Image Credit: Christophe Vorlet
By Jason Zweig | Jan. 6, 2017 10:59 am ET
Let’s make a deal.
You give me your money, and I’ll invest it in the stock market. You take all the risk, and I’ll give you the reward. Well, most of it. Every year, I’ll collect 1% from you, even if you lose money on my stock picks. That 1% is as much as one-fourth of the expected long-term return on stocks after inflation. Trust me: I’m worth it.
If that deal sounds unfair to you, you’re right. But the investment industry has long offered clients fees that have nothing to do with performance. That’s changing, but not nearly fast enough.
Under federal rules, a mutual fund can raise fees when it outperforms if — but only if — it symmetrically lowers fees when it underperforms.
That so-called fulcrum fee helps put fund managers on the same side of the table as you. When you make more money, their fee goes up; when you make less, their fee goes down.
But managers overwhelmingly prefer charging flat fees that aren’t tied to returns. Only 211 stock or bond mutual funds with a combined $996 billion in assets, out of a grand total of 7,621 funds with $13.8 trillion in assets, charge performance-based fees, according to Jeff Tjornehoj of Broadridge Financial Solutions in Denver. That’s fewer than one in 36 funds, and less than $1 out of every $14 in total assets.
And that isn’t progress. Back in 1972, the Securities and Exchange Commission reported that 103 out of 999 funds, or more than 10%, were charging fulcrum fees.
In the private partnerships he ran in the early 1960s before taking over Berkshire Hathaway, Warren Buffett charged zero fees until returns exceeded 6%. He took 25% of any gains above that. Mr. Buffett also promised to penalize himself for underperformance: If he came up short of 6% in one year, he wouldn’t charge fees the next year until the partnership recovered the difference. A 5% annual return, for instance, would have to be followed by at least a 7% return the next year before Mr. Buffett could resume taking his 25% incentive fee.
Mind you, there wasn’t any year in that period when Mr. Buffett earned less than 6%, so he never had to forgo the fee. But he pointed the way toward a model of fairness that too few fund managers have followed.
Mr. Buffett told me by email this past week that he’s planning on writing extensively about fees in his widely anticipated annual letter to Berkshire shareholders, which will be released in a few weeks, and that he hopes “more clients will demand lower fees.”
Some investors argue that performance-based fees create an incentive for managers to take excessive risks in pursuit of a fee bonanza. But flat fees create similar motivations without offering any discount on the downside.
Researchers have found that funds with performance fees can earn higher returns and be less likely to buy overvalued stocks.
Finance professors at Cass Business School in London have argued that you should prefer fixed fees only if you can be certain — before you invest — that a fund manager is both extraordinarily skillful and willing to take plenty of risk. In all other cases, you’re better off with variable fees; if the manager turns out to be inconsistent or timid, at least you will have the consolation of lower costs during periods of underperformance.
Orbis Investment Management, a global firm headquartered in Bermuda that manages about $30 billion, charges its institutional clients a maximum base fee of 0.45% annually. In addition, the firm takes 25% of outperformance relative to the indexes it tracks — but sets that money aside as a reserve so it can also refund 25% of any underperformance.
Adam Karr, a San Francisco-based partner at Orbis, says the fee structure “creates more volatility for us as a firm” but is “much fairer for clients.”
AJO, a firm in Philadelphia that manages $29 billion for institutional clients, manages $11 billion of that using fulcrum fees. In some cases, AJO also reserves its outperformance fees in what Ted Aronson, the firm’s founder, calls a “holding tank” from which they can be refunded if performance lags.
He says the performance of accounts with and without fulcrum fees is roughly the same — but clients who have them tend to be more likely to stay put in market downturns, partly because they are more sophisticated and partly because they feel greater loyalty.
Only a handful of mutual-fund companies, including Fidelity, Janus, Putnam, USAA and Vanguard, use fulcrum fees. Almost no exchange-traded funds do.
In recent months, investors fleeing mutual funds have been dumping even those that have cut fees, replacing them with lower-cost index funds. Until managers cut costs further, investors will — and should — continue to desert them. Fulcrum fees are an old idea whose time has come again.
Source: The Wall Street Journal, http://on.wsj.com/2hXZxQE
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