There’s an old Arab saying: “If a camel gets his nose in the tent, his body will soon follow.”
It’s a great, funny metaphor. You can picture the curious nose of the camel poking in, then the neck and, before long, all the rest of it.
In English we would say “Give them an inch and they’ll take a mile.” In more prosaic terms, a small allowance is easily abused. Anyone who has children understands the problem of staying up just 10 minutes more on a school night. Pretty soon it’s an hour.
That’s exactly what’s happened with an obscure, easily-missed mutual fund fee. Decades ago, the U.S. Securities and Exchange Commission allowed mutual funds to extract a fee from their own investors to pay for marketing their funds to others, an arrangement rife with conflicts of interest.
It was a stopgap measure. Investors were leaving mutual funds in droves during the tough bear market of the late 1970s. The industry pleaded for help and the government provided.
Since people were leaving of their own volition by seeking redemptions, it seemed fair to ask the remaining investors to shoulder part of the cost of attracting new investors. Arguably, it was good for those that remained to try to slow the mass exodus.
Thus the 12b-1 fee was born. At first the costs were modest but, as The New York Times reports, the camel’s nose was inevitably followed by the rest of the beast. A once-obscure mutual fund fee last year cost investors $12.4 billion!
It’s amazing when you think about it. A fee meant to force investors to shoulder a portion of the marketing cost of a mutual fund turned over time into a juicy income stream of its own.
Perhaps the funds use it for that purpose. In some cases, though, the SEC finds that they do not and cracks down. But the startling fact is that the 12b-1 fee has survived through all of the bull markets since, when funds demonstrably had almost no need to market themselves.
Mass redemptions have long been unusual, except in cases of mismanagement. A long market rise has lifted all boats. Yet the 12b-1 fee stayed in place — and grew.
Finding mutual fund fees
What investors fail to take into account is that high advisory and mutual fund fees affect their returns drastically. If you look at your retirement accounts, you will find all kinds of costs associated with actively managed mutual funds.
There are many: trading commissions, fees for management (the actual stock picking), fees for the advisor who selects your funds and sales commissions, known as “loads.”
All of this movement in your account is meant to help you beat the stock market averages. Subtract the cost of all the fees, though, and that goal becomes increasingly elusive. It’s very hard to keep up with the indexes if you start out deep in a hole because of fees.
As Vanguard Group founder John Bogle often states, fees matter. At my firm, Rebalance, some of our clients choose to test drive our portfolios first. They might have several accounts, so they invest one or two with us in a portfolio that closely replicates what their actively managed fund advisors are doing.
As my colleague and Rebalance Co-Founder Scott Puritz recently testified before a U.S. Senate committee, the real cost of high fees soon becomes apparent. Inevitably, the weight of fees leads to fewer dollars in the actively managed account compared to balances held at Rebalance.
The camel is suddenly in the tent, and soon our client begins to think differently about retirement investing.