By Scott Burns
Lately there has been a minor buzz in the media and on the conference circuit about exchange-traded funds putting clauses in their prospectuses that would allow them to charge 12b-1 fees, which are a mechanism that fund companies use to pass along to investors the costs of marketing, record-keeping, and commissions. These fees are capped at 25 basis points, but they are essentially a sales load that investors keep paying as long as they hold the fund.
Very few ETFs charge 12b-1 fees, which is a big part of the cost advantage ETFs have over mutual funds--even low-cost index funds. The average ETF expense ratio is 0.55%, while the average expense for open-end index funds is 0.81%. Even the ETFs that charge 12b-1 fees still have very competitive net expense costs among their peers due to lower costs elsewhere or the waiving of fees that might include the 12b-1 that is being charged on paper.
Just because an ETF provider isn't currently charging 12b-1 fees doesn't mean that more than a few of them haven't reserved the right to do so in the future. And that is what all the hubbub is about. There seems to be concern that providers are suddenly going to break with tradition and start charging these fees after decades of not doing so.
It is our opinion that this will not happen--regardless of who enters the ETF market. Now, to be clear, what we are talking about is charging 12b-1 fees on top of existing fees. If some ETF provider decides to reallocate money from one expense bucket to the 12b-1 bucket while overall fees stay the same, it is pretty clear that the investor hasn't suffered an adverse event.
At any rate, our belief that ETF providers won't charge 12b-1 fees isn't because we feel they are kind souls with investors' best interests in mind. Rather, the market efficiency of the way ETFs transact will prohibit them from doing so. Because ETFs trade on the exchange and are generally very liquid, any provider that broke rank would find themselves without assets in short-order as investors opted for low-cost options. ETFs in general are commodity products (at least when you look at where the assets currently reside), and in a commodity product, the forces of supply and demand drive the price to the lowest cost.
What allows mutual funds to charge 12b-1 fees is that the mutual fund distribution model is structurally less efficient than trading on the major exchanges. An argument could be made that mutual fund companies need to charge these fees to pay off the middlemen who control fund distribution and make sure that their products are available to the most investors possible. When a stock exchange is the middleman, investors can piggyback off the billions of other trades that take place every day and pay a very low up-front load in the form of a brokerage fee.
Another reason we consider the concern over 12b-1 fees to be overblown is that they may not even exist by the end of 2010. Securities and Exchange Commission chairman Mary Schapiro has made no secret of her dislike of this practice. It is pretty clear that obliterating the 12b-1 rule and making major changes to the way fund companies disclose the source of their fees is on top of the SEC's very busy agenda.
So, while ETF providers may have reserved the right to charge these fees, in reality they will never be able to exercise the option.
