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Disclosure of cost of mutual fund fees is essential reform

The Baltimore Sun

The Securities and Exchange Commission is looking to "reform or repeal" the sales and marketing fees it has allowed mutual funds to charge for the past quarter century. Now two congressmen have floated legislation that would push for changes to the fee structure and that would alter the way costs are disclosed to investors.

A lot of interested parties have weighed in on the debate, couching their suggestions in legalese and self-interested protectionism. So allow me to make it clear to the regulators and legislators the one and only course for real reform: Just give us the cost! If anyone is serious about real reform and disclosure, this is the only honest solution. Quote costs only in one single figure that delivers all-inclusive, out-the-door, no-fine-print, no-excuses, this-is-the-cost-of-owning-the-fund honesty.

If it makes the lawyers and the fund managers happy, they can stick a breakdown of those fees somewhere beneath the definitive expenses number and a chart showing how the costs will add up over time.

This whole issue actually stems back to 1980, when the SEC issued the "12b-1 rule," allowing funds to charge fees - beyond ordinary operating expenses - to cover the sales and marketing of the fund. The idea was to help smaller funds grow to where they were economically viable and to then use that greater size to help reduce other costs.

Fast forward to 2007, and it's easy to see that what was intended as a temporary fix has become a nightmarish fixture. More than 70 percent of funds now have 12b-1 fees, according to the Investment Company Institute; fund firms say that 12b-1 fees give investors the ability to pay for financial advice over time, rather than all at once - which is true - but they also use the fees to pay for space in fund "supermarkets," the brokerage superstore platforms for investments.

In fact, a "no-load fund" - meaning one purportedly without sales charges - is allowed to carry a 12b-1 fee of up to 0.25 percent. What's more, according to a 2004 ICI study, just 2 percent of the billions of dollars collected in 12b-1 fees each year actually goes for promotion and advertising of the funds; the bulk is spent compensating brokers and financial advisers or for spreading the cost of initial sales charges out over time.

The vagaries in what the fee covers are where the confusion starts. Throw in the fact that fund firms have always wanted to break out the sales and marketing costs from the actual management fees, in order to make their pay seem reasonable.

For average investors, the breakdown of fees is interesting, but also irrelevant. The two key factors driving fund sales are performance and costs, not whether a fund gets to a certain fund level by having a 12b-1 fee or not.

If Fund X charges 1.0 percent in management costs and 0.25 percent for sales and marketing, and Fund Y carries no 12b-1 fee but has an expense ratio of 1.25 percent, the total costs are the same. The sales/marketing fee is a non-issue. And if Fund X lowers its management costs, dropping its overall expense ratio below that of Fund Y, it's cheaper to own, despite the sales/marketing fee.

There has been talk that regulators should "externalize" 12b-1 charges, applying them at the individual account level rather than deducting it from fund assets. For reasons too complicated to explain here, this plan would be a tax nightmare; moreover, it would force a radical change in fund accounting, and shareholders would eventually pay the freight for the new systems.

So if 12b-1 fees are not going away - and they're not - investors should hope for a simple, three-step resolution to fee disclosure:

1. Change the name; naming anything after the rule that allows it is dumb. Give it a name that says precisely what it's for.

2. Make sure that every expense ratio is quoted from the top down. Currently, a fee table shows management fees, then 12b-1 fees, then other expenses, and puts the important number - total annual fund operating expenses - at the bottom.

Have fund companies quote the bottom-line number. Then, after a fund shows how that overall cost will hit home, let it break out the components down below.

3. Keep Congress out of it. The 12b-1 fee was an outgrowth of a regulatory decision, and it should be dealt with now by regulators, not by politicians who lack the real knowledge to judge the unintended consequences of their actions.

When it comes to fee disclosures, improving the system is simple: Just tell us what we most want to know.

Charles Jaffe is senior columnist for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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