The 12b-1 Debate: If It Ain’t Broke . . .
by Michael J. Sharp, Arun Sen, Debo Sarkar & ElaElaElaine Buckberg

“When the Commission adopted Rule 12b-1 more than a quarter century ago, the idea was that 12b-1 fees would be a temporary solution to address specific distribution problems, as they arose. But today’s use of 12b-1 fees have strayed from the original purposes underlying the rule, and it is time for a thorough re-evaluation.”1 With what seems to be a misguided presumption that 12b-1 fees have deviated from their original purpose, the Securities and Exchange Commission announced its 12b-1 Roundtable. Some commentators at the Roundtable2 proposed substantial revision or even abolition of 12b-1 fees. The authors, however, believe that such drastic measures are unnecessary and would, in fact, lead not to lower fees but only to disruption in the marketplace and, as a result, would adversely affect investors. In this paper, we will show that Rule 12b-1 and its fees were intended to be a long-term way to support distribution of mutual funds; that the mutual fund industry is highly competitive; and that mutual fund flows respond to 12b-1 fees, constraining fee levels. We will also show that investors receive substantial services in exchange for 12b-1 fees. We will conclude by arguing that, although abolition of 12b-1 fees would be counterproductive, revisions that increase transparency may benefit investors.

Original Purpose Was To Be Proactive and Evolving

So-called 12b-1 fees came into existence in October 1980, when the SEC “adopt[ed] rule 12b-1 to permit open-end management investment companies to bear expenses associated with the distribution of their shares.”3 That is to say, Rule 12b-1 permitted fund companies to use fund assets to support distribution. Current 12b-1 abolitionists argue—as, for example, quoted above—that the Rule and 12b-1 fees were intended to be a temporary fix that would help grow a fledgling mutual fund industry. That, however, is simply not the case.

As an initial matter, the Roundtable started off with and prominently featured Rule 12b-1’s authors, Joel Goldberg, the former Director of the SEC’s Division of Investment Management, and Richard Grant, a former special counsel to the SEC Division of Investment Management and Associate Director of that division, who made perfectly clear that Rule 12b-1 and its fees were meant to be a long-term solution. When asked by a Roundtable panelist whether 12b-1 fees were to just get us “through a tough time,” Goldberg said: “Absolutely not … [It was] never suggested once they [the mutual funds] reach a certain size, they would stop paying.”4

Interested parties, though, did not need to wait for the Roundtable to dispel the myths about 12b-1 and its intended purpose. Similar support is found in the Rule’s history, which makes plain that, rather than making a limited rule to be used only for funds in dire straits or for no-load funds, the SEC designed Rule 12b-1 to be proactive and evolving, enabling all funds to experiment with various distribution arrangements. According to the Adopting Release, “[r]ecognizing that new distribution activities may continuously evolve in the future, and in view of the impracticality of developing an all-inclusive list, the Commission maintains that the better approach is to define distribution expenses in conceptual terms (e.g., financing activities primarily intended to result in the sale of fund shares.)”5 The Rule was built to last, and the SEC provided clear endorsements that it is appropriate for fund assets to be used for distribution or compensation to brokers over the life of an investment to facilitate fund share sales.

Subsequent SEC Actions Helped Expand Distribution and Investor Choices

Subsequent SEC action also confirms that the Rule was not intended to be short-lived but was intended to grow along with industry developments. The Rule anticipated that funds and intermediaries would experiment with new fee structures to facilitate distribution, subject to fund board oversight. 6 Given this mandate, mutual funds, with SEC review and approval, evolved to provide a range of share classes, pricing structures, and Rule 12b-1 fees that offer investors more types of mutual funds and more pricing structures suited to different investors.

For example, soon after the SEC adopted the Rule, funds submitted and received exemptive relief from the SEC staff to experiment with alternative pricing structures, in addition to Rule 12b-1 fees.7 Funds adopted share classes with contingent deferred sales charges that declined as investors stayed long-term in the fund.8 Each share class, with different load and 12b-1 fee structures (“spread loads”), was created with different investor choices and investment time horizons in mind.

