fiduciary

The recent Labor Department determination that all financial advisors making recommendations for individuals’ retirement savings must act as fiduciaries is reviving interest in the topic of mutual fund/ETF fees and expenses.

Being a fiduciary means that the advisor has to place the client’s interest ahead of his own.  It isn’t permissible, for example, for a fiduciary to recommend an investment that is likely to return 5% per year, for selling which he gets a large commission, over a virtually identical one that will return 8%, but which pays a small commission.  For a non-fiduciary, which is what brokers/financial planners are when dealing with non-retirement assets, pushing the low return/high commission alternative is still ok legally.

Personally, I don’t like it that the fiduciary standard doesn’t apply to non-retirement investments.  I also don’t understand why individual investors don’t appear to be worked up about this.  I do understand why the big banks are opposed to fiduciariness, since applying the fiduciary standard to all advice to individuals strikes at the heart of the profits of the traditional “full service” brokerage industry.

12b-1 fees

The 12b-1 part refers to the section of the Investment Company Act of 1940 that governs how an open end mutual fund is allowed to pay for fund distribution and servicing.  It covers things like advertising, sending materials to prospective shareholders or having a call center to answer questions about the fund.

The general idea is that a fund benefits from retaining existing shareholders and adding new ones, so it’s a legitimate use of shareholder money to promote both objectives.

But the most common use of funds under the 12b-1 rule–and the least well understood, in my view–is periodic payments to financial advisors by a fund while clients continue to hold shares.   In the industry, these payments are called “trailing commissions,” or “trailers.”

The SEC doesn’t limit the amount of this fee, although FINRA (the Financial Industry Regulatory Authority, the investment industry trade group) rules set an effective  cap of 1.0% of fund assets yearly.  My sense is that the most common fee percentage for an equity fund is 0.25% – 0.50%.  The best hard data I can find come from the ICI (Investment Company Institute, a mutual fund trade group), and are from 2003.  At that time, aggregate 12b-1 fees amounted to just under half the total administrative expenses, at 0.43% of assets annually.  The rest were old-fashioned (more clearly understood by customers) sales charges.

why is 12b-1 a current issue?

Historically, disclosure of these fees has been exactly crystal clear.  Try finding information about them on the ICI website, if you don’t believe me.  In fact, I can’t recall having met anyone not involved in selling mutual funds who was aware these fees exist.

So, does a broker/financial planner who advises a client on retirement investments in mutual funds have to make sure the customer understands that 12b-1 fees are being subtracted from NAV on a regular basis?  Once he gets that, does the customer put two and two together and realize he’s subject to these fees on non-retirement investments, too–and has been from day one?

How does he react?

The difficulty I’ve experienced in gathering factual data for this post tells me that fund companies think the reaction will be strongly negative.