BOSTON – Critics of mutual funds have long maintained that one big problem with the entire investment genre is that the money manager gets paid even when the fund falls short of expectations.
So while management can talk about what it is doing to make money, the truth is that shareholders pay whether the fund delivers or not.
But a brand new fund has put a twist on that proposition, creating a fee structure that actually could leave management getting absolutely nothing if it can't deliver expected results. While this type of compensation structure — known as a performance fee — is hardly a new idea, seeing it done to the extreme should make investors wonder why it's not more widely available.
Moreover, it might have them looking at funds with similar performance fees.
To see why that is, let's examine the new TFS Small Cap fund (TFSSX) , the second offering run by TFS Capital Management of Richmond, Va. TFS is best known for hedge funds, although it has a market-neutral mutual fund that has done well throughout its 18-month history.
In hedge funds, managers are used to making money only if shareholders profit, so it wasn't a big stretch for Larry Eiben and his co-managers to bring that mentality to open-ended mutual funds. With the new small-cap fund, management's goal is not just to beat the Russell 2000 index, but to top it by 2.5 percentage points.
"Anyone can get an index fund — buying the benchmark — for pennies, so we don't feel we deserve much compensation for just doing as well as the index," Eiben says. "If we don't add value, we shouldn't get paid."
To that end, TFS established an unusual performance fee. If the fund hits the mark and tops the Russell by 2.5 percentage points, management collects the normal 1.25 percent fee. But for every 0.02 percentage point difference between the fund and Russell-plus-2.5, the management fee changes by 0.01.
In plain English, if the fund beats the Russell by more than 2.5 percentage points, management will be entitled to a bonus that, at its maximum, would double expenses to 2.5 percent (a level achieved by topping the benchmark by 5 percentage points). If management lags the index, however, it must rebate fees to the fund. While management can get paid if the fund loses money but beats the index, it gets nothing if performance matches or is below the Russell.
According to Strategic Insight, an industry research firm, less than five percent of all equity funds have performance fees. Janus recently added a sliding pay scale to some of its funds, and Fidelity and Vanguard have long used them for certain funds, but no firm has ever allowed fees to swing this wildly, or to risk going completely unpaid.
"A swing of 100 percent is unheard of," says Sam Campbell, an analyst with Financial Research Corp. in Boston. "From an investor's standpoint, this is the most attractively structured performance fee out there."
In fact, the TFS fee structure effectively would turn mutual funds into a meritocracy, where funds survive entirely based upon their ability to deliver. Investment companies keep thousands of mediocre funds alive because, quite frankly, shareholders keep paying; those funds won't move to a sliding scale any time soon.
Eiben says that TFS will give the new fund some time to show it can succeed, but it won't be around if management can't make money.
"We want to go long enough to validate that we can add value," Eiben says. "We're not afraid to go several years without compensation, but if we are consistently underperforming over an 18-month or two-year period and we don't think it's just a blip, we might liquidate the fund and tell investors they would be better off going elsewhere."
That's a far cry from fund companies cashing their checks for decades without a sniff of superior performance. Of course, TFS is so new to the fund business that the fee structure is one heck of a marketing ploy for a new and unproven fund.
Performance fees are not a panacea, and they can be tricky to get right. Late in 2004, the Securities and Exchange Commission came down on several firms — most notably Bridgeway Capital Management and Putnam Investments — for miscalculating sliding fees.
Eiben noted that the SEC took much longer than expected to approve TFS Small Cap.
Even with one fund willing to risk it all, investors should not expect sliding fee scales to become commonplace.
"It's a good way to align investor interests with management," says Geoff Bobroff of Bobroff Consulting in East Greenwich, R.I. "In funds that have a benchmark that really reflects what a fund is trying to do, it makes a lot of sense. That said, I don't think most managers will want to go quite this far in aligning their interests with shareholders."
Copyright (c) 2006 MarketWatch, Inc.