The Effect of 12b‐1 Plans on Mutual Fund Expense Ratios: A Note

Abstract

IN 1980, THE SECURITIES AND Exchange Commission approved rule 12b-1 which authorizes mutual funds to deduct a sum of money, called a distribution fee, from net assets, with the money to be paid to selling agents. Proponents of the plan argue that it offers incentives for brokers to sell the funds. The increase in the size of the fund then purportedly produces economies of scale. Opponents of the plan argue that it enables no-load and low-load funds to become de facto load funds while publicly proclaiming their no-load or low-load status.1 In addition, some load funds use the plan, and critics argue that their quoted sales charges understate the full impact of selling expenses. The plans have stirred considerable controversy in the financial press.2 Since 12b-1 plans are only sales incentives, they would be expected to have no effect on the mangement of a fund; thus, gross returns and risk should be unaffected. Unless the plan produces an offsetting benefit through economies of scale, the net effect on shareholders should be to lower net returns at the same level of risk. This study examines the effect of 12b-1 plans on mutual fund expense ratios. Previous studies [1, 2, 3, 4, 5, 6, 7] have looked at risk-adjusted mutual fund returns and have drawn some conclusions about the effect of expenses,3 but no study has attempted to explain how expense ratios differ in a cross-sectional sample of funds. By developing a model of factors influencing expense ratios, the impact of the plan can be examined simultaneously with such other factors as economies of scale. Section I provides more detail about the issue of expense ratios, identifies the model, and describes the data. Section II presents our results, and Section III provides a summary and conclusions.