12b-1 fees are annual distribution fees related to mutual funds. They are operational expenses, and they’re usually a part of a fund’s expense ratio. These fees are separate from the normal management fee and are typically for marketing expenses. 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. You can consider meeting with a financial advisor to learn more or to help you determine if the investment makes sense for your portfolio.
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 when 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 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||The 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. 12b-1 fees are part of a mutual fund’s expense ratio, which is the annual cost of owning the fund expressed as a percentage of the fund’s assets. Other fees that make up the expense ratio include management fees, administrative fees, and other operating expenses.
You should note that mutual funds are required to disclose fees and expenses, including 12b-1 fees. 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 tracks 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.
A 12b-1 fee is named for the rule from the SEC that allows mutual funds to use their fund assets to pay for marketing. The fee is not the same as a fund’s management fee, which is used for operating expenses such as hiring an investment team. It’s important to pay attention to these fees since they can increase the total cost of investing in a mutual fund.
Tips for Building a Strong Investment Portfolio
- Navigating the costs of investing is one of the most difficult things to understand and pay attention to. You can work with a financial advisor to help you recognize those costs and determine when it makes sense for you to invest. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- 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.
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