The mutual fund marketplace is broken. Time to fix it.

Wall Street and Washington have it wrong. The most important debate today isn’t whether financial professionals should adopt the suitability standard or the fiduciary standard. The pros and cons have been argued ad nauseam; eventually, from D.C. to Main Street, we will all recognize the appropriate choice.

The more flagrant issue to address — and a relatively easy one to fix — is the mind-boggling array of share classes offered by many open-end mutual fund companies. Many share class variations offer no competitive advantage to investors. Many share classes exist only to hide fees paid by mutual funds to brokers in exchange for feeding them business.

While investment professionals understand the nuances of buying or selling an open-end mutual fund with a load, most individual investors are oblivious. The explicit cost of the sales commission never appears on an investor’s statement. Many investors are unaware of the impact that a load versus a no-load transaction will have on their portfolios. A 5.75% front-end load means that only 94.25 cents of every dollar gets invested, and this gap compounds over time.

MURKY SYSTEM

Unfortunately, this is just the beginning of the murky and complex open-end mutual fund system. How about an Energizer bunny commission, one that keeps on paying? In 1980, the mutual fund industry invented a new way to pay commissions and called it a 12(b)-1 fee. It is, in effect, a commission that pays not once, at the time of sale, but continuously. The fee is paid directly from the mutual fund company to the broker and goes on until the shares are sold. As with the loads, the investor is out of the loop in terms of seeing an explicit fee, and often unaware it exists.

Oddly enough, most of the legal requirements behind the mutual fund distribution system center on disclosure. As long as load and 12(b)-1 fees are described in the prospectus they are allowed. But, let’s be honest, how many investors read a mutual fund prospectus?

This isn’t a cottage industry. A single mutual fund may offer five, six or seven, some even 15 or more, combinations of loads and 12(b)-1 fees. The name of the fund will be the same in every case, yet again decreasing the fund’s transparency and increasing investor confusion. And the underlying assets will be the same. The only differences are the type and size of the loads and the kickback arrangement for 12(b)-1 fees.

Mutual fund companies, and brokers selling the funds, have successfully duped investors for years. As proof, look at the market for S&P 500 index funds. What’s a fair price to pay for a commoditized fund, such as an S&P 500 index fund? Despite virtually no difference among the funds, except for distribution and fees extracted, there were 92 funds as of Dec. 31, 2014, that tracked the S&P 500 index, and the annual expense ratios varied enormously. The highest expense fund, Rydex’s C shares (RYSYX) charged 2.32% per year, while Fidelity (FXAIX), in a price war with Vanguard, was the lowest at 0.02%. If there ever was proof that the market for mutual funds is broken, that’s it.

If you were buying a commodity, such as a bag of rice, would you expect to see some bags priced 100 times more than others? That’s what we see in the mutual fund world. Most of the high expense S&P 500 Index funds are offered by insurance company affiliates that pay up to 1% per year in 12(b)-1 fees to the selling broker. Would this be possible if clients were aware of these fees? It is like all the bags of rice seemingly sell for the same price, but some bags have leaks. How big are the leaks? There is more than $9 billion invested in S&P 500 Index fund shares with 12(b)-1 fees; the annual leakage comes to more than $21 million, and goes to only a handful of firms.

HUGE DRAIN

Compare a high expense S&P 500 index fund to a low expense fund over time and the drain on performance is startling. Take Vanguard’s Investor shares (VFINX) with a 0.17% expense ratio compared with Invesco’s B shares (SPIBX) with a 1.35% expense ratio. After investing $100 in each fund, over the 17 years the Invesco fund has existed, the Vanguard fund accrued 24% more wealth. It gets worse. In case an Invesco shareholder quickly discovers the bad deal, they face a 5% back-end load to get out.

Let’s stop this nonsense. The solution is simple: Eliminate 12(b)-1 fees and back-end loads and require front-end loads to appear on statements as an explicit expense.

Dave Umstead is founder and president of Cape Ann Capital Inc., a fee-only registered investment adviser founded in 1999. Jim Jasinski, a former UBS broker, joined Cape Ann Capital in 2009 and is now co-owner and CEO of the firm.