What is the 12b-1 fee?

Mutual funds allow investors to average out the market risk and provide a steady and systematic investment profile. Because of its lower risk, it is considered to be the best diversification tool. However, as mutual funds are professionally managed, they employ a host of portfolio managers and incur several expenses on operations and management. These expenses are either covered directly from the mutual fund’s assets or are carried forward to the mutual fund's shareholders.

One such important yet controversial fee is the 12b-1 fee which is charged for the marketing and distribution purposes of the mutual fund. This blog elaborates on what the 12b-1 fee is and how it can affect your overall investment.

What is the 12b-1 fee?

The 12b-1 fee is a fee paid annually by mutual fund investors to the fund’s broker or advisor. The 12b-1 fee is included in the mutual fund’s expense ratio and generally ranges between 0.25% to 0.75% of the fund’s total net assets, with the latter being the maximum allowed rate. The 12b-1 fee was made legal after the introduction of the section of the Investment Company Act of 1940. With the 12b-1 fee, the investor is paying the fund house an amount to market the fund and increase the customer base.

12b-1 Fee Broken Down

The 12b-1 fee was launched to help the mutual fund business and allow fund houses to have the capital to market and expand the mutual fund. It was believed that by marketing a fund, its Net Asset Value (NAV) would increase, and the overall expenses would be lowered based on economies of scale. However, the above justification is yet to be proven, and experts believe that the 12b-1 fee is now used more to reward the intermediaries for selling the shares of the mutual fund.

The 12b-1 fee is among the numerous fees charged by a mutual fund. The Securities and Exchange Commission does not limit how much a fund can charge as a 12b-1 fee. However, the National Association of Securities Dealers (NASD) limits the rate at 0.75% of a fund’s average net assets per year.

The 12b-1 fee is not part of a mutual fund’s fee structure. It means that the 12b-1 fee does not ensure whether a mutual fund will be classified as a no-load or load fund. A mutual fund is a no-load fund if the total amount of the fund’s 12b-1 fee is less than 0.25%, along with the fund’s average annual net assets.

Uses of the 12b-1 fee: Mutual Fund Expenses

The main aim of the 12b-1 fee is to cover some expenses incurred by the mutual fund. There are generally two types of expenses covered by the 12b-1 fee:

• Distribution Expenses: These types of expenses are incurred on marketing and increasing the sale of fund shares. The expenses also include the cost of printing and mailing the fund prospectus, advertising, compensation of brokers and others to sell the shares.

• Shareholder Service Expenses: The shareholder service expenses include the cost of employing people for responding to investor queries. However, it is up to the fund to include such costs in the list of expenses covered under the 12b-1 fee. They may choose to cover such costs directly from the fund’s assets.

Although the above two expenses are the most common under the uses of the 12b-1 fee, some fund houses also use the 12b-1 fee to cover other expenses such as transfer agent, custodial, legal, accounting and other administrative expenses.

Use of 12b-1 fee: Broker Sold Shares

Brokers sell three types of fund shares: Class A, Class B, and Class C. Class A shares do not charge a back-end load and only come with the front-end load fee. Because of this, Class A shares have a lower 12b-1 fee and usually don’t charge the maximum fee of 0.75%. Class B shares charge a back-end load but do not charge a front-end load, allowing the class of shares to always charge a 12b-1 fee. However, Class C shares have the highest possibility to charge the maximum 12b-1 fee, which may push the fund's overall expense ratio to above 2%.

Final Words

Although most fund houses justify the charging of the 12b-1 fee, smart investors try to avoid the fee at all costs because of an increasing expense ratio. Furthermore, some funds may hide the 12b-1 fee without the shareholders knowing that they are being charged for marketing and distribution of the fund to attract more customers. Hence, you must read the prospectus of the mutual fund in detail to determine the fee you are being charged. You can compare various mutual funds based on the 12b-1 fee and then take an informed investment decision.