Something good will come out of the mutual fund industry's current mess: More shareholders will start asking questions about fund practices that have nothing to do with abusive short-term trading but cost the average investor far more over time.
Take, for example, the widespread imposition of so-called 12b-1 fees.
These are expenses that come right out of your pocket: They are deducted annually from many funds' portfolios to pay marketing and distribution costs -- mostly to compensate the brokers and other financial advisors who hawk funds. A 12b-1 fee can reduce your fund return by as much as 1 percentage point a year.
It's all legal, even if most fund owners don't realize they're paying these fees (on top of general portfolio management expenses) because they don't bother to read the details in their funds' prospectuses.
But the history of 12b-1 fees is an interesting tale that explains a lot about how the fund industry got to the troubled state it's in.
In 1980, when fund assets totaled $135 billion, or about 2% of the current amount, the Securities and Exchange Commission decided that the business could use some help to boost its growth.
So the SEC approved Rule 12b-1, which allowed funds to begin charging existing shareholders a new fee to pay for increased efforts to market the portfolios.
In theory, faster asset growth would mean that a fund would realize economies of scale in its overall expenses. That is, if assets rose a fund could reduce its management fee as a percentage of assets, because the managers would automatically be earning more dollars on a bigger portfolio base. If the percentage management fee fell, shareholders' returns would rise by the same amount.
It sounded win-win for management and shareholders. And when the SEC approved 12b-1 fees, it did so with the idea that they would be temporary -- lasting only long enough to make the win-win scenario real.
Yet 23 years later, 12b-1 costs are as permanent a fixture as any on the fund industry landscape. About two-thirds of all stock and bond funds levy the fees.
When New York Atty. Gen. Eliot Spitzer, the fund industry's principal nemesis these days, rails that fund fees are "grossly out of control," he helps to inflame other critics' condemnation of Rule 12b-1 in particular.
"You could make a very good case that they [the SEC and the fund industry] lied to Congress" about 12b-1 fees in 1980, said Don Phillips, managing director of fund research firm Morningstar Inc. in Chicago.
But it's an exaggeration to say that 12b-1 assessments amount to a wholesale fleecing of fund shareholders. Not surprisingly, the industry argues just the opposite: It says that 12b-1 costs did indeed result in lower overall costs for many investors.
Nonetheless, there is enough controversy over 12b-1 fees to warrant the SEC revisiting them. The agency's staff recommended just that in a lengthy report in 2000, though the commission didn't follow through.
Amid the scandal that has rocked the industry since early September, involving widespread allegations of improper trading of fund shares by insiders and by favored clients, the SEC is under pressure to do a comprehensive review of fund practices and expenses.
Fund investors, however, don't have to wait for the SEC. They can easily check on their own what they're paying to own mutual funds, including 12b-1 fees -- and whether a fund is worth the cost.
The key question for fund shareholders is, what is 12b-1 money being used for? According to a survey last year by the Investment Company Institute, the funds' trade group, 63% of 12b-1 fees went to compensate brokers and pay related "distribution" expenses.
In other words, the money probably is going primarily to pay whoever sold you your fund.
The vast majority of investors seek advice in buying funds. Do-it-yourselfers are a rarity.
Before 1980, investors who bought a fund from a broker typically paid an upfront commission of as much as 8% of the purchase amount.
But the industry, and Wall Street, knew that such commissions posed a marketing problem, said Kathryn McGrath, a Washington attorney who spent much of her career in the 1970s and 1980s at the SEC.
"Americans like to pay on 'time,' " meaning credit, she said. "They don't like to pay a big wad up front."
With the dawn of 12b-1 fees, that problem was solved: Brokers could sharply reduce their commissions or get rid of them entirely. In place of the commissions, investors would pay up to 1% a year in 12b-1 fees to compensate their brokers.
Morningstar calculates that the average stock fund's 12b-1 fee takes 0.42% of assets each year. Added to general portfolio management expenses, that lifts the total annual "expense ratio" of the average stock fund to 1.58%, the firm says.
That comes right out of shareholders' returns each year.
For the average bond fund, the 12b-1 fee is 0.39% and the total expense ratio is 1.11%.
