The Effect of 12b-1 Plans on Mutual Fund Investors, Revisited

Abstract

Rule 12b-1, adopted by the SEC in 1980, allows mutual funds, under specified circumstances, to assess asset-based fees in order to support distribution and advertising. 12b-1 fees are usually used in combination with a back-end load as an alternative to a front-end sales load for compensating professionals for advice and assistance provided to investors. Although 12b-1 plans are used widely by mutual funds, their benefits have been questioned. A number of papers (Ferris and Chance, 1987; Trzcinka and Zweig, 1990; McLeod and Malhotra, 1994; Sigglekow, 2000) have found a positive correlation between a fund's 12b-1 fee and its expense ratio, leading some to conclude that 12b-1 fees impose a deadweight loss on mutual fund investors. This paper revisits the effect of 12b-1 plans on shareholder welfare by studying holding-period returns instead of fund expense ratios. Holding-period returns have the advantage of incorporating the cost to fund shareholders of front load fees and deferred loads, as well as 12b-1 fees. Consistent with hypothetical results in Clark (1995), Livingston and O'Neal (1998), and O'Neal (1999), the empirical results in this paper show that the link between 12b-1 fees and holding-period returns is complex, as it depends on the investor's holding-period, the size of any front or deferred load, the size of the 12b-1 fee itself, and other details of a mutual fund's fee arrangement. For example, an investor with a short horizon will usually be better off paying a higher-than-average 12b-1 fee (and thus incurring a higher-than-average expense ratio) in order to avoid paying a front load. The paper concludes that, given mutual fund fee arrangements in place today, little can be said about shareholder welfare by looking at fund expense ratios in isolation from front and deferred load fees. Thus, earlier papers on 12b-1 fees may have little implication for the welfare of mutual fund investors.