Mutual Fund Fee Reform: A Multibillion-Dollar Sleight of Hand?

Would 12b-1 reform truly make fund ownership cheaper?


[See What 12b-1 Reform Means for Investors.]

While this all looks fairly clean on paper, its implementation could cause a number of changes in the brokerage industry. Here are some possibilities:

More 'churning.' Brokers sell mutual funds to investors. Currently, when brokers put investors in class C shares, they can count on receiving commissions in perpetuity. Under the proposal, though, they'd be cut off after a set number of years. As a result, some worry that brokers could, right before the ongoing fees expire, move their clients into new mutual funds and have the commission clock start over.

This commission-based trading is known as portfolio churning, and it could essentially transform the supposed reform into a multibillion-dollar sleight of hand, with fees that were supposed to disappear magically re-emerging. "If the [brokers aren't] getting paid that much anymore, maybe they'll just churn the portfolios more so they can collect more commissions," says Russel Kinnel, Morningstar's director of mutual fund research. "One would hope they wouldn't do that, but it's a possibility."

Currently, brokers can churn portfolios without fear of lawsuits. That's because, unlike registered investment advisors, brokers aren't held to a fiduciary standard. In other words, they only need to find suitable investments—as opposed to the best investments available—for their clients. Under the newly minted financial reform bill, though, the SEC is authorized to study and make changes to the standards to which brokers are held.

More competition. As part of the SEC's proposal, new share classes would be allowed to emerge in which brokers set the loads. Currently, brokers have their commissions dictated to them by fund companies. In other words, every broker who sells shares of a given fund receives the same percentage commission. By letting brokers set their own commissions, the SEC hopes that they will compete for clients by offering to undercut one another, thereby putting downward pressure on loads.

"The brokers could institute different loads," says Susan Ferris Wyderko, the executive director of the Mutual Fund Directors Forum, a group that provides outreach and education for the independent directors of U.S. mutual funds. "They would presumably advertise their rates along with explanations of what benefits the shareholders would get."

A middle ground. A lot about the new fee structure remains speculative. What's clear, though, is that even if the SEC gives the final nod to its proposal, brokers won't part easily with the billions in fees that they're used to collecting. Now that they won't be bringing in as much from loads set by fund companies, they'll have to find ways to generate them themselves. With the new share classes that allow them to set commissions, they have that opportunity. Competition will likely drive some loads down, but that could be offset at least partially by an increase in churning.

Bottom line: Smart investors know how much they're paying and where the money is going. Under the new rules, they'll be allowed to shop around for the cheapest loads and, if they put money in C shares, insist on keeping it there after the conversions kick in. Billions of dollars won't simply disappear into thin air, but overall, mutual fund investing could get a bit more affordable.