As with any for-profit business enterprise, the mutual fund industry charges fees for the services it offers. In their most basic form, these services consist of managing a pool of commingled assets in accordance with an investment strategy. That strategy may include outperforming an index over time. In fact, this strategy is the lifeblood of the actively managed fund component of the industry.

A well-managed fund will tend to grow in popularity and earn more investors over time. However, for several decades now, and for reasons that used to make much more sense than they do today, mutual funds have charged existing investors for marketing and promoting their services to prospective investors. These charges are known as 12b-1 fees.

The Basics of the 12b-1 Fee
A mutual fund charges its investors a 12b-1 fee to pay for marketing and promotion expenses. According to a discussion of 12b-1 fees on the website for the Securities and Exchange Commission (SEC), "these fees are deducted from a mutual fund to compensate securities professionals for sales efforts and services provided to the fund's investors."

It also details that 12b-1 fees first emerged in the 1970s during a period when mutual funds were seeing significant redemptions and wanted an avenue to help attract new assets. The funds needed sufficient assets to protect existing investors from the fund managers' having to make forced sales at depressed asset prices or when stocks and bonds were not trading at favorable levels. The fee's official name stems from a 1980 SEC rule implemented to authorize its use.

Fast forwarding approximately half a century, the ability for funds to charge 12b-1 fees has grown more controversial. Mutual funds are much more popular these days, which makes the original motivation for creating the fee much less meaningful. Funds are also much larger, with the largest managing hundreds of billions of dollars in assets. 12b-1s also have a percentage fee, such as 25 basis points or 0.25% of all the assets managed in a fund. With billions under management, it is difficult to see the need to charge investors to market the fund to other potential investors. Estimates of 12b-1 fees have been around $10 billion annually in recent years across all funds that charge the fee. Additionally, while 12b-1 fees vary across individual funds, one study estimated an average annual fee of 13 basis points, or 0.13%. It is also estimated that around 70% of mutual funds charge 12b-1 fees in at least one share class.

Where to Find the 12b-1 Fee
The 12b-1 fee is a component of a mutual fund's total expense ratio. Websites including Morningstar and Yahoo! Finance generally list the total expense ratio by fund. However, to get the most accurate and current expense ratios, it is necessary to dig into a mutual fund prospectus. The prospectus must list specific fees and charges by each mutual fund class offered.

The mutual fund prospectus will have one or more sections detailing fees and expenses. Generally, the fund's annual operating expenses will be broken down into components. The largest fee is usually the management fee, which is what the portfolio managers charge to run the fund. The distribution fee, or 12b-1 fee, will also be listed. Other fees and expenses may include sales charges such as front-end and back-end sales loads that investors incur when they buy or sell a fund. There may also be other operating expenses, such as account administration fees, recordkeeping fees and networking fees to wholesalers and other financial intermediaries that also help to sell the fund.

There are other selling fees beyond the 12b-1 marketing and promotion charges. These will be explicitly broken down and detailed in either the mutual fund prospectus or a corresponding document called a statement of additional information.

Important Considerations
Investors may question whether it is appropriate for a mutual fund to charge its existing investors a fee to market and promote the fund to other potential investors. Controversy has bubbled up from time to time over this issue, especially following the credit crisis and ensuing Great Recession that called into question many aspects of how the financial services industry operates and charges its clients. SEC proposals at the time looked to cap the 12b-1 fee at 25 basis points and to make the fee more transparent to investors who might not even know that they are being charged for marketing, promotion and related sales activities.

The Bottom Line
Many mutual funds warrant criticism for their high fees and uneven performance. That being said, many worthwhile funds with great performance records charge very reasonable fees. In fact, 30% of mutual funds don't charge 12b-1 fees, since their managers find them unnecessary or would rather protect the financial interests of their existing investors. To find the best funds and balance the risks against the rewards of funds that charge 12b-1 fees, investors should read the mutual fund's prospectus and SAI, and then make an educated decision over whether the fund is likely to earn a sufficient return for the fee it will charge.

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