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 Pitfall, 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 reduced or abolished.
Some of the industry’s fears have come true. Last March, the SEC published a report on its “review priorities” for 2022 for registered investment advisers (RIAs) and broker-dealers. Among the concerns raised was the use of funds by RIAs with 12b-1 marketing and distribution fees for clients. The SEC has also aggressively pursued some recent enforcement actions against RIAs related to these fees, and it’s possible the regulator will eventually eliminate the fees.
The SEC created Rule 12b-1 allowing fees in 1980 to help the mutual fund industry cover distribution costs. Fees are often used to compensate brokers on a commission basis, giving them an incentive to hold on to a fund after they have already sold it to a client and received their commission, called an entry fee. With the 157 billion dollars
US Funds Washington Mutual Investors
fund (ticker: AWSHX), for example, there is a 5.75% commission to buy the fund and an ongoing 12b-1 annual fee of 0.25% to compensate advisors, in addition to 0.22% for management fees and 0.09% for other expenses.
Despite initial fund industry claims that 12b-1 would ultimately save investors money by creating “economies of scale” for large funds, critics say it 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. Now is the time to seriously consider repealing Rule 12b-1.
Now Gensler has the power to do so.
“It’s definitely a Democratic majority [in the SEC] right now,” says Amy Lynch, former SEC examiner and president of consulting firm FrontLine Compliance. “If President Gensler wants something, he will get it.” Lynch points out that according to its public agenda, the SEC will issue a proposed rule on “fund fee disclosure and reform” sometime in October. If the 12b-1 fee were to be repealed, it would likely happen then.
Still, Lynch isn’t sure Gensler will kill him. “He is already fighting the [financial services] industry on many other proposals it has released over the past year,” she says. “I think at this point, [the SEC] must decide which battles they want to fight. She thinks additional restrictions on how 12b-1s can be used and additional disclosure required to use them are more likely than outright repeal. The SEC did not respond to a request for comment.
One of the primary conflicts of interest addressed by the SEC’s enforcement actions involves dual-registration advisers. In a 2019 study titled “Worst of Both Worlds? Dual-Registered Investment Advisors,” Nicole Boyson, a finance professor at Northeastern University, wrote about how 12b-1s influence “dual-recorded” advisors who operated as both commission brokers and RIAs.
|Total assets (bil) – Jan. 2018||Total assets (bil) – June 2022||Total Share Classes – Jan 2018||Total share classes – June 2022|
|Pooled funds with 12b-1 fees||$3,645||$3,167||13,023||11,011|
|Semi-bundled funds without 12b-1 but revenue sharing||10 104||12,576||12,052||12,790|
|Unbundled funds without 12b-1 or revenue sharing||5,870||8,049||2,081||2,226|
Source: Morning Star
As fiduciaries, RIAs have a heavier regulatory burden than commission brokers, requiring them to put the financial interests of their clients before their own. Most RIAs charge a percentage of assets under management, historically 1%, instead of fees, so they’re not supposed to favor a loaded fund over a no-load one. But Boyson found that dual-registration advisers still favor higher-cost 12b-1 funds for their RIA account clients. Even if these funds did not charge an upfront commission, the 12b-1 fee would still pay the advisor 0.25% of assets per year.
“If I’m a registered investment adviser and I generally charge 1%, I’m almost always going to use funds that have 12b-1 fees, so I’m effectively getting 1.25%—1% directly from the customer and 0.25% indirectly from the customer,” says Boyson.
Yet much has changed in the fund industry since Gensler’s testimony in 2004. According to the Investment Company Institute, a fund trade group, 89% of gross mutual fund sales went to mutual funds. no-load 12b-1 no-load in 2021, up from 46% in 2000. There has been a dramatic shift towards low-cost funds. index funds and away from commission brokers.
However, this does not mean that the funds are now conflict-free. In fact, in some ways, eliminating 12b-1 could make things worse. “The 12b-1s introduce a level of transparency not present with share classes that have other types of revenue sharing,” says Aron Szapiro, head of retirement research and public policy at Morningstar. .
“Revenue sharing” is a more generalized form of fund manager compensation for distribution that includes 12b-1s, but can also include much less transparent payouts. Often, for example, fund advisory firms pay brokers out of their earnings for favorable treatment rather than directly out of an individual fund’s expense ratio.
Szapiro calls the funds without 12b-1 but with other “semi-bundled” revenue-sharing agreements. These funds can still be high-fee, but the reason is largely unseen, as there is no standardized disclosure for such arrangements. So while Edward Jones reveals he received $98.7 million from US funds in revenue sharing in 2020, for example, Morgan Stanley does not provide specific numbers for each family of funds.
Assets of semi-bundled funds have grown from $10.1 trillion in January 2018 to $12.6 trillion in June 2022, while assets of funds “bundled” with 12b-1s have grown from $3.6 trillion at $3.2 trillion.
Much like that old Whac-A-Mole game, every time the SEC lowers the regulatory mallet to an unsavory price, a new one pops up somewhere else.
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