Should Indirect Brokerage Fees Be Capped? Lessons from Mutual Fund Marketing and Distribution Expenses

Abstract

Theory predicts that capping brokers' compensation exacerbates the exploitation of retail investors. We show that regulated caps on mutual fund 12b-1 fees, effectively sales commissions, are associated with negative equity fund performance, but only after a structural shift toward maximum permitted levels of the fees around 2000. Past this break point, flow-performance sensitivity shifts from the middle-to the highest-performing funds, suggesting that the fee cap increases performance-chasing behavior by constraining brokers' incentives to learn about lower-ranked funds. The policy implication is that regulators must reevaluate the efficacy of caps on brokerage fees.

Should Indirect Brokerage Fees Be Capped? Lessons from Mutual Fund Marketing and Distribution Expenses

“…The regressors used in equation 5are described in the Appendix, and FUND_ALPHA is measured based on Carhart's (1997) 4-factor model and APB, as proposed by Hunter et al (2014). In model 3 of Table 5, we find a significant Table 5 provides the regression results of the impact of setting 12b-1 fees at the cap on subsequent fund performance.…”

“…Load Table 2 provides descriptive statistics for U.S. equity funds before and after 2000. The variable FUND_SIZE is the fund's total net assets (in $millions); ln(SIZE) is the natural logarithm of fund size; FUND_AGE is the number of years since the fund's inception; ln(AGE) is the natural logarithm of fund age; FAMILY_SIZE is total net assets at the fund management company level (in $millions); ln(FAMILY_SIZE) is the natural logarithm of family size; TURNOVER is the portfolio turnover of the fund, calculated by dividing average assets during the period by the lesser of the value of purchases and the value of sales during the same period; HERFINDAHL is a measure of mutual fund industry concentration; VOLATILITY is the standard deviation of a fund's net returns over the past 12 months; FUND_FLOW measures the percentage growth of a fund that is due to new investments, following Sirri and Tufano (1998); FUND_REVENUE is the expense ratio times the fund's AUM; FAMILY_REVENUE is the aggregate of fund revenues at the fund family level; 12B-1_FEE is the fee paid for the marketing and distribution of funds; NON_12B-1_FEE is calculated by subtracting the 12b-1 fee from the expense ratio; MANAGEMENT_FEE is the fee paid out of fund assets to the funds' investment adviser; EXPENSE_RATIO is the ratio of the fund's operating expense over total net assets; TOTAL_FEE is the expense ratio plus one-seventh of front-end loads; GROSS_RETURN is the monthly net return plus one-12th of the reported expense ratio; NET_RETURN is the monthly net of expense returns; and FUND_GROSS(NET)_ALPHA is the monthly fund's gross (net) returns adjusted using Carhart's (1997) This fragmentation of the industry at the fund level is consistent with the structural change in competition in the late 1990s, as reported by Wahal and Wang (2011).…”

“…18 Accordingly, we follow the approach of Hunter et al (2014), who account for commonalities in mutual fund strategies and the time-series correlation of residuals between individual funds. We use the Carhart (1997) 4-factor model augmented with an additional factor, called an active peer benchmark (APB), that represents an equal investment in all same-category funds. Similar to Hunter et al (2014), we use the "best-fit" primary benchmark, as assigned by Cremers and Petajisto (2009), to minimize the agency issue surrounding self-designated benchmarks, as documented by Sensoy (2009).…”

“…Our next step toward understanding whether retail investors are being sold poorly performing funds after the structural change in the charging of marketing and distribution expenses is to examine performance persistence before and after 2000. We follow the ranking/evaluation methodology of Carhart (1997), Bollen and Busse (2005), and Elton, Gruber, and Blake (2013) to examine the out-ofsample performance of mutual funds.…”

“…In Table 4, we find that (net-of-expense) alphas monotonically decrease from quartile 1 (top-ranked funds) to quartile 4 (bottom-ranked funds) for both funds charging 12b-1 fees at and below the cap during the pre-and post-2000 periods. For example, before 2000, top-ranked funds that charged 12b-1 fees at the cap exhibit a monthly Carhart (1997) 4-factor (APB) alpha of 5.1 bps (61.2 bps/year), while the second, third, and fourth quartiles exhibit alphas of −6 bps, −24 bps, and −13 bps, respectively.…”