Thanks to Securities and Exchange Commission (SEC) Rule 270.12b-1 of October 1980, mutual funds have the right to charge their investors for their advertising and marketing costs.
Many savvy experts and mutual fund consumer advocates, believe it's wrong for a mutual fund to charge their shareowners for their advertising. However, these fees are quite common. In 1998 John Bogle stated they were charged by 7,000 out of 12,000 mutual funds. In 2009 they're estimated to amount to $28 billion.
Prior to this ruling by the SEC, fund assets could not be used to market it. The common practice was for mutual funds to charge a front load to get in. These ranged from one to eight percent. This is money that was taken off the top of the investor's initial deposit. If they opened an account with $2,000, they'd pay up to $160 just for the privilege of opening that account. Much of that went to broker as a reward/commission for sending the new customer. And naturally this motivated the brokers to send more new customers.
However, this is one issue I'm not so sure I share Bogle's dismay at. For every other product you buy, you must, in effect, pay the costs of marketing it. If the company can't receive back the costs of marketing the product, it must take that product off the marketplace because the company is losing money.
I don't know any current figure, but traditionally for brand name consumer products from toothpaste to first run movies, from 25 to 33% of the price you pay went to recover the costs of marketing it to you -- TV commercials, radio ads, newspaper displays and so on.
I agree it makes good sense to avoid this. That's why generic products are so much cheaper than brand names. And where they're equivalent, that's what I buy.
I don't invest in actively traded mutual funds, because they have lots of other expenses I disagree with, but I can't contemplate objecting to any business for recovering its marketing costs.
However, there is another side to this issue. When consumers pay retail price for toothpaste (and thus pay for the associated advertising costs), they are not helping to create a future disadvantage to themselves. Maybe just the opposite -- because if a toothpaste becomes highly popular the cost of producing it goes down and so in the future the retail price might go down. But at least it won't go up because of the toothpaste's success.
That's not true of mutual funds. It's easiest for mutual fund managers to pick high growth stocks when they have only a small pool of money to place. When they're successful and lots more money pours in, it becomes much harder to find high quality, high growth stocks. Yet the manager has to invest that cash. They do the best they can, but they can no longer be as selective with a hundred million dollars as they were with ten million. And at one billion they're a closet index fund.
So the early mutual fund investors, by paying for the advertising to pull in new investors, lose future returns.
Is that fair to demand of them? Is it fair to ask a mutual fund family to keep a successful fund small? Some funds close to new investors, but that does put a cap on their profits.
This means basically that actively traded mutual funds are a kind of trap. If they beat the market, they'll attract lots of new money chasing hot funds, and their performance inevitably slows down. That's not good for either the new or old fund investors.
Therefore, my personal advice is to avoid mutual funds that take out 12b-1 fees, that charge loads, that take out excessive other management expenses, and which won't close successful funds to new investors. And don't chase hot funds.
