ETFs and 12b-1 Fees: what you need to know

Mutual funds thrive when three things happen: current shareholders continue to invest in the fund, new shareholders arrive and shareholders exit in small numbers. While continued investments and satisfied shareholders are important to the fund’s overall health, new shareholders must arrive in significant numbers. To attract this new money, funds advertise. To pay for those advertisements, funds levy a fee called a 12b-1. Here’s what you need to know about this fee and why exchange traded funds may be considering it.

What is a 12b-1 fee?

In a pre-1980 world, mutual funds charged sales loads to their new investors. They did so for several reasons, not the least of which was to retain those investors. But during that pre-1980 decade, index funds made their appearance. These funds sought to do everything they could to lower the cost of ownership. Not only did these funds seek to replicate the index and give the investor a clear view of what the market was doing, they sought to lower the costs of ownership by lowering fees and attempting to eliminate loads, the fee paid upfront or upon exiting the fund.

12b-1 fees were adopted as a rule to the Investment Company Act of 1940 to allow mutual funds to charge their shareholders for advertising and marketing costs. To the investor, this seemed as if the funds were responding to the new kid on the block, the index fund, and lowering their costs. More accurately, they shifted the fee to another expense line.

Do all funds charge 12b-1 fees?

Do funds with a 12b-1 fee perform better or worse than those that don’t charge it?

Because mutual funds fall into two basic categories, actively managed or passively invested, the performance results depends on the fund. Passively managed or index mutual funds performance is tied to the index and return just slightly less than the index. Actively managed funds however seek to beat the index and must overcome their fees in order to do that. About a third do in any given quarter.

Why don’t exchange traded funds charge a 12b-1 fee?

The way this investment is constructed made this fee unnecessary. Exchange traded funds are purchased by the fund creator and the shareholder buys an interest in the fund without actually impacting the portfolio. Any costs to advertise the fund is borne by the ETF. Currently, no ETFs charge investors this fee.

Will they charge ETF investors in the future?