March 2, 2004
Regarding the 12b-1 rule:
My understanding has been that 12b-1 fees were allowed originally to help offset the costs of selling additional shares of a fund, thereby enlarging its asset base and helping it to achieve economies of scale. This was approved at a time when assets in mutual funds comprised a much smaller part of total invested dollars. It was a time when a fund with an asset base of 300 million dollars was considered large, perhaps even TOO large, and when there were many fewer funds available to choose from.
Since then, the fund industry has exploded in size. Whether this is due in part to the 12b-1 rule is hard to say, but many if not most funds have received approval to levy a 12b-1 fee, often at a maximum of 0.25 basis points, although frequently at higher rates.
One-quarter of one percent seems like a small fee to help achieve economies of scale, thereby reducing fund expense ratios, hopefully by more than the 12b-1 fee amount. In practice, it has not worked that way. Expense ratios have frequently gone up and seldom come down, even when funds achieve asset bases exceeding billions and even tens of billions of dollars. Economies of scale have proven to be illusory, at least they seem to disappear at a much lower asset base than expected.
My suggestion: Modify rule 12b-1 to cap total 12b-1 fees per fund at 0.25 basis points on the first 250 million dollars of assets. A 100 million dollar fund would be allowed to assess the full 0.25 basis points, collecting 250,000 dollars from its investors. A 250 million dollar fund could collect the full 0.25 basis points, or 625,000 dollars, to apply to distribution expenses. But a 1 billion dollar fund would be capped at the same 625,000 dollar amount, reducing the effective load on its shareholders to a 0.0625 basis points fee. By this approach, early shareholders who would benefit from a larger asset base pay to help the base grow, but only up to a point. An alternative approach is to prohibit 12b-1 charges on funds larger than 500 million dollars.
I would further limit the 12b-1 fees allowed for a fund complex to the equivalent of the maximum for 20 funds, or 12,500,000 dollars. The idea is to prevent an unscrupulous fund management company from issuing shares in clones of the same fund, just to get around the per-fund maximum once a fund has reached the 250 million cutoff point. For the purposes of this rule and the rule above, multiple classes of the same fund are all counted, collectively, as a single fund.
This limit is logical, since in almost all cases, funds within a family share research and administrative expenses, which really do quickly slow their growth as fund families and their funds get bigger. Besides, the excessive growth of either entity by that point no longer benefits existing fund shareholders.
I dont know if my cutoff points are exactly right, they could be off by a factor of as much as 2 on either limit. But if they were much higher, they would be more or less meaningless, at least in the context of my arguments.
A second suggestion: No fund that is closed to new investors should be allowed to continue to charge 12b-1 fees.
Finally, regarding per-account fees: It is not exactly clear what you mean, but my interpretation is that the term is meant to differentiate one-time or time-of-purchase fees from per-annum fees. Per-account fees can make sense to the extent that they are minimal and only used to pay for items that would otherwise unfairly inflate the expense ratio or reduce returns, not if they are sales loads.
Thanks for the opportunity to comment. I apologize for the style of this note. Dollar signs and some other punctuation marks did not transfer to your site.