In addition, in response to public criticism and investor demand for deferment of sales charges, in the 1980s the SEC improved prospectus disclosures and fee tables. It also worked with the NASD to impose a regulatory ceiling on the amount of asset-based fees a fund may charge shareholders. The SEC approved amendments to NASD Rule

2830(d)(2)(E), which prohibits the offer or sale of fund shares with an asset-based sales charge in excess of 75 basis points, and NASD Rule 2830(d)(5), which prohibits the offer or sale of fund shares with a service fee (i.e., payments by a fund for personal service and/or maintenance of shareholder accounts) in excess of 25 basis points.9

In the 1990s, the SEC adopted additional rules to facilitate use of alternative share classes and back-end loads. For example, the SEC designed Rule 18f-3 and Rule 6c-10, which permitted funds to adopt multiple share classes and contingent deferred sales loads, respectively, without the need to obtain an exemptive order.10 The SEC also adopted changes to Form N-1A to consolidate 12b-1 fee expenses data in a fee table.11

The Commission staff helped facilitate these changes, consistent with the original purpose of the Rule, and let competitive market forces respond to investor demand for alternative compensation structures and streamlined disclosure of fund-distribution expense in a fee table. As we will show below, those competitive market forces seem to have worked.

The Mutual Fund Industry Is Competitive

Characteristics of the Market

Rule 12b-1 abolitionists’ arguments seem to imply that the mutual fund industry is non-competitive and that abolishing the fees will reduce the fees paid by investors. The facts, however, do not support that conclusion. It is beyond reasonable dispute that the mutual fund industry over the last few decades has demonstrated the features of a highly competitive market: information is transparent and readily available; barriers to entry are low; and there is no excessive market power among any of the participants. To be competitive, industry information must be transparent and readily available. In the case of mutual funds, investors have access to plentiful information concerning mutual funds from the fund families, from fund distributors, and on the Internet. In addition, services such as Morningstar and Lipper provide extensive information on the mutual fund industry, much of it free. Furthermore, there is ample evidence that investors actively follow and react to information provided by these sources.12

Moreover, the expansion of the mutual fund industry demonstrates that barriers to entry are low. The number of mutual funds has increased substantially in the last few decades, growing from about 650 open-end funds in 1975 to more than 8,700 in 2006. The total net assets invested in these funds have also increased over time, going from $172 billion in 1975 (in 2006 dollars) to more than $10.4 trillion in 2006 (see Figure 1). At the same time, the percentage of U.S. households that have invested in mutual funds has gone from 6% in 1980 to 48% in 2006.13

Further, market shares of mutual fund companies are sufficiently diluted that no single company has excessive market power.14 The market shares of those companies that have entered the business have fluctuated over time,15 as would be expected in a competitive industry. In a market where significant barriers are present, one would expect that a small number of companies (unlike a competitive market) would maintain a large market share over a considerable period of time. That is not the case in the mutual fund industry.

Competitive Pressure Constrains Mutual Fund Fees

Perhaps the strongest indication of a competitive market comes when pressure from rivals forces firms to deliver the best possible goods or services at the lowest possible price. In the mutual fund industry, competition for retail investors has indeed disciplined funds to provide high-quality service at a low price. Indeed, as Figure 1 shows, average total expenses across the industry have fallen over the last few decades.16 Companies that fail to compete efficiently are forced to leave the industry, and the pattern of mutual fund companies exiting the business provides clear evidence of this.17

Of course, investors ultimately care most about the risk-adjusted return on their investment, which takes into account the fees charged by the fund. So, if a mutual fund charges high fees that diminish its fund returns relative to competitors, it will have difficulty attracting new investments. By shifting their investments in response to differences in performance net of fees, investors impose competitive constraints on mutual fund pricing. Studies have consistently found that funds with the highest historical performance attract the largest net flows.18 In a similar vein, the literature has generally determined that assets in the market tend to be invested in funds with the lowest expense ratios, demonstrating that investors do care about costs and behave accordingly. This is borne out by a number of academic studies that clearly show that investors have preferred funds that have lower fees, all other things being equal. Using data from 1970-1999, Brad M. Barber, Terrance Odean and Lu Zheng (2005) find that funds with the lowest decile of expense ratios have 36% of total net assets whereas funds with the highest decile of operating expenses have only 1% of total net assets.19 John C. Coates IV and R. Glenn Hubbard similarly find that, in 2004, 94% of assets of S&P 500 Index funds were in the funds with expense ratios of less than 0.5%, while there was only small demand for S&P 500 Index funds with expense ratios of 0.5% to 1% or 1% to 1.5%.20 Other articles are broadly consistent with these findings,21 the implication being that investors seek out funds with low expenses.

