What are 12b-1 fees, and why are they charged by some mutual funds?

12b-1 fees, also known as distribution fees, are a type of fee charged by some mutual funds to cover marketing, distribution, and sales-related expenses. These fees are named after the section of the Investment Company Act of 1940 that authorizes them. Here's an overview of 12b-1 fees and why they are charged by some mutual funds:

1. Purpose of 12b-1 Fees:

• Marketing and Distribution: The primary purpose of 12b-1 fees is to cover the costs associated with marketing and distributing mutual fund shares. This includes expenses related to advertising, promotional materials, and compensation to financial intermediaries (such as brokers and financial advisors) who help sell the fund.

2. Types of 12b-1 Fees:

• Distribution (12b-1) Fees: These fees are used to compensate intermediaries for distributing and selling the mutual fund shares. Distribution fees are ongoing and typically expressed as a percentage of the fund's average assets under management (AUM).
• Service (12b-1) Fees: Some mutual funds charge service fees, which cover the cost of providing ongoing services to shareholders, such as account maintenance, record-keeping, and customer support.

3. How 12b-1 Fees Impact Investors:

• Expense Ratio: 12b-1 fees are included in a mutual fund's expense ratio, which represents the total annual operating expenses as a percentage of the fund's average AUM. Investors indirectly pay these fees through the expense ratio, which can reduce the fund's net returns.
• Lower Net Returns: The presence of 12b-1 fees can reduce the net returns investors receive from the fund. Higher expense ratios, which include distribution and service fees, result in lower net returns over time.
• Transparency: Mutual funds are required to disclose 12b-1 fees in their prospectus and annual reports, allowing investors to understand the costs associated with the fund.

4. Regulation of 12b-1 Fees:

• The Securities and Exchange Commission (SEC) regulates 12b-1 fees and requires mutual funds to disclose these fees to investors. Funds are also required to have a 12b-1 plan, which outlines how these fees are allocated and used.
• There are limitations on the amount of 12b-1 fees that can be charged. Distribution fees are typically capped at 0.75% of a fund's average AUM, while service fees are capped at 0.25%. These caps are designed to prevent excessive fees from eroding investors' returns.

5. Evolution of 12b-1 Fees:

• Originally, 12b-1 fees were introduced to help mutual funds attract assets and increase their AUM. Over time, these fees have evolved, and they are now primarily used to compensate financial intermediaries who distribute and sell mutual fund shares.

It's important for investors to be aware of 12b-1 fees when considering mutual fund investments, as these fees can impact the fund's overall expenses and net returns. Some investors may prefer funds with lower expense ratios, which typically do not include or have lower 12b-1 fees. Additionally, understanding the role of these fees in a fund's operation can help investors make informed decisions that align with their financial goals and preferences.