“As the Securities and Exchange Commission weighs changing a rule that allows mutual funds to charge investors fees to cover sales and marketing costs, an SEC economist has concluded that the fees do little more than enrich fund companies,” writes Tom Lauricella in today’s Wall Street Journal.

“The charges, known as 12b-1 fees after the rule that created them in 1980, cost fund shareholders an estimated $10 billion a year. Both the mutual-fund and brokerage industries have lobbied the SEC intensely to leave the fees alone, arguing they help fund investors and are crucial to how financial advisers get paid. But critics say the fees are misused and mislead investors about the true cost of owning a fund. The fees are deducted from fund assets, eroding returns, but aren’t explicitly spelled out for investors the way commissions are.”

“The SEC study, written by staff economist Lori Walsh, comes down squarely on the side of the critics, saying the fees don’t accomplish their original intent and aren’t an appropriate substitute for clearly defined sales commissions. ‘Fund advisers use shareholder money to pay for asset growth from which the adviser is the primary beneficiary through the collection of higher fees,’ the report said. ‘This result validates the concerns raised by opponents of 12b-1 plans about the conflicts of interest created by these plans.’ “

“The study comes as the agency is seriously considering an alternative to the fees that would allow funds to deduct distribution-related costs from shareholder accounts rather than from fund assets.”

“While no decision has been made, some SEC officials believe this approach would make clear to investors exactly how much they pay in commissions. The SEC made the paper public by including it among comments the agency received in response to questions it raised in February about 12b-1 fees, mainly focused on whether they should be abolished.”

“Critics of the fees were pleased by the study. ‘The implication of the SEC study is that 12b-1 fees are a dead-weight cost and of no net benefit to fund shareholders,’ says Stewart Brown, a professor of finance at Florida State University in Tallahassee.”

“Mr. Brown notes that such fees now total $9 billion to $10 billion annually, up from $2.3 billion for the entire decade of the 1980s. An SEC study released in 2001 found that 12b-1 charges were one of the main reasons for a big jump in overall fees paid by investors between 1979 and 1999.”

“The idea of allowing mutual funds to charge fees to cover sales and marketing costs was conceived during the 1970s as a temporary way to help a then-struggling fund industry compete with other financial products. The theory was that fund shareholders would ultimately benefit because, as a fund grew larger, the fixed costs would be spread over a larger base. As a result, each shareholder would end up shouldering a smaller portion of the larger fund’s expenses, translating into higher returns, the theory went.”

“The SEC adopted the rule in October 1980. Among the first to impose the fees were so-called no-load funds that don’t charge commissions and had previously paid marketing costs out of their own profits.”

“Over time, however, the fees were adopted by broker-sold funds that charged commissions. They began using them as a substitute for upfront sales charges, then the most common way of selling funds. That made the funds more attractive because investors could pay the commission over time. But some investors wound up paying more than they would have if they had paid the upfront commission.”

“Funds also began charging investors 12b-1 fees to cover costs that aren’t directly related to promoting sales of a fund but rather for ‘shareholder servicing,’ such as processing transactions, maintaining records, and mailing account statements and reports.”

“Today, about 67% of all funds charge the fees, according to Morningstar Inc. Studies have found that 12b-1 fees average just shy of the maximum 1% allowed by the SEC, but they vary widely and roughly one-third charge less than 0.25%, Morningstar says.”