Why Closed Portfolios Levy 12b-1 Is Open to Question

With the stock market rising for most of this decade, investors naturally pay less attention to 12b-1 marketing fees or, for that matter, any other expenses. When a fund is up 20% for a year, a 0.25% charge doesn’t loom very large.

But these 12b-1 fees, often controversial, are still eating into profits. And their persistence when funds are very large or closed is worth an examination.

The fees raise money that a fund company can use for promotional purposes, but that has been defined broadly. Originally, the fees were permitted because they can indirectly help shareholders by boosting a fund’s assets and giving it economies of scale. Such savings could be passed on in the form of lower expenses later.

So what actually happens when a fund is very big or reaches sufficient size that it decides to close its doors to new shareholders? Does the 12b-1 fee also disappear?

Usually not.

In fact, roughly three dozen mutual funds continue to charge the controversial marketing fees to shareholders even while excluding new investors.

Why do the fees persist? Other than the pure profit motive, it appears most of these funds are using the fees to replace sales charges. These are load funds that use the money collected to pay brokers and financial planners who signed up investors years ago. But even a few no-load funds charge them as well.

There’s nothing illegal about maintaining a 12b-1 fee on a fund that decides to close its doors to new money, although you certainly could argue that the practice violates the spirit of the law.

The fee, named for a section of the Securities and Exchange Commission’s rule book, was sanctioned in the early 1980s by the agency as a way to help funds promote themselves and attract shareholders at a time when most people didn’t know what a mutual fund was.

Investors benefit from a fund’s having more assets if fixed costs

are shared by more people. And more assets almost always are desirable for a fund’s management company, which pegs other expense fees to the amount of assets in a fund. (That latter factor explains why fund closings themselves are uncommon.)

Money raised by 12b-1 fees can be used to pay for advertising, marketing and other distribution costs. Merger Fund in Valhalla, N.Y., levies a 12b-1 fee of 0.25% a year, equal to $2.50 for each $1,000 investment, to pay for “record-keeping, sub-accounting, sub-transfer-agency and shareholder liaison services,� according to the prospectus. Merger is one of the no-load funds that have shut their doors to prospective new investors yet continue to charge a 12b-1 fee.

Incidentally, the SEC allows funds to call themselves “no-load� funds as long as the annual 12b-1 charge is 0.25% or less. Load funds can levy 12b-1 fees of up to 1%. Some observers argue for no-load funds as much for this reason as for the lack of a sales charge. (It’s also interesting that a few no-load funds have converted to load status recently. Although existing shareholders won’t be hit with a sales charge, they might not notice when the fund raises its 12b-1 fee.)

More than half of all mutual funds levy 12b-1 fees, and most of those charge in excess of 0.25% a year, says researcher Lipper Analytical Services in Summit, N.J. On funds that carry no 12b-1 fees, the management company pays distribution costs out of its own pocket.

The most controversial use of 12b-1 fees is to compensate brokers and financial planners for selling certain mutual funds and for servicing shareholder accounts thereafter. To a large degree, the prevalence of 12b-1 fees reflects a corresponding drop in the number of funds charging a hefty front-end sales charge, or load. Many investors are reluctant to pay a load, and 12b-1 fees are the mechanism that allows fund companies to get around that.

What typically happens is that a fund company will pay a broker or financial planner a commission shortly after a client invests. Rather than offset this cost by charging a load, the company will recoup its outlays gradually from money it collects from the 12b-1 fee.

The 12b-1 charge “reimburses us for the upfront loads to brokers that we put up,� said Eileen Davis, a spokeswoman for the Van Kampen American Capital family of funds in Chicago. “We’re just paying ourselves back, getting reimbursed for expenses already incurred.�

As noted, part of the 12b-1 fee, typically 0.25% or so, may be used to compensate brokers for providing continuing advice and guidance to a fund’s investors, whether or not they request it. This servicing portion of the 12b-1 fee is an ongoing charge and thus remains in force even after a fund closes its doors to new shareholders.

If you’re unhappy about paying a 12b-1 fee on a fund that no longer is trying to grow in size, there’s not much you can do about it aside from sell. Although a fund’s directors or trustees can vote to drop such charges, they rarely do.

A better bet would be to research each fund before you invest. By scanning the fee table in the prospectus, you can find out how much the fund charges, if anything, in 12b-1 fees. The prospectus also might indicate whether a fund closure is planned.

Existing shareholders often benefit when a fund closes its doors because too many assets--just like too few assets--can harm performance. But you don’t want to keep paying to boost a fund’s asset base when that no longer is an objective.

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The three dozen closed mutual funds that continue to charge 12b-1 fees include the well-known ones listed below (with category). Each charges a 0.25% 12b-1 fee as a percentage of assets:

* Aim Aggressive Growth (small-company growth)

* John Hancock Regional Bank B (financial)

* Heartland Value (small-company value)

* Ivy International A (international)

* Merger (mid-cap)