The Effect of 12b-1 Fees on the Competitive Landscape

12b-1 Fees and Fund Flows, Expenses and Returns

While the mutual fund industry may be considered broadly competitive, the central question of concern in this article is the role that is played by 12b-1 fees within this market. Much of the criticism of 12b-1 fees stems from the fact that managers receive compensation based on the size—rather than the performance—of their funds.22 Opponents of 12b-1 fees often claim, therefore, that fund managers have an incentive to use 12b-1 fees to increase the size of their funds instead of focusing on maximizing fund performance. 23 The clear implication of this criticism is that 12b-1 fees somehow serve to “trick” investors into moving their capital into funds while the performance of those very same funds actually suffers. Whether or not there truly exists such a relationship between 12b-1 fees on the one hand, and flows, returns and expenses on the other, is an empirically testable proposition. However, there has been relatively little literature—academic or otherwise—focused on the issue of 12b-1 fees.

One recent paper that has looked at the issue was written by Lori Walsh (2004).24 Her findings would appear to bolster the critics of 12b-1 fees, finding a generally negative relationship between 12b-1 fees and net returns, but a positive relationship between 12b-1 fees and expenses and flows. That is, all other things being equal, funds with higher 12b-1 fees attract more new money, while those funds actually have higher expense ratios and lower returns. The Walsh paper, however, uses data through 2002,25 aggregated at the fund level. This would, as noted in Walsh (2004), dilute the effect of 12b-1 fees since not all share classes in a fund charge the fees. Walsh’s stated purpose was to measure economies of scale at the fund level, so an analysis at the share-class level would be inappropriate. 26
Our objective was different, however. We thus conducted an analysis at the share-class level, and also included data for more recent years, motivated by the following fact: as the mutual fund industry has grown dramatically in the last decade and a half, the proportion of funds that have adopted 12b-1 fees has also grown steadily. Specifically,
as can be seen in Figure 2, in 1993 out of a total of 6,266 share classes,27 only 2,104 charged 12b-1 fees, or 34%. By 2006, there were 13,191 share classes charging 12b-1 fees, 64% of the total. A similar pattern holds even among no-load share classes. It is thus apparent that the industry is evolving, and there is good reason to study the most recent data available.

Using Center for Research in Security Prices (CRSP) data from 1993 to 2006, we ran a regression to measure the relationship between net flows into funds and 12b-1 fees. A graphical illustration of the relationship we found is presented in Figure 3.28 As can be seen from the graph, net flows are higher for funds with a small but positive level of 12b-1 fees, compared to funds without 12b-1 fees. However, in contrast to Walsh (2004), we found that among funds that charge 12b-1 fees, funds with higher fees tend to have lower net flows, all other things being equal.29 Ultimately, funds with sufficiently high 12b-1 fees experience lower flows than funds not charging any 12b-1 fees.30

These results suggest two points. First, charging a small amount of 12b-1 fees for distribution helps funds attract more capital, but high 12b-1 fees are counterproductive. Second, the notion that 12b-1 fees lead to uncontrolled asset growth may be misplaced, at least in recent years. That is, while 12b-1 fees might cause higher expenses and lower returns, investors respond reasonably by avoiding such funds. Put another way, market forces should to some extent constrain 12b-1 fees in the same way they constrain total expenses. So any problems associated with 12b-1 fees may not be as severe as some critics aver.

Elimination of 12b-1 Fees Would Not Likely Reduce Total Fund Fees and Loads

Eliminating 12b-1 fees will not necessarily reduce fund expenses. Because funds will continue to incur servicing costs, these costs may be shifted to another fee component—some combination of higher non-management fees, management fees and loads—such that total expense ratios would not necessarily fall. Existing data cannot meaningfully address what would happen if 12b-1 fees were eliminated, as it is possible that the very nature of the industry would be transformed. However, the reduction in overall fees that followed the introduction of 12b-1 is consistent with the hypothesis that changing one fee might not change total fund costs (see Figure 1).

