Mutual Funds, Advisors Go Pay-for-Performance

Filed in archive Investing on July 5, 2006

Ron Lieber at the Wall Street Journal; is discussing a couple of investments that let you pay based on the performance of your investment.

Lieber profiles the TFS Small Cap Fund:

TFS starts by setting a benchmark: Its goal is to beat the Russell 2000 index by 2.5 percentage points. If it hits that target, investors pay fees of 1.25% a year. For every additional 0.02 percentage point of outperformance, there is an additional 0.01 percentage point in management fees. So, if TFS beats the index by four percentage points, investors pay 2%. Fees are capped at 2.5%.

The process works in reverse, too. If the fund beats the Russell 2000 index by just one percentage point, investors pay only 0.5% in fees. If it merely matches the index or underperforms it, the fees drop to zero.

Lieber also profiles RK Investment Advisors, which does a similar thing for individual investors who work with them, although they do give themselves a chance for more upside if they do well.

Other fund managers who get paid a flat percentage regardless of performance grouse that these managers could make wild investments in hopes of inflating return, thus setting you up for greater risk (and greater losses, since they don't lose money if you lose money).

It's a valid counterargument, but for those of us who have paid to have others manage our money, only to see them do no better than the returns of a full market index, the pay-for-performance model certainly appears worth a look.