The mutual fund industry provides prudent investors who select funds carefully with diversification at a relatively low cost. Diversification protects investors from the hazard of having too large a fraction of their holdings in one stock or other type of asset. If one asset happens to lose value, undiversified investors would have no other assets balancing it.
If it were not for mutual funds and certain similar instruments, investors would have to spend a far larger amount of money to achieve a prudent mix of assets in their portfolios. With a broad-based mutual fund, any investor can own a wide variety of assets from the first small purchase.
Thus, mutual funds benefit small investors by pooling their funds. A mutual fund can also buy stocks and other assets with lower transaction fees and lower costs of doing business than a small investor can. A mutual fund uses the investor’s money efficiently, and this efficiency actually increases as the size of the mutual fund increases (at least up to a point), because a larger fund is able to be more diversified and more efficient.
Large funds can hold a wider array of assets in their portfolio than small funds hold. They can pay less to acquire these instruments because transaction costs do not grow proportionately with the amount being purchased. The costs to run the fund also do not grow proportionately as the fund grows because the number of personnel needed does not grow at the same rate as fund size. Funds do not need a lot more people to run a lot more money. For these reasons, it is generally to the mutual fund holder’s advantage if his or her mutual fund grows.
At the same time, mutual fund holders are better off with knowledge about their investments. Mutual fund investors frequently have questions about their funds, their assets, and markets in general.
So investors benefit from growth in the number of holders of their mutual fund, and they also benefit from knowledge about what is happening to the money they have invested in the fund.
Recognizing these facts, regulators allow mutual funds to charge a 12b-1 fee, to raise money to increase the number of stakeholders in their funds and to provide these investors with information and assistance.
The 12b-1 fee is intended for “advertising and promotion,” by statute. In practice, it pays the people who answer the phone when someone calls with a question, and pays to inform investors. It also compensates brokers who encourage investors purchase a particular fund.
The 12b-1 fee does help a fund grow, and therefore it benefits the managers of the fund by increasing their assets and thus their potential management fees. Yet it also benefits the fund holders.
Some funds are popular and successful enough that they “close,” that is, they stop accepting new funds and/or new investors. The fund managers may have come to feel that their fund is too large, and in danger of becoming inflexible.
If such a fund is closed, it is obviously no longer using advertising and promotion to grow. However current investors still have questions, and changes they wish to make to their holdings. Therefore, funds are still using 12b-1 fees for designated purposes. However, most investors would agree that the total fee should decrease, because, over the long run, fees do make a significant difference to returns.
These fees can amount to one percent per year. Regulators say that the fees that go for distribution and marketing cannot exceed .75 percent a year. Service fees cannot exceed .25 percent a year. That extra .25 can go to the salesperson for providing continuing service to the investor. Mutual funds are allowed to earn a fee for shareholder services whether or not they have a 12b-1 plan, just as they are entitled to management fees.
The 12b-1 fee does eventually decrease after a fund closes, though under current regulation fees continue for a period because the sales force is being compensated over time.
People who buy mutual funds should pay close attention to the fees they pay. These fees make a substantial difference to returns. However, it is important to pay attention to all fees, whatever they are called, and to select funds, everything else being equal, that take the smallest total percentage of the mutual fund’s assets.
Many times, investors have a choice. They can pay a load when they buy a fund, and then little or no 12b-1. They can buy a different class of shares, and perhaps pay a fee when they sell the shares. Alternatively, they can choose to pay a set amount each year, to the 12b-1. Each of these choices has drawbacks, and comparisons are difficult. However, there is help available.
The mutual fund sections of many websites, such as marketwatch.com and moneycentral.msn.com, offer evaluations and comparisons of mutual funds. Potential investors can compare funds while taking into account the effects of all their fees, not merely the insidious 12b-1.