One concrete example that shows that overall expenses would not necessarily be reduced by eliminating 12b-1 fees is that of the Charles Schwab Corp.’s elimination of 12b-1 fees on three money market funds. In 1990, Schwab decided to manage its own money market mutual funds. Prior to that, Schwab was selling three money funds – regular, government and tax-free – that were managed by Kemper Financial Services. When Schwab sold Kemper funds, the expense ratios for all three funds included 12b-1 fees. Schwab decided to revise the fee structure and eliminated the 12b-1 fees from all three funds. However, it ratcheted higher non-management fees.31 The tax-exempt fund had 12b-1 fees of 0.33%, non-management fees of 0.11% and management fees of 0.19%. After the elimination of the 12b-1 fees, the non-management fees quadrupled to 0.46% and the management fees dropped a little to 0.17%. The expense ratio remained the same at 0.63%.32

Brokers’ Services and Benefits to Investors Mutual funds are a cost-effective way for retail investors to diversify. Informed investors will prefer mutual funds as long as fund charges do not exceed the fund’s diversification and transaction cost benefits. For investors with small investable assets, mutual funds are clearly the cost-effective choice, compared with creating a diversified personal account.

Investors obtain significant benefits from financial intermediaries and their broker-dealer representatives, paid for in part from Rule 12b-1 fees. As described below, broker-dealers and their individual representatives provide professional marketing, sales, recordkeeping and administrative services – all part of the “distribution” process for which 12b-1 fees are tailored.

Broker-dealers incur significant expenses to offer and sell mutual funds, such as performing due diligence on fund companies and funds; providing research, portfolio analysis, tools and website functionality; reviewing and updating fund sales literature and performance data; training sales forces on new mutual fund developments; delivering
consolidated statements and tax-reporting efficiencies; delivering prospectuses; and other services. Over the past 25 years, the number and types of funds, strategies and share classes offered to investors have increased dramatically. Various features (such as breakpoints, letters of intent, householding, exchange features, etc.) differ from one fund company to another. With this rapid rise in the number and complexity of funds and changes to fund prospectuses each year, broker-dealers also incur increased expenses in offering and maintaining so many funds.

Indeed, due in part to the costs associated with adding funds to its mutual fund platform and the ongoing maintenance, diligence, and prospectus updates, even a large, full-service retail brokerage firm does not sell all mutual funds. For example, a large broker-dealer like Smith Barney sells over 100 fund families, and offers more than 2,000 funds, out of a universe of close to 9,000 publicly registered funds. As part of a broker-dealer’s due diligence, the firm will screen fund companies and funds for appropriateness for its customer base. Distribution costs make it prohibitively expensive for even large full-service firms to review and evaluate all open-end funds for sale to its clients even with 12b-1 fees used to cover some of those costs. Without Rule 12b-1 fees to subsidize some of these costs, and in order to maintain their due diligence standards, broker-dealers would likely be forced to offer investors fewer investment choices.

Individual representatives independently spend significant time reviewing prospectus changes, fund performance data, fund pricing changes, breakpoints and other data for their clients to determine if the mutual fund remains a suitable investment given costs already incurred. These representatives provide clients with information such as performance updates, reports on the underlying mutual fund portfolio, reports on the manager of the fund, personnel changes in the fund, information about upcoming and past capital gains distributions, size of the embedded capital gains at the fund level, the impact of markets changes and of world events on the mutual funds they own. Clients regularly call their representatives for updates.

Moreover, sales of mutual funds involve significant work and training. As professionals, representatives are obligated by law and regulation to know various features of competing fund products, their alternative share-class and cost structures,
and potential benefits to investors, such as breakpoint discounts for larger transactions, rights of accumulation, account aggregation preferences, householding features of various funds, and exchange privileges. Because fund investments are considered longer term, fund shareholders benefit from and have a reasonable expectation of their representative continuing to monitor the performance of an investment over time as well as monitoring the availability of breakpoints and other benefits. The 12b-1 fees, therefore, are used to compensate representatives for part of the services performed for their clients.

Finally, Rule 12b-1 fees have had an impact on the retirement/401(k) industry. Broker-dealers and other intermediaries may provide sales, marketing, education, administrative, and recordkeeping services to companies and their 401(k) participant employees. Many of these intermediaries rely on 12b-1 service and administrative-fee components to subsidize and customize their services to plan sponsors. With alternative fee choices, plan sponsors as fiduciaries have a range of choices to pay for plan administration, and 12b-1 fees help pay for these services.

