Hidden Fees in Mutual Funds

Posted in: Economics, General, Stock Market, Thought of the Week

Over the past two decades, advertisement spending by the mutual fund industry has followed the broader equity market. As the stock market rises, fund companies aggressively advertise to get retail investors back into the market, and when the market is under pressure, they pull back spending. Nearly every major mutual fund company advertises in such a manner, and sporting events are one of the most attractive mediums. Our Investment Committee is a dedicated team of investment professionals with decades of experience researching industries and companies, and they recognize the necessity and power of brand advertising. It is understandable that the mutual fund industry needs to promote itself and build a brand, but the biggest problem our Investment Committee has with brand advertising is who ends up paying the bill.

A mutual fund expense ratio is the explicit cost that mutual funds charge investors. The SEC requires each fund to state the total expense ratio and the fees that make up this ratio in the fund’s prospectus. One of these fees is referred to as the “12b-1” fee, which is the annual marketing and distribution fee for a mutual fund. The SEC originally authorized this fee because legislators believe that if mutual funds were able to advertise, they would be able to increase their assets under management over time and thus lower their expenses. Basically, the SEC assumed that 12b-1 fees would somehow lower overall costs for investors. In reality, the 12b-1 fee actually only pays two expenses (neither of these lower costs for the investor):

  1. Incentives for Brokers: According to research conducted by the University of Texas, almost two-thirds of all 12b-1 revenues go to the salesperson and his/her broker dealer as a quasi-commission. These fees can sometimes be as large as 1% of an investor’s balance per year, although they are deducted from accounts daily. Essentially you are paying a small commission every year on the fund you own.
  2. Marketing: The fund manager can legally take assets from within the fund and use them to pay for marketing expenses. Our Investment Committee cannot reconcile how reducing the current value of an investor’s account in order to pay for advertising is in any way advantageous to the investor.

Nearly every academic study that we have found has concluded that 12b-1 fees are a “dead weight” cost that does NOT achieve a reduction in the expense ratio as originally intended by the SEC. The mutual fund industry is spending billions of their investors’ money each year to pay for marketing and distribution costs because the SEC has deemed the practice beneficial to their customers. There is a reason the executives in the mutual fund industry have gone great lengths to ensure that these highly profitable fees remain intact. Our Investment Committee strongly urges investors to talk to their financial advisor to determine any exposure to 12b-1 fees within their portfolio.

Read this week’s Thought of the Week to learn more about the hidden fees in mutual funds that you may not know you are paying.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.