A Fearful Symmetry

Tyger Tyger, burning bright,
In the forests of the night;
What immortal hand or eye,
Could frame thy fearful symmetry

– William Blake, “The Tyger”

Fidelity’s Abigail Johnson is in the FT today talking up fulcrum fees. Apparently Fidelity recently announced they would be launching a number of new mutual fund share classes with a fulcrum fee structure (details TBC). Here is Ms. Johnson:

Asset managers have typically charged a flat fee for active management. Most clients understand that even the best managers suffer some periods of underperformance measured over the long term.

Fulcrum fees would align the asset manager’s interests with those of the asset owner and encourage investors to remain committed to active strategies through the natural fluctuations in short-term performance

But is a flat fee fair, regardless of the value that is being delivered? Too often this model leaves us open to accusations of overcharging for mediocre performance. In a world increasingly dominated by index funds that allow cheap access to markets this is clearly unjustifiable. “Performance fees” are even more egregious. On top of the base fee, they add further charges when the manager does well — heads we win, tails you lose.

We need a fundamental rethink of the way asset managers charge their clients. Fulcrum fees have been used in the US since the 1970s — charges that rise when the fund outperforms, but fall by the same amount when the fund underperforms. Simple.

An important thing to remember is that it is generally not permitted under the Investment Company Act of 1940 for a mutual fund manager to charge a performance fee (e.g. the 2 & 20 structure common to hedge funds and private equity). If it were allowed, everyone would do it. Trust me.

However, the 1940 Act does allow symmetrical performance-based fees. In this structure, if the fund is outperforming its benchmark the manager’s fee is adjusted upward as a reward, while if the fund underperforms its benchmark it will be adjusted downward as a penalty. Later in her editorial Ms. Johnson acknowledges that despite being on the books for decades, this is not a popular compensation structure.

No kidding.

This is a classic issue of incentives. Fulcrum fees are bad juju for a lot of asset management businesses. Some old-but-good Vanguard data will show you why:

Vanguard_underperformance-chart.PNG

So according to this study, in a fulcrum fee arrangement 97% of these funds are going to get whacked with a performance penalty for a minimum of five years over any arbitrarily long time horizon. Meanwhile, if you stick with a flat fee based on assets under management you are guaranteed to collect your full management fee 100% of the time.

So why is one of the world’s largest asset managers now championing the structure?

My $0.02:

  • Investors are probably more cost conscious now than they have ever been. This is partly a function of academic research on the impact of expenses on investment results, but more so because investors have access to a proliferation of cheap investment alternatives (note: cheap does not necessarily equal better, though for the time being it seems most people are treating the two as synonymous).
  • Add to the above the fact that a lot of active funds aren’t as active as you might think.
  • On a totally anecdotal level, I would say investors are more aware of issues around conflicted advice as relates to investment manager compensation than they have been historically. Personally I attribute a lot of that to the internet and the number of professional and personal blogs devoted to personal finance and investing.

Fidelity isn’t run by idiots. In my view they are making the smart play. Better to get out in front and position yourself on the leading edge of investor-friendly compensation structures. It gives you some initiative in dealing with the business impact and will also provide some marketing ammunition, like investor-friendly editorials in the FT. Vanguard has been doing this for decades now and it has paid off in spades. I know this all sounds rather cynical but remember we are talking about trillions of dollars in mutual fund assets that are perpetually up for grabs.

Now over to William Blake for a pithy conclusion:

When the stars threw down their spears
And water’d heaven with their tears:
Did he smile his work to see?
Did he who made the Lamb make thee?

Tyger Tyger burning bright,
In the forests of the night:
What immortal hand or eye,
Dare frame thy fearful symmetry?

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