In sum, broker-dealers and other financial intermediaries provide valuable services to investors, and Rule 12b-1 fees are a primary reason investors enjoy a broad selection of investment choices and receive integrated financial services.

• Commissions to be earned in the future could offset brokers’ incentives to sell higher load funds;
  
• The trailing commission mechanism offsets brokers’ incentives to switch customers’ investments to alternative diversification options
  – self-diversification or separately managed
  accounts – that may generate higher commissions;
  
• Transactions arising from switching funds – resulting in new load-based commissions for the brokers – are minimized.
  
  An Empirical Test of the Principal-Agent Point
  
  Our contention that 12b-1 fees might help to reduce churning in investor’s accounts, across different investment alternatives, can be at least partially tested empirically. Less churning implies that investors will tend to hold their positions in a given fund for a longer period of time. Churning can damage a fund’s returns by forcing the fund manager to incur additional transaction costs to respond to redemption requests; such transaction costs directly reduce fund assets and thereby harm returns. While the actual holding period in funds on the part of individual investors is not directly observable, a proxy for holding periods that has been used in the literature is portfolio turnover.36 This is a quantity that mutual funds have to regularly report, measuring what portion of the securities
  in their portfolios is sold over some interval of time. Logically, the longer the holding period in a fund, the less the turnover should be.37 If our hypothesis concerning churning and 12b-1 fees is correct, one might expect a negative relation between 12b-1 fees and portfolio turnover. Again using CRSP data for 2003-2006, we ran a regression
  of turnover on 12b-1 fees, controlling for other relevant factors. We do indeed find a negative and significant relationship between 12b-1 fees and turnover, all other things being equal.38 This is consistent with (though not a proof of) our primary hypothesis.
  
  Conclusion
  
  We have shown here that, contrary to current rhetoric, 12b-1 fees were intended to be a long-term solution that would permit fund assets to finance distribution costs. We have also shown that circumstances in the mutual fund industry point to a competitive environment that should have and does have a naturally constraining effect on all fees, including 12b-1 fees. In addition, we have shown that investors receive substantial services and benefits from broker-dealers in exchange for the 12b-1 fees that are being paid. And we have shown that 12b-1 fees create incentives for brokers to continue to provide such services and benefits and to avoid situations in which unnecessary fund transactions are minimized. However, the discussion does not need to end there. Are 12b-1 fees in need of no change? We think not.
  

