What Is 12B-1 Fund?
A 12b-1 fund is a mutual fund that charges its shareholders an annual fee to cover marketing and distribution expenses. This fee, known as a 12b-1 fee, is part of the fund's expense ratio and is deducted directly from the fund's assets under management (AUM). These fees are named after Rule 12b-1 of the Investment Company Act of 1940, which permits funds to use their assets for distribution-related activities. The 12b-1 fund concept falls under the broader financial category of mutual fund fees and expenses.
The primary purpose of the 12b-1 fee is to compensate broker-dealer firms and other financial intermediaries for selling fund shares, as well as for advertising and promotional materials. These costs are disclosed in the fund's prospectus.
History and Origin
The concept of using mutual fund assets to pay for distribution expenses faced historical resistance. Before 1980, the Securities and Exchange Commission (SEC) generally held the view that it was improper for a mutual fund to finance its own distribution.25 However, Section 12(b) of the Investment Company Act of 1940 allowed for exceptions if the SEC promulgated specific rules.24
In 1980, the SEC adopted Rule 12b-1, reversing its long-standing position.22, 23 This rule allowed mutual funds to pay for marketing and distribution costs directly from their assets, provided they adopted a formal 12b-1 plan approved by the fund's board.21 The original justification was that these fees would help funds grow their assets, leading to economies of scale and potentially lower overall operating expenses for shareholders.20 This evolution marked a significant change in how mutual funds could fund their growth and compensate those who sold their shares.
Key Takeaways
- A 12b-1 fund charges an annual fee from its assets to cover marketing and distribution expenses.
- The fee is named after SEC Rule 12b-1, which allows this practice.
- 12b-1 fees are included in a fund's overall expense ratio.
- These fees primarily compensate intermediaries for selling fund shares and cover advertising costs.
- While initially intended to foster fund growth and economies of scale, their effectiveness in lowering overall costs for investors has been a subject of debate.
Formula and Calculation
The 12b-1 fee is calculated as a percentage of a fund's average annual net assets value. While there isn't a complex formula, the fee is a direct deduction from the fund's total assets. The maximum permissible 12b-1 fee for marketing and distribution expenses is capped at 0.75% of a fund's average net assets per year under FINRA.org rules. An additional 0.25% may be charged for shareholder services, bringing the total possible annual 12b-1 fee to 1.00%.19
The amount charged is typically expressed as:
For example, if a fund has an average annual net asset value of $100 million and charges a 0.50% 12b-1 fee, the fund would deduct $500,000 annually for these expenses.
Interpreting the 12B-1 Fund
When evaluating a 12b-1 fund, understanding the implications of its fee structure is crucial. The 12b-1 fee directly reduces the fund's overall returns, as it is deducted from the fund's assets before performance is calculated.17, 18 Investors should review the fund's prospectus to identify the exact percentage charged, as this fee is an ongoing operational expense.15, 16
Funds with higher 12b-1 fees will have a greater drag on performance compared to similar funds with lower or no such fees, assuming all other factors are equal. The fee is designed to incentivize intermediaries to sell the fund, which might not always align with an investor's best interests, as it can create a conflict of interest.14
Hypothetical Example
Consider an investor, Sarah, who places $10,000 into a hypothetical mutual fund, "Growth Global Fund." This fund is a 12b-1 fund that charges an annual 12b-1 fee of 0.50% of its average net assets.
In the first year, assuming the fund maintains its average net asset value near $10,000 throughout the year, the 12b-1 fee deducted from Sarah's portion of the fund's assets would be:
This $50 is deducted from the fund's assets, reducing the fund's net asset value and, consequently, Sarah's investment return. If the fund's investment performance before fees was, say, 7%, the 0.50% 12b-1 fee would reduce the gross return by that amount, resulting in a lower net return for Sarah. This fee is an ongoing cost as long as Sarah holds her investment in the 12b-1 fund.
Practical Applications
12b-1 funds are a common structure for mutual funds that aim to expand their investor base by compensating sales professionals. These funds are prevalent in situations where financial advisors or broker-dealer networks play a significant role in distributing investment products. For instance, funds sold through commissioned financial planners or brokerage firms often incorporate 12b-1 fees to cover these sales incentives and marketing efforts.13
Regulators, such as the Securities and Exchange Commission, require transparent disclosure of 12b-1 fees in the fund's prospectus and summary prospectus, allowing investors to identify these costs.12 The Investment Company Institute provides a resource center detailing aspects of Rule 12b-1 and intermediary payments.11
Limitations and Criticisms
Despite their intended purpose of promoting fund growth, 12b-1 funds and their associated fees have faced significant criticism. A primary concern is that these fees are an ongoing expense deducted directly from fund assets, which can erode investor returns over time.10 Critics argue that 12b-1 fees create a conflict of interest, as they incentivize salespersons to recommend funds that pay higher commissions, potentially without regard for the fund's suitability for the investor.9
Another limitation is the lack of explicit transparency for investors regarding the total amount of 12b-1 fees they have paid over time, as these fees are embedded in the fund's net asset value rather than being a separate, upfront charge.8 While the fee percentage is disclosed in the prospectus, the cumulative impact may not be immediately apparent. Some experts suggest that investors can find comparable funds without 12b-1 fees, or with lower fees, offering potentially better long-term returns. The average 12b-1 fee for mutual funds was approximately 0.26% in 2019, according to Morningstar, which, while seemingly small, can accumulate significantly over time.7
12B-1 Fund vs. Sales Load
The main distinction between a 12b-1 fund and a fund with a sales load lies in how distribution costs are charged. A 12b-1 fund imposes an annual fee, a percentage of assets, which is continuously deducted from the fund's assets. This ongoing charge is sometimes referred to as a "level load."
In contrast, a fund with a sales load, also known as a load fund, typically charges an upfront commission (a front-end load) when shares are purchased, or a deferred sales charge (a contingent deferred sales load or "back-end load") when shares are redeemed.6 While sales loads are usually one-time events, 12b-1 fees are recurring expenses. Some share classes of mutual funds may feature both a sales load and a 12b-1 fee, while others might only have one or neither. The disclosure in the fund's prospectus is critical for understanding these fee structures.5
FAQs
Q: What exactly does a 12b-1 fee pay for?
A: A 12b-1 fee primarily pays for the marketing and distribution expenses of a mutual fund. This includes compensating brokers and other financial professionals who sell fund shares, advertising costs, printing and mailing of prospectuses, and sometimes shareholder services.4
Q: Are 12b-1 fees part of the expense ratio?
A: Yes, 12b-1 fees are considered an operating expense of the fund and are included in the fund's total expense ratio.3 Investors can find this information in the fund's prospectus.
Q: Can a mutual fund be considered "no-load" if it charges a 12b-1 fee?
A: A fund can be designated "no-load" if it does not charge any sales loads (front-end or back-end). However, even a "no-load" fund may still charge 12b-1 fees, provided these fees are below a certain threshold (typically 0.25% of average annual net assets according to FINRA rules).2
Q: How do 12b-1 fees impact my investment returns?
A: Since 12b-1 fees are deducted directly from the fund's assets, they reduce the fund's net asset value and, consequently, your overall investment returns. These ongoing fees can compound over time, making a noticeable difference in long-term performance.1 It's important to consider all fees when evaluating an investment adviser or fund.