Ebook Dynamic Setting of Distribution Fees in the US Mutual Fund Industry
On 4 December 2002, in a remark to a roundtable on Investment Company Regulation at the Security and Exchange Commission (SEC), Joel Goldberg, former Director of the SEC’s Division of Investment Management at the time of the controversial approval of Rule 12b-1, stated that if a mistake had been committed by the SEC in promulgating this rule, it was that they “…did not foresee that payments out of fund assets would be used as a substitute for a sales load…. [I]t is just astounding that we never thought of it”. Since its inception in 1980, Rule 12b-1 has been designed to regulate when and how expenses for share distribution can be made by mutual funds. However, as observed by Freeman (2007), what started as a minor supplemental marketing boost available to mutual funds to garner more new money and support growth has become an industry addiction at the expense of fund shareholders. To give an idea of the economic relevance of the issue, the U.S. mutual fund market, with $12 trillion in assets under management as of year-end 2007, generated a staggering all-time high of $13.4 billion in 12b-1 fees. Furthermore, this figure does not even include the additional proceeds from front and back-end loads paid by fund shareholders.
The use and abuse of 12b-1 fees and front-end loads remains a controversial topic. Some studies have examined it by asking whether the introduction and adoption of 12b-1 plans have actually conveyed any benefits to shareholders (Ferris and Chance, 1987, McLeod and Malhotra, 1994, Sigglekow, 2004, and Walsh 2005). Another approach has been to investigate the hauling effect of distribution fees on the asset growth of mutual funds (Sirri and Tufano, 1998, Barber et al, 2005, Huang et al., 2007, Jain and Wu, 2000, Nanda et al., 2005). Despite the numerous studies cited above and the increased levels of public scrutiny, we are not aware of any work that has explicitly addressed the question of how mutual funds determine their distribution fees in the first place. What factors do management companies actually consider when they decide to alter their distribution fees? Is it possible to identify a strategy that management companies follow when making these decisions? These are the questions we aim to address in the present study.
Since the fees paid to fund managers are typically determined as a percentage of total assets under management, asset growth is generally a desirable feature from a fund managers’ perspective. The literature on mutual funds provides extensive evidence of a convex flow-performance relationship, where funds with recent brilliant performance receive disproportionate net inflows (Ippolito, 1992, Gruber, 1996, Chevalier and Ellison, 1997, Goetzmann and Peles, 1996, Sirri and Tufano 1998, and Lynch and Musto, 2003). Thus, good performance seems to be an effective route to asset growth. However, high volatility and low persistence of fund returns suggest that performance is not a factor that fund managers can easily control. Alternatively, in order to promote asset growth, a fund can manipulate its distribution system by means of 12b-1 fees and loads, which certainly are under the control of the management company. An effective use of the distribution channel could increase net inflows and generate higher revenues and possibly even higher profits. Fund managers may therefore be tempted to increase their distribution fees in order to have more resources for strengthening their distribution channels.
Since the past performance of a fund seems to play such an important role in flow allocation, a natural question arises as to whether the decision to alter distribution fees is independent of realized performance. Indeed, an increase in distribution fees may be more effective in some periods rather than in others for example immediately after an improvement in performance. Our first hypothesis is that past performance does play a significant role in the determination of distribution fees.
A second question relates to investors’ ownership costs. Clearly, any increase in distribution fees has a direct impact on the total cost borne by fund shareholders. This in turn may persuade existing shareholders to disinvest, as well as acting as a deterrent to new investment. With this in mind, our second hypothesis is that the decision to alter distribution fees, in an attempt to stimulate growth, is not independent of changes in other fee components (e.g. management fees) that ultimately affect the shareholders’ total cost of ownership.
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