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Trailing Commissions: To 12b-1 or Not to 12b-1?
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Sure, 12b-1 sounds more like something you'd say while playing Battleship than while talking about investing. But a 12b-1 fee isn't kid's stuff. It's shorthand for money flowing out of your pocket (investors paid about $9.5 billion in 12b-1 fees in 2009, according to the SEC).
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12b-1 fees are named after a law passed in 1980 that allows your mutual fund to use part of your returns to pay for advertising, distribution, and other marketing costs. That usually translates as commissions for the broker who sold you the fund.
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Funds can actually charge two different kinds of 12b-1 fees. The first, called a service fee, can be as high as 25 basis points—that's 25 cents for every $100 your fund makes (one basis equals 0.01%; 100 basis points equals 1%) and is used to pay brokers for general services, such as answering your questions. The second, called a distribution fee, is really a commission, and can be as high as 75 basis points.
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Both load and no-load funds can charge 12b-1 fees, though for a fund to call itself a no-load fund, it can't charge more than 25 basis points. A no-load fund is mutual fund in which shares are sold without a commission or sales charge. Overall, nearly half the mutual funds in existence charge some sort of 12b-1 fee.
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Recently, there has been a lot of heated debate about the value of 12b-1 fees. They were introduced to help promote the fund and thus drive assets into it. The thought was that as assets grew, fund companies would lower expenses as they reached economies of scale. That hasn't happened and few investors are aware of these fees and how they are impacting their returns. As a result, critics are pushing the government to cap, limit, or even eliminate 12b-1 fees.
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However, even if you're extremely cost conscious, don't automatically exclude funds with 12b-1 fees from consideration. Instead, pay attention to what really matters: the total cost of your fund, to which 12b-1 fees contribute.
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