For many investors, mutual fund fees are among the largest hidden costs of investing. They can be confusing, too. Fund companies can charge investors a variety of fees, and according to this guidance from the U.S. Securities and Exchange Commission, some fund companies may not be characterizing their expenses correctly.  This should be a little alarming to those investors who think they have a handle on what the fees they are paying for holding mutual funds.  The problem lies in the murkiness of fee reporting by these funds, which are required to account for fees differently, depending upon what type of fee it is.  If it is a shareholder and record-keeping fee, it is called a “sub-accounting fee.”  If it was a fee that pays for activities that result in a sale of mutual fund shares, those are considered “distribution fees.”

According to “U.S. regulator warns mutual funds on mischaracterising fees,” a Reuters article published January 6, 2016, “Mutual funds may be misdirecting fees, which has the potential to hurt investors’ returns, the U.S. Securities and Exchange Commission said in guidance it released on Wednesday, after examining some mutual funds, investment advisers, broker-dealers, and transfer agents.”

In particular, the SEC raised questions as to whether payments characterized as sub-accounting fees where actually “used to pay for activities that are primarily intended to result in the sale of mutual fund shares.”

The SEC has been examining how mutual funds are handling certain fees but, in its recent guidance, the SEC expressed particular concern that the mutual funds’ actions could have a direct impact on investor returns, since many investors base their buying decisions on their understanding of what the funds’ fee levels are, so “potential mischaracterization of fees may lead [such investors] to invest in funds that they would not otherwise have selected.”

To further complicate this matter, the SEC regulations also limit the kinds of activities that can be expensed by funds to help generate sales of fund shares. These regulations are designed to help prevent conflicts of interest and the inappropriate use of fund assets towards compensating sales activity that goes “unreported” as a distribution fee.  This, too, can hurt investors when others recommend mutual funds without properly disclosing that they get compensation.

In the guidance release, the SEC called for mutual fund boards to put new processes in place to evaluate whether they are mischaracterizing distribution fees as “sub-accounting” fees and for advisers and other professionals to voluntarily inform boards when they find “certain activities or arrangements that are potentially distribution-related [existing] in connection with the payment of sub-accounting fees.”

We are pleased that the SEC is starting to focus on this issue, which has been one of concern to savvy investors for quite a long time. Unfortunately, with the barely noticeable corrections posed by the SEC, we don’t see much improvement in the level of either accurate or comprehensive reporting of fees by mutual funds changing for the better in the short term.

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