Notes

1. “Commission Announces Roundtable Discussion Regarding Rule 12b-1,” SEC Press Release 2 2007-106 (May 29 29, 2 2007), available at (http://www.sec.gov/news/press/2007/2007-106.htm).
2. See generally Unofficial Transcript of SEC Rule 12b-1 Roundtable, available at (http://www.sec.gov/news/openmeetings/2007/12b1transcript-061907.pdf) (hereinafter, “Unofficial Transcript”). Portions of this article are taken from a comment letter submitted to the SEC as part of the Roundtable public record. See Letter from Michael J. Sharp, General Counsel, Citi Global Wealth Management, to Nancy M. Morris, Secretary, U.S. Securities and Exchange Commission, dated July 19, 2007.
3. See Investment Company Act Rel. No. 11414 (Oct. 28 28, 1980), 1980 WL 2 20761, (Oct. 28 28, 1980) (hereinafter, “Adopting Release”).
4. Unofficial Transcript, supra note 2, at 16.
5. Investment Company Act Rel. No. 11414 (Oct. 28 28, 1980), 1980 WL 20761, Oct. 28, 1980, at p. 8.
6. Id. at p. 7.
7. See, generally, Report of the Working Group on Rule 12b-1, Submitted to Investment Company Institute Board of Governors (May 2 2007) at Appendix II, p. 40 (hereinafter, (“ICI Report”)).
8. Id.
9. See Order Approving Proposed Rule Change Relating to the Limitation of Asset-Based Sales Charges as Imposed by Investment Companies, Securities Exchange Act Release No. 3 30897 (July 2, 1992) 57 FR 30985 (July 13, 1992).
10. Investment Company Act Rel. No. 2 20915 (Feb. 23 23, 1995); Investment Company Act Rel. No. 222 22202 (Sept. 9, 1996).
11. Investment Company Act Rel. No. 23 23064 (Mar. 13, 1998).
12. See, e.g. Diane Del Guercio & Paula A. Tkac, Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows, Federal Reserve Bank of Atlanta Working Paper (2002) available at (http://www.frbatlanta.org/invoke.cfm?objectid=8383FD2626B4-9AF0-11D5-898489848984898400508BB89A83&method=display).
13. See 2 2007 Investment Company Fact Book, available at (http://www.icifactbook.org) (hereinafter, “Fact Book”). Data was also derived from the Center for Research in Security Prices, Graduate School of Business, University of Chicago (CRSP).
14. Publicly available data from CRSP indicates that the Herfindahl-Hirschman Index (HHI) for the mutual fund industry was below 5 500 for 1994-2005. According to the U.S. Department of Justice, an HHI value below 1000 means a market is “unconcentrated” (U.S. Department of Justice and the Federal Trade Commission, Horizontal Merger Guidelines, Revised April 8 8, 1997, Section 1.51).
15. Data from CRSP shows this to be true for the 25 25 largest mutual fund companies in 2 2005 for the period of 1996-2005.'
16. Here, we refer to asset-weighted averages.
17. See, e.g., Steven J. Brown & William N. Goetzmann. Performance Persistence, 50 J. Fin. 679 (1995).
18. See Brad M. Barber, Terrance Odean & Lu Zheng, Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows, 78 J. Bus. 2 2095 (2005); Eric Sirri & Peter Tufano, Costly Search and Mutual Fund Flows, 53 53 J. Fin. 1598 (October 1998); Steven Gallaher, Ron Kaniel & Laura Starks, Madison Avenue Meets Wall Street: Mutual Fund Families, Competition and Accounting Working Paper Series (2006); Vikram Nanda & V. Jay Wang, Family Values and the Star Phenomenon: Strategies of Mutual Fund Families, 17 Rev. Fin. Stud. 677 677 (2004); Noel Capon, Gavan Fitzsimons and Russ Alan Prince, An Individual Level Analysis of the Mutual Fund Investment Decision, 10 J. Fin. Services Res. 59 (1996).
19. Barber et al. supra note 18.
20. John C. Coates IV & R. Glenn Hubbard, Competition and Shareholder Fees in the Mutual Fund Industry, American Enterprise Institute Working Paper (2006), available at (http://www.aei.org/publications/pubID.2457724577245772457724577/pub_detail.asp).
21. See sources cited supra footnote 18.
22. William P. Dukes, Philip C. English II & Sean M. Davis, Mutual Fund Mortality, 12b-1 Fees and the Net Expense Ratio, 29 29 The J. of Fin. Res. 235 235, 236 236 (2006).
23. Id.
24. Lori Walsh, The Costs and Benefits to Fund Shareholders of 12b-1 Plans; An Examination of Fund Flows, Expenses and Returns, Office of Economic Analysis, United States Securities and Exchange Commission Working Paper (2004). Much of the literature on 12b-1 fees has been referenced previously. For additional articles that include 12b-1 fees in their analysis, but do not focus on them per se, see Barber et al. (2005), Gallaher et al. (2006), and: Daniel Bergstresser, John M.R. Chalmers & Peter Tufano. Assessing the Costs and Benefits of Brokers: A Preliminary Analysis of the Mutual Fund Industry, Working Paper (2006).
25. None of the previously cited papers use data gathered after 2002, either.
26. We do not comment here on whether estimating economies of scale at the fund level is necessarily meaningful.
27. The data source used, CRSP, only provides data at the share class level prior to 2003.
28. While the model specification we used is largely similar to that used in Walsh (and the wider academic literature on fund flows), one element we added was to estimate the discrete effect of a fund charging some level of 12b-1 fees as opposed to not charging any 12b-1 fees at all. This allows us to distinguish between a fund moving from no 12b-1 fees to a small but positive level of 12b-1 fees, and a fund that already charges 12b-1 fees increasing those fees.
