12b-1 fees are annual distribution fees related to mutual funds. They are an operational expense, and they’re usually a part of a fund’s expense ratio. In this guide, you’ll find not only an in-depth explanation of 12b-1 fees, but also ways that you may be able to keep your fees low. If you have more questions about mutual funds or the charges associated with them, consider meeting with a financial advisor in your area.
What Are 12b-1 Fees?
Mutual fund investors pay 12b-1 fees to cover the marketing, promotion and service expenses of their investments. The idea is that this money is used both to attract new investors to a particular fund and to compensate the professionals doing the sales work.
These fees incorporate revenue-sharing principles where fund managers use a client’s assets under management (AUM) to pay service providers. The marketing and distribution fee is a commission investors pay to financial advisors and brokers, while the service fee clients pay to investment managers who provide advice and customer service.
Why Do You Have to Pay 12b-1 Fees?
During the 1970s, there was a period where a significant number of investors were withdrawing from mutual funds, and fund managers were looking for a way to attract new investors. Because the success of mutual funds depends on having significant assets that clients invest within them, fund managers wanted to come up with a way to protect existing investors and avoid selling assets at lower prices. Thus, 12b-1 marketing fees were born via the creation of a new SEC law in 1980.
Mutual funds justify charging current investors to attract new investors by stipulating that running a these investments has inherent underlying fixed costs. Supporters, in turn, believe that the more investors there are, the more account custodians can spread those fees out. This could theoretically drag down the average price for each individual investor. In reality, however, these fees tend to incentivize brokers to sell certain mutual funds. This practice isn’t necessarily positive for investors either, as funds with higher AUMs are more expensive to run.
Average Cost of 12b-1 Fees
The 12b-1 fee is divvied up into two distinct charges: a distribution/marketing fee and a service fee. 12b-1 fees are capped at 1% annually, with distribution/marketing fees and service fees limited to 0.75% and 0.25%, respectively.
This affects the various types of mutual funds in different ways. “A share” mutual fund investors pay a separate upfront sales and marketing commission, so they are typically only face the service fee portion of the 12b-1 fee. Inversely, “C share” mutual fund investors pay both the distribution/marketing fee and the service fee to compensate their fund managers.
The actual cost may be more than you think, though. Studies show that 12b-1 fees increase the expense ratio rather than lessening costs over time. Despite the justification that has long been provided for the fee, charges don’t seem to change at all just because more people invest in the mutual fund.
Furthermore, even marginally higher expenses can drastically cut into a fund’s long-term performance. For example, a 1% fee changes your growth percentage from 10% to 9%. This can quietly eat away thousands of dollars of potential earnings in the process. Consider the following table:
|How 12b-1 Fees Affect Investments|
|$10,000 Invested for…||Ending Balance at 10% Growth||Ending Balance at 9% Growth||Difference in Investment Return|
How to Avoid 12b-1 Fees
Fortunately, not all mutual funds charge 12b-1 fees. Many broad-market index funds are low-cost, with annual fees under 0.25%. A growing number of investors are managing their own investments by using websites like Vanguard. This cuts out fund managers and, consequently, fees like the 12b-1.
When researching mutual funds, look for funds with low overall expense ratios. To determine whether the fund charges 12b-1 fees, you’ll have to dig into the mutual fund’s prospectus. Under the shareholder fees section, it will say how much the fund charges for marketing and distribution or account services. This ever-important paperwork is available for review even if you’ve yet to invest in the fund.
You may also want to consider investing in an exchange-traded fund (ETF) or a passively managed mutual fund. Each of these investments track stocks in a particular index, whereas securities are under the maintenance of a manager. Both ETFs and passively managed mutual funds have low expense ratios because of the lack of a manager.
Tips for Building a Strong Investment Portfolio
- Diversification is one of the premier strategies you can use to create reliable growth from an investment portfolio. This principle dictates that investors should spread their assets across as many different investment types and areas of the market as possible. By doing this, you’re insuring your money in case of a market collapse.
- Don’t be too proud to take the advice of a professional. The SmartAsset financial advisor matching tool aims to make it easy to help you find an advisor that can help with your personal needs. Answer the personal finance questions within the tool, and we’ll pair you with as many as three nearby advisors.
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