SEC SNIFFS AT MART COSTS: SUPERMARKETS UP AGAINST REGULATORS FOR FIRST TIME OVER 12(B)1 FEE DISCLOSURE

The Securities and Exchange Commission is taking a close look at the “shelf fees” fees charged by fund supermarkets – the one-stop shops that burst on the scene in the early 1990s to become one of the most powerful distribution channels in the mutual fund industry.

The fees, typically 25 to 35 basis points, are charged to fund companies by supermarkets like those at No. 1 Charles Schwab & Co. and No. 2 Fidelity Investments, which sell funds from many different groups under one roof. Since 1993, the amount of money in supermarkets has rocketed 615% to $186 billion, according to Boston-based Financial Research Corp.

“We’re in the process of putting together some kind of statement on fund supermarkets and the legal issues that surround them,” said Barry Barbash, director of the division of investment management, speaking at an industry conference last week in Orlando, Fla. “We’re analyzing how fund supermarkets are working.”

At issue is how the fees, which cover a combination of marketing costs and recordkeeping services, are disclosed to shareholders. SEC officials apparently feel shareholders shouldn’t foot the bill for a fund’s marketing costs without adequate disclosure – something fund industry watchers like Morningstar Inc. have been saying for years.

Under SEC guidelines, a mutual fund is not allowed to pay for marketing or distribution with shareholders’ money unless it does so through a specific fee, known as a 12b(1) charge. Otherwise the fund company – not the fund – must absorb the cost.

While critics of mutual fund supermarkets say the SEC’s inquiry is long overdue, many fear it will incite more funds to pass marketing costs on to investors, in the form of newly-introduced 12b(1) fees. And that may further inflate expenses. The minimum fund management fee, a major part of expenses, has increased every decade since the 1940s. (InvestmentNews, Mar. 23) Currently, about 63% of the 8,900 mutual funds sold in the U.S. charge 12(b)1 fees, which run as high as 1
% and average about 0.36%, says Chicago-based Morningstar.

In the interest of appealing to penny-pinching consumers, many funds sold through supermarkets do not impose such charges. At Boston-based Fidelity’s FundsNetwork, for instance, 70% of funds don’t have 12(b)1 fees.

study coming soon

“There may be – and probably is – a distribution aspect to the fees being paid to the supermarkets,” says Douglas J. Scheidt, chief counsel in the SEC’s division of investment management. “What other reason is there to be in a supermarket besides selling more shares?”

The SEC’s study won’t recommend any enforcement actions and is expected to be released “very soon,” Mr. Scheidt says.

The SEC’s impending report marks the first time the supermarket industry has come up against regulators. While fund networks have been around in some form for years, they didn’t take off until 1992 when Schwab introduced OneSource, which offers 1,300 funds. Schwab’s success lured others into the game, most notably Fidelity, Jack White & Co. and wirehouses like Salomon Smith Barney Holdings Inc., Merrill Lynch & Co. and PaineWebber Group.

The scrutiny affects not only the hundreds of fund companies that offer their wares through this medium but also San Francisco-based Schwab, which declined to comment until the SEC releases its report. An official at No. 2-ranked Fidelity Investments could not be reached by presstime.

still the best way

The growth in supermarkets has been driven not only by consumers but also fee-based investment advisers who trade through them on behalf of clients. Jack White, based in San Diego, charges fund companies 25 basis points; Fidelity charges 35 and Schwab bargains for a rate from 30 to 35 points. The marts also collect fees from investors and financial advisers.

“It’s very disturbing,” says Peter DiTeresa, associate editor of the Morningstar Investor newsletter. “The SEC is obviously striving for transparency in the fees, but there’s got to be a way of acc
omplishing that without encouraging 12(b)1 fees.”

The SEC’s snooping may also make it more difficult for the supermarkets to attract new fund groups since many would have to get shareholders to OK 12(b)1 plans.

“It won’t scare people away entirely,” says David Phelan, a partner in the mutual fund practice of Boston law firm Hale & Dorr. “A supermarket is still one of the best ways for a small company to get its funds out there.”

Besides making it easier for investors to buy funds, supermarkets help dozens of small funds compete against industry titans. Not every fund that lacks a 12b-1 plan and is sold through a supermarket need worry about the SEC’s soon-to-be-released report. Some opt to pay for joining a supermarket entirely on their own. Others divide the cost, charging the administrative portion of the fee to the fund and the distribution portion to themselves.

“It’s a complicated issue,” says Andrew Guillette, an analyst at Cerulli Associates in Boston. “There is obviously some ambiguity out there about the services the supermarkets are providing the funds.”