Money managers could escape big 12b-1 fee changes

Investors and analysts say money managers aren't likely to be slammed by a pending Securities and Exchange Commission review of 12b-1 fees they think will focus on improving disclosure, but regulators have left the door open for more far-reaching changes.

SEC Chairwoman Mary Schapiro has been promising a review of 12b-1 fees, introduced in 1980 to help a struggling mutual fund industry cover distribution and marketing costs, since she assumed her post in January 2009.

Noting that investors may have little understanding of what money managers are doing with 12b-1 fees, which have averaged more than $10 billion a year over the past five years, Ms. Schapiro said in a February speech, “We need to critically rethink how 12b-1 fees are used and whether they continue to be appropriate.”

Scrapping 12b-1 fees altogether would have a “huge impact”" on the industry, with the 25 basis points typically charged accounting for up to 25% of a fund company's overall fees for managing mutual funds, said Chris McNickle, a managing director with Greenwich Associates, and head of the Stamford, Conn.-based strategic consulting firm's investment management practice.

Sell-side analysts cite Franklin Resources Inc., Legg Mason Inc., Waddell & Reed Financial Inc. and Calamos Asset Management Inc. as firms that would be vulnerable if 12b-1 fees were eliminated.

A Feb. 25 report by Kenneth B. Worthington, who covers asset managers for New York-based J.P. Morgan Securities Inc., noted that 2009 12b-1 fees of $1.1 billion were collected by BlackRock, Inc., $596 million by Franklin Resources, $412 million by Legg Mason and $361 million by AllianceBernstein Holding LP.

In a March 30 report, Robert Lee, an analyst with New York-based Keefe, Bruyette & Woods Inc., noted that 70% of Waddell & Reed Financial's assets under management are in mutual funds which charge 12b-1 fees, followed by Calamos, at 49%; Franklin Resources, at 41%; Invesco Ltd., at 26%; Eaton Vance Corp., at 25%; Legg Mason, at 19%; and Federated Investors Inc., at 18%.

For now, most observers say they don't expect the SEC to kill 12b-1 fees outright.

With “entire distribution networks” built on 12b-1 fees over three decades, it's difficult to see those fees being swept away, or even changed in a way that would have a meaningful impact on profitability, said Mr. Lee in an interview.

Chances are, the SEC's review of 12b-1 fees will lead to “an increase in disclosure,” predicted John P. Miller, a senior vice president and portfolio manager with Chicago-based Ariel Investments LLC. Ariel holds three listed money managers in its portfolios: Franklin Resources, Janus Capital Group Inc. and T. Rowe Price Group Inc. Mr. Miller cited performance and high-quality management teams as decisive factors behind those investments.

Improved disclosure and increased transparency are the likeliest outcomes, agreed Michael Kim, an analyst with New York-based Sandler O'Neill & Partners, adding “the impact to the bottom line” of listed money managers probably will be negligible.

Analysts and investors note that money managers pass on the bulk of 12b-1 fees they collect to distributors, so any move to cut back on those fees would have the same effect as squeezing a balloon, with other fees rising to fill any gap created.

A surprise move to kill 12b-1 fees could result in a temporary jolt, but “companies would figure out ways to fund their marketing,” said John Carey, a senior portfolio manager with Boston-based Pioneer Investment Management Inc.

With the money that fund managers collect from 12b-1 fees ultimately flowing to distributors, eliminating those fees would likely have more impact on fund investors — who could face less tax-advantaged direct charges for those distribution services — than on the bottom lines of the fund managers, predicted Brian Reid, chief economist with the Washington-based Investment Companies Institute.

The SEC's Ms. Schapiro, in recent public statements, has left the option of eliminating 12b-1 fees on the table, and said the outcome of the commission's review won't stop at improved disclosure. Efforts to reach Ms. Schapiro were unsuccessful.

In an annual report on the outlook for the money management industry released March 25, Moody's Investors Services cited such regulatory uncertainties as one factor behind its decision to not lift its call from “negative” to “stable” for the coming 12 to 18 months. In an interview, Dagmar Silva, a vice president and senior analyst with Moody's, said while it's difficult to predict the industry impact decisions on areas such as 12b-1 fees will ultimately have, that uncertainty — on top of trends such as growing demand for lower-fee strategies such as exchange-traded funds and fixed income — adds to Moody's reluctance to sound an all-clear for the industry.

Mr. Worthington, in his recent J.P. Morgan report, conceded the SEC has talked about looking at 12b-1 fees before, but this time around “it seems more serious.”

If those fees are eliminated, more investors could shift to brokerage wrap programs, which would benefit money managers such as BlackRock, Legg Mason and Nuveen, which have the greatest penetration to those programs, he said.

In their reports, both Messrs. Worthington and Lee say eliminating 12b-1 fees would raise questions about whether mutual fund companies would have to start picking up some of those distribution costs, resulting in margin pressures. Attempts by fund managers to compensate by boosting management fees would require shareholder approval, according to Mr. Worthington's report, which concluded that some firms could see their margins lowered.

Even so, in the face of lobbying from industries subject to regulation, ambitious regulatory agendas in the past have ended up being “less extreme and more balanced,” and that's the most likely outcome in this case, Mr. Worthington said. He said investors should look at any selling pressure resulting from 12b-1 uncertainties as a buying opportunity.

For now, however, investors note that the prospect of 12b-1 fee changes hasn't been dominating the market. The stocks of Waddell & Reed and Calamos, which have some of the highest exposures to 12b-1 fees, have been among the best performers for the past six months, notes Matthew Lombardo, an analyst covering financial stocks for Victory Capital Management in Cleveland.

Overall investor flows for money managers remains the biggest driver for stock-price performance, and diversified firms with lots of international and global equity products have continued to lead the market this year, participants note.