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Mutual Fund Investors Aren’t Invited to the Super Bowl

September 26, 2014Blog, Thought of the WeekJana Franco

 

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Mutual Fund Investors Aren’t Invited to the Super Bowl

 

Mutual Funds Love to Advertise

Over the past two decades, advertisement spending by the mutual fund industry has followed the broader equity market. As the stock market rises, fund companies aggressively advertise to get retail investors back into the market, and when the market is under pressure, they pull back spending.

Nearly every major mutual fund company advertises in such a manner, and sporting events are one of the most attractive mediums, given the psychology behind associating their brand to events that involve performance-based, winning achievement.

NOTE: These sponsorships typically come with lavish box seats and first-class plane tickets to events. Mutual fund executives then use these perks for themselves and to invite top producers at the fund for rewarding strong sales performance.

The Investment Committee is a dedicated team of investment professionals with decades of experience researching industries and companies, and we recognize the power and necessity of advertising.

Therefore, we completely understand that the mutual fund industry needs to promote itself and build a brand, much as Coca Cola spends millions every year at sporting events and TV commercials. Where we take issue, however, is who ends up paying the bill.

 

Welcome to 12b-1 Fees

A mutual fund expense ratio is the explicit cost that mutual funds charge investors, and the SEC requires each fund to state the total expense ratio and the fees that make up this ratio in the fund’s prospectus. One of these fees is referred to as the “12b-1” fee, which is the annual marketing and distribution fee for a mutual fund.

The SEC originally authorized this fee because legislators believed that if mutual funds were able to advertise, they would be able to increase their assets under management over time and thus lower their expenses.

Essentially, the SEC actually assumed that 12b-1 fees would somehow create economies of scale to magically lower overall costs for investors. In practice, the 12b-1 fee actually only pays two expenses (neither of these lower costs for the investor):

  1. Incentives for Brokers: According to research conducted by the University of Texas, almost two-thirds of all 12b-1 revenues go to the salesperson and his/her broker dealer as a quasi-commission. These fees can be as large as 1% of an investor’s balance per year, although they are actually deducted from accounts daily (even a no-load fund can charge up to 0.25%). Hence, if you invest in a fund with a 12b-1 fee, you are paying a small commission every year on the fund you own.
  2. Marketing: The fund manager can legally take assets from within the fund and use them to pay for marketing expenses. The Investment Committee cannot reconcile how reducing the current value of an investor’s account in order to pay for advertising is in any way advantageous to the investor.

According to a 2010 article in The Wall Street Journal, roughly 70% of all mutual funds charge 12b-1 fees totaling $9.5 billion annually. Since 1990, based on data from Lipper Inc. and the Investment Company Institute, investors have paid more than $140 billion in 12b-1 fees!

NOTE: These fees even sometimes result in private commissions to brokers and often pay for fishing trips or vacation incentives provided by the broker’s firm for selling their mutual fund.

Furthermore, nearly every academic study that we can find has concluded that 12b-1 fees are a “dead weight” cost that do NOT achieve a reduction in the expense ratio as originally intended by the SEC.

Simply put, the mutual fund industry is spending billions of their investors’ money each year to pay for marketing and distribution costs because the SEC has deemed the practice beneficial to their customers.

 

Implications for Investors

Let’s assume for a moment that your bank removed cash out of your checking account every month in order to help pay for their annual sponsorship of the Professional Golfers Association (PGA).

The bank’s justification for such a business practice is that this form of targeted advertising will increase awareness of their products, and as they are able to attract more customers over time, they will then lower fees on your checking account at some point in the distant future.

Given the cost of such sponsorships can run into the multi-millions, the bank executives will most likely be thanked with lavish perks from the PGA ranging from “sponsor tents”, which come fully stocked with top shelf liquor and caviar, to hundreds of free tickets that the bank can hand out to whomever they please.

In this situation, how would you feel knowing that you…

  1. Paid for bank executives to kick back and relax at the most exclusive golf tournaments worldwide?
  2. Received no invitation from the bank to attend because your ticket is already allocated to the guy who originally sold you your checking account as a reward for exceeding his quarterly sales quota?
  3. Will not see your checking account fees decline by even a few basis points (one basis point is 1/100th of 1%)?

Imagine the outrage if consumers were subjected to such questionable business practices, particularly if the government endorsed such behavior. Yet this hypothetical situation is very real in the mutual fund industry because the executives have gone to great lengths to ensure that these highly profitable fees remain intact.

Therefore, if the idea of paying for a mutual fund manager to fly first-class for box seats at the Super Bowl is even slightly unsettling, then we strongly urge investors to talk to their financial advisor to determine any exposure to12b-1 fees within their portfolio.

The bottom line is that when we pay for Super Bowl tickets, we prefer to be the ones attending. Therefore, we do not use these products in any of our strategies.

 

Footer for thought of the week

 

This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser.

 

Tags: advisor, finance, financial advice, financial planner, ocean springs, Retirement, Strategist, Thought of the Week, Wealth CAPS
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