As industry watchers debate the merits of proposed changes to the rules governing mutual fund fees, some fee-free funds are generating head-turning returns – and they won’t have to make big changes to comply.

The Securities and Exchange Commission has proposed a new set of rules to limit the onerous and sometimes vague fees that have raised the ire of many investors. The so-called 12b-1 fee is traditionally described as a marketing and distribution fee, although a large portion goes to financial intermediaries (like brokers, financial planners and advisors), who recommend and sell the funds.

The fee is named for Rule 12b-1, which was adopted by the Security and Exchange Commission in 1980 and allows mutual fund companies to draw from their assets to pay those investing professionals.

Different share classes charge different 12b-1 fees. Class A shares typically charge an upfront sales load and no 12b-1 fee, or a minimal one. Class B shares allow investors to skip the load but charge a ‘back-end’ load if shares are sold before a cutoff date, as well as a 12b-1. Class C shares might charge a higher 12b-1 fee but typically promise no load on the way in or the way out.

The fund industry says the fees have effectively expanded options for investors. “Since their introduction, Rule 12b-1 plans have provided an important addition to the choices investors have in how to pay for their fund shares,” according to the Investment Company Institute, and industry organization.

Critics of the 12b-1 fee say the ambiguity with which these and other fees are used has become too taxing on investors.

Under the SEC’s proposal, the 12b-1 fee would be renamed “marketing and service fee,” and limited to 0.25% of fund assets per year. Distribution-related expenses above that sum would be considered a sales charge, and fund directors would be spared the gymnastics of having to sign off on them each year, says Russel Kinnel is Morningstar’s director of mutual fund research.

Industry watchers like Kinnel say there are a variety of ways that funds will make up for the money they’ll lose with changes to fee rules and that such changes will not necessarily lower costs for investors or even make clear what they are paying for.

“The companies need to make up the revenue in some manner,” says Charles Rotblut, vice president of the American Association of Individual Investors. “Certainly any fund company is going to do as much as it can to increase assets under management, so they will be looking at fees to see if they can get back and make up for lost revenue.”

For this week’s Fund Screen, SmartMoney looked at the best performers of funds that already have a 12b-1 of 0.25% or less. Most of them (all but two) had no 12b-1 fee. We narrowed the field to those that were in the top 10% year to date and for the trailing three- and five-year periods for their peer group; received at least a five-star from Morningstar; and kept their annual expenses nominal. We were left with 44 funds and share classes. Below are the 10 that have performed the best, year to date.

The list included bond funds, growth and value funds that have kept expenses small.

The best year-to-date performer is the Fidelity Select Leisure Fund (FDLSX), which has 78% of its equity holdings in consumer services. Its top six holdings have returned more than 10% each this year, including a 30% year-to-date increase in shares of hospitality business Wyndham Worldwide (WYN), and a 23% jump in Yum Brands (YUM), which owns the KFC, Pizza Hut and Taco Bell brands.

Another that made the list was Parnassus Small Cap (PARSX). Manager Jerome Dodson shoots for companies that have or are growing economic moats, which proved beneficial during the market upheaval in 2008. But he’ll also invest in companies that don’t necessarily fit that bill if the stock is trading cheaply and its fundamentals are intact, like Electronics for Imaging (EFII), writes Morningstar analyst Katie Rushkewicz. The fund also uses social and environmental criteria in choosing investments.

Parnassus has benefitted from strong returns in two of its top three holdings, medical device company Cyberonics (CYBX) and network equipment provider Tellabs (TLAB), which are up 17% and 28%, respectively, for 2010.

The Criteria: The funds on the table have a minimum investment of $5,000 or less. They’re open to new money and charge an annual expense ratio no greater than 1.5%. In addition, their performance track records were in the top 10% year to date and over the trailing three- and five-year time periods for their peer group. All have five-star ratings from Morningstar, and as usual, we did not include load funds. Additionally, none have a 12B-1 fee greater than 0.25%.

Fund Name Ticker Assets (In Millions) Year-to-Date Return (%) 3-Yr Return 5-Yr Return Expense Ratio
Fidelity Select Leisure FDLSX 285 15.82 2.01 5.72 0.93
TCW Emerging Markets Income I TGEIX 634.2 14.5 13.58 10.94 1.17
Parnassus Small-Cap PARSX 229.8 10.16 3.73 6.88 1.2
Managed Account High Income MHINX 87.8 9.86 9.71 8.61 0
Vanguard Interm-Term Bond Index VBIIX 12100 9.6 9.05 6.8 0.22
Metropolitan West Total Return bond M MWTRX 10100 9.42 9.36 7.69 0.65
RidgeWorth Mid-Cap Value Equity I SMVTX 1100 9.17 2.12 7.05 1.03
Westcore Select WTSLX 176 9.05 1.68 8.11 1.15
PIMCO All Asset D PASDX 16800 8.96 5.72 5.39 1.26
Sequoia SEQUX 3100 8.95 -1.29 3.16 1.01

Published August 8, 2010

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