You usually do get what you pay for. Unless, that is, you're paying someone to pick stocks or bonds for your mutual fund. Over the past three years, for instance, just one-third of the funds in Morningstar's database beat their benchmarks after adjusting for risk. Managers of all the other funds got paid for giving investors lower returns than they would've received from index funds.
If you're feeling generous, congratulate the fund industry for getting money for nothing. Otherwise, I'd like to tell you about an oddly named little fund family that, for its own survival, is taking a bold step in the right direction--toward pay for performance.
Based in the shadow of Massachusetts Institute of Technology, n/i numeric investors is a nest of quants whose miles of computer cable deliver a daily flood of stock and company data. Its four funds hold $265 million in assets, almost an afterthought to the $4 billion it runs for institutions. Last year, poor returns and the departure of star manager John Bogle Jr. put the fund family in a pinch. "I was naive about the fickleness of investors," founder Langdon Wheeler told me. When some funds faltered, many investors bailed out. "And if assets get small enough, you're paying for the privilege of running money," he said. So Wheeler nearly folded the fund operation.
FAILURE RATES. Instead, n/i last fall asked investors to adopt a pay-for-performance deal. In place of charging its flat 0.75% annual management fee on fund assets, n/i proposed to charge as little as 0.35% or as much as 1.35%. The actual fee would be set by how well or poorly each fund did against its benchmark index over the prior 12 months. For example, if a fund were to beat its benchmark by nine or more percentage points, n/i would collect a 1.35% fee (table). Each percentage point less in relative performance would lop a tenth of a point off the fee. If n/i failed to meet the index, it would get the minimum, 0.35%.
Investors in one of the funds, n/i Micro Cap, turned thumbs down. That fund has done so well that had its investors been paying for performance, they would have been hit for the full 1.35%. They're betting that they'll keep getting premium returns at a middling price. But holders of three other funds agreed, and next year the management fee they pay will be set by the returns they get. "We can take that risk," Wheeler said, "because we have the hubris to think that we can add value."
These aren't the only, or first, funds to pay for performance. At Fidelity Investments, fees on 34 funds with $325 billion in assets vary with relative returns. Ditto at 17 of Vanguard Group's 20 actively managed stock and balanced funds. Fidelity and Vanguard go n/i one better by tracking returns over three-year periods. That, said Vanguard principal Jeff Molitor, keeps managers from taking too much risk if they trail the benchmark late in the year, or from sitting on a lead if they get ahead early.
Yet these are exceptions. Among some 11,000 funds, Morningstar counts just 161 with pay-for-performance plans. While Fidelity's and Vanguard's plans penalize managers for trailing their benchmarks, few are set up, as n/i's are, to pay a minimum if they merely match their benchmark. If giant Fidelity Magellan, for instance, meets the Standard & Poor's 500-stock index, Fidelity gets its basic fee, now 0.57%, over twice the fee on its Spartan 500 Index Fund.
It's perhaps quixotic to expect a revolution any time soon in how funds pay managers. But I'll risk looking foolish with this modest proposal: Before any mutual fund's board of directors signs another advisory contract, it should ask, "What would it cost our fund holders to get the average returns promised by an index fund investing in similar stocks or bonds?"
In a few cases, such as funds pursuing exotic strategies or markets, a comparable index fund may not exist. Most funds, however, could set a comparably low minimum fee for mediocre--index-matching--returns. Higher returns could earn higher fees, as high as the market can bear. In other words, investors would pay for what they get. Can you imagine anything fairer?
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