29. Both of these effects—that of adopting small fees, and further increasing those fees—were statistically significant.
30. Running the regressions year by year did show a positive relationship between 12b-1 fees and flows in the mid to late 1990’s, as has been found in the cited literature, but this relationship was not statistically significant. As noted earlier, aggregation at the fund level is difficult using CRSP data before 2 2003. To account for Walsh’s point that a share-class not charging 12b-1 fees might be affected by another class in the same fund which does charge the fees, we also ran the regressions for 2 2003-2006 only, and included a variable to indicate whether for a given share class any share classes in the same fund were charging 12b-1 fees. This variable was not statistically significant, and our overall results remained qualitatively the same. Our finding is not inconsistent with the results in the following paper, showing that funds with 12b-1 fees are more likely to disappear: William P. Dukes, Philip C. English II & Sean M. Davis, Mutual Fund Mortality, 12b-1 Fees and the Net Expense Ratio, 29 Rev. Fin. Res. 235 235 (2006). We conducted an analysis of fund exits similar to what was done in Dukes et al. (2006), extended to include the period 2 2003-2006. We also found that funds with higher 12b-1 fees are more likely to disappear (whether considering 2 2003-2006 only, or 1993-2006 altogether). Again, this finding is consistent with our inflow regression results.
31. Eric Savitz, Lipper Gauge—The Schwab Advantage: Running Funds Could Easily Pay Off Big for Discount Broker, Barron’s M 23 23 (May 14, 1990).
32. Id.
33. ICI Report, supra note 7.
34. Fact Book, supra note 13, at 55.
35. The principal-agent problem in the investor-investment advisor context was first examined by Laura Starks, Performance Incentive Fees: An Agency Theoretic Approach, 22 J. Fin. Quantitative Analysis (1987). The issue was further analyzed by Joseph Golec, Empirical Tests of a Principal-Agent Model of the Investor-Investment Advisor Relationship, 27 27 J. Fin. and Quantitative Analysis (1992). See also, Tomasz Bednarczyk & Dirk Eichler, Theory of Mutual Funds: The Effect of Principal Agency Conflicts on Mutual Fund Size, Working Paper, European Business School (2002); Wei-Lin Liu, Motivating and Compensating Investment Advisors, 78 78 J. Bus. (2005); Yoon K. Choi, Relative Portfolio Performance Evaluation and Incentive Structure, 79 J. Bus. (2006).
36. The following papers discuss the fact that portfolio turnover responds to short term investor pressure: William Lewis Randolph, The Impact of Mutual Fund Distributions on After-Tax Returns, 2 2 Fin. Services Rev. (1994); Li Jin, How Does Investor Short-Termism Affect Mutual Fund Manager Short-Termism, Working Paper (2005).
37. Walsh looks at the volatility of flows and cash balances to address the possible smoothing effects of 12b-1 fees, and finds inconclusive results.
38. The model specification was similar to what was used in the regressions for inflows—the only change being that lagged flows were now an independent variable, and turnover was the dependent variable. Again, we included both an intercept and a slope for 12b-1 fees in the regression. The intercept was positive and significant, while the slope was negative and significant, implying that a small level of 12b-1 fees might increase turnover, but as 12b-1 fees increase, eventually the effect is in the other direction. This is consistent with the theory that 12b-1 fees provide brokers with an incentive to reduce churning: a very small but positive level might not provide this incentive.
39. The SEC already may be moving in this direction and recently held a public hearing to consider rule proposals advocating the use of a short form, summary prospectus, among other proposals. See Notice of Sunshine Act Meeting available at (http://www.sec.gov/news/openmeetings/2007/ssamtg111507.htm).
40. This point is outside the general theme of this article, but in the Adopting Release, the SEC set forth a list of factors that directors should consider in determining whether to use fund assets fees for distribution. See Adopting Release supra note 3 3. The Investment Company Institute (ICI) established a Working Group that analyzed mutual fund distribution issues, including potential changes to Rule 12b-1. The ICI Working Group issued a report in May 2 2007, and as part of that report recommended that the SEC eliminate the Board factors from the Adopting Release since it forces the Board to focus on these enumerated factors rather than “other relevant, non-enumerated factors.” ICI Report supra note 7. See also SIFMA White Paper on Mutual Fund Distribution and Shareholder Servicing Practices, June 13, 2 2007, available at (http://www.sifma.org/regulatory/pdf/12b-1MFWhitePaper6-13-07.pdf).
    
    
    About the Author
Michael J. Sharp is General Counsel of Citi Global Wealth Management, Arun Sen is a Consultant, Debo Sarkar is a Senior Consultant and Elaine Buckberg is Senior Vice President of NERA Economic Consulting. Contacts: Michael.Sharp@citi.com, Arun.Sen@nera.com, Debo.Sarkar@nera.com or Elaine.Buckberg@nera.com.