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Potential conflicts of interest in mutual funds.

Article Excerpt
The way that investors pay for the advice of financial professionals about their mutual funds has evolved over time. Approximately 80% of mutual fund purchases are made through broker-dealers or other financial professionals, such as financial planners and pension plan administrators. Previously, the compensation that these financial professionals received for assisting investors with mutual fund purchases was paid by either charging investors a sales charge, or "load," or by paying for such expenses out of the investment adviser's own profits.

However, in 1980, the Securities and Exchange Commission adopted rule 12b-1 under the Investment Company Act to help funds counter a period of net redemptions by allowing them to use fund assets to pay the expenses associated with the distribution of fund shares. Rule 12b-1 plans were envisioned as temporary measures to be used during periods of declining assets. Any activity that is primarily intended to result in the sale of mutual fund shares must be included as a 12b-1 expense and can include advertising; compensation of underwriters, dealers, and sales personnel; printing and mailing prospectuses to persons other than current shareholders; and printing and mailing sales literature.

The National Association of Securities Dealers (NASD), whose rules govern the distribution of fund shares by broker dealers, limits the annual rate at which 12b-1 fees may be paid to broker-dealers to no more than 0.75% of a fund's average net assets per year. Funds are allowed to include an additional service fee of up to 0.25% of average net assets each year to compensate sales professionals for providing ongoing services to investors or for maintaining their accounts. Rule 12b-1 provides investors an alternative way of paying for investment advice and purchases of fund shares. Apart from 12b-1 fees, brokers can be paid with sales charges called "loads"; "front-end" loads are applied when shares in a fund are purchased and "back-end" loads when shares are redeemed. With a 12b-1 plan, the fund can finance the broker's compensation with installments deducted from fund assets over a period of several years. Thus, 12b-1 plans allow investors...

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