performance suffers as well. The only one who wins is your advisor or broker who gets more and more of your money. What can you do about this? Find out what you are paying and why. If you find you have been unknowingly a victim of this practice, pull your money out and find a manger or broker who does not participate in these scams.
And as for the Supreme Court, if they really want to look at why expenses are so much higher for us individual investors, maybe they should start with 12b-1 fees.