In the market’s early days owning common stock was a bit of an elitist affair. Mutual funds democratized the investment process, enabling a wider range of socioeconomic groups to invest in markets and accumulate wealth over several generations.

Over time mutual funds faced increased competition from other investment vehicles. For example, deep-discount brokers and Internet platforms have made it far easier for individuals to purchase stocks, while exchange-traded funds have lowered the cost of pooled investment and improved transparency.

Now proposed regulatory changes could alter the competitive landscape in the mutual fund industry, though the Securities and Exchange Commission’s (SEC) announcement didn’t elicit the howls of protest that usually greet new rules.

A History of Reform

Section 12b of The Investment Company Act of 1940 prohibited mutual funds from acting as distributors of their own assets, save under limited circumstances.

Historically, mutual funds charged a front-end sales load to compensate third party distributors.

But after years of struggling to maintain their asset bases during nearly a decade of stagflation, many mutual funds upped the competitive ante in the mid- 1970s by introducing no-load offerings. This trend increased distribution costs and diverted assets from front-loaded funds.

By 1980 the fund industry convinced the SEC to amend Section 12b. Rule 12b-1 allows mutual funds to distribute their own shares and pay for these activities through a charge against the underlying assets.

Regulators had instituted the rule to enable new and smaller funds to attract investors. At first the rule had the intended effect, facilitating asset growth and reducing overall costs through economies of scale.

But over the long term the self-distribution rule became a loophole for increasing fee revenues.

These days most of the fees collected under Rule 12b-1 compensate intermediaries that sell shares in the fund, including fund supermarkets and other online distribution platforms.

Despite paying more than $9.5 billion in 12b-1 fees in 2009—an exponential increase from just a few million dollars in 1980—most investors have no idea what the fees are and, in many cases, don’t even realize they’re paying them.

This situation prompted SEC Chairwoman Mary Schapiro to characterize 12b-1 revenues as another form of compensation in a recent hearing.

Second Effort

On July 21 the SEC commissioners proposed new limits on sales charges that are based on a fund’s asset size.

At present, funds can charge asset-based sales fees against existing accounts as long as the fund continues to make new sales. Many investors, particularly those who own C-class shares, pay these charges as long as they hold the position.

Under the new rules, ongoing asset-based sales would be limited to the highest fee levied by the fund for shares with no ongoing sales charges.

That is, if the share class with the highest sales charge carries a 3 percent front-end load, no other share class can charge more than 3 percent over time.

Additionally, although funds can continue to charge a maximum annual 0.25 percent 12b-1 fee, they would have to more clearly identify the purpose of the charge in both the prospectus and transaction confirmation statements.

The second major proposal to come out of the SEC’s July 21 meeting could significantly alter how investors purchase mutual fund shares.

Based on rules put in place more than 70 years ago, brokers sell mutual funds under terms set by the fund itself. If you pay a 4.75 percent sales load when you purchase shares, the fund set this charge and disburses the collected money to the broker-dealer.

But the SEC commissioners proposed a new share class where the broker-dealer—not the fund—sets the sales charges.

Funds wouldn’t be allowed to deduct other sales charges from that class of shares, preventing them from sticking investors with a double whammy.

If approved, these changes would significantly change the way mutual funds are distributed—a major positive for individual investors. The proposed rules would force brokers that sell mutual fund shares to compete on price.

Outcomes

These changes will certainly cost fund advisers money; the price tag on asset-based sales charges alone will run into billions of dollars in short order.

But so far only a handful of folks have come out against the changes— tacit acknowledgement from the industry that the competitive landscape has changed dramatically over the past few years.

Although mutual funds are one of the most commonly owned investment products, that’s largely because they’re the only option in the overwhelming majority of retirement plans. But the day will come when that changes.

The other inevitable outcome is that costs will fall over time, a development that should attract more investors. And mutual fund performance should improve as expenses eat up a shrinking portion of returns.

In short, the SEC’s proposed rules would bring some short-term pain to the industry and catalyze a bit of consolidation, but the changes should be a net positive for both investors and the industry over the long haul.