Friday, May 11, 2007

SEC's Perspective on 12b-1 fees

Comments from SEC Chairman Christopher Cox in an address to the Mutual Fund Directors Forum.

"What the SEC had in mind in 1980 is that requiring current investors to subsidize the sale of fund shares to new investors could be a good thing - even from the standpoint of the current investors - because increasing overall fund size could help better diversify their holdings, and also proportionally reduce
the burden of administrative costs that might now be spread over a wider pool of investors. After all, higher expense ratios reduce investors' returns percentage point for percentage point.
But whether, in fact, a fund's current investors are getting a break depends upon how the investment advisory contract is written. If increasing the size of the fund simply enlarges the fees earned by the investment adviser, the supposed benefits from economies of scale are undone. So one of the things that independent directors must concern themselves with in reviewing the propriety of any 12b-1 fees used for distribution is whether the fees paid to the management company and other vendors, as a percentage of total fund assets, has risen or fallen as the fund has grown. If the size of the fund is increasing, but the expense ratio isn't falling, then using a 12b-1 fee for marketing and distribution expenses is very likely harming, not helping, the current investors.There are other reasons to
question the continued vitality of Rule 12b-1. Today the mutual fund industry is no longer at risk of suffering crib death, as was the case years ago when rule 12b-1 was adopted. At more than $10 trillion and counting, the survival of the mutual fund industry is plainly no longer at issue. Indeed, we have learned by this point in the 21st century that it can be just as big a problem for investors when a fund grows too large as when it is too small. The assumption can't always be made that growth in total assets inevitably assists existing investors. When funds grow too big, they can lose flexibility, with the result that investors get lower returns.For all of these reasons, the original premises of Rule 12b-1 seem highly suspect in today's world. If ever it was justified to indulge an irrebuttable presumption in favor of using fund assets to compensate brokers for sales of fund shares, that time surely has passed. Collecting an annual fee from mutual fund investors that is supposed to be used
for marketing is no more consumer friendly than forcing cable TV subscribers to pay a special fee of $250 a year so the cable company can advertise HBO and Showtime to lure potential